Demonetization: Consequences & The Way Forward

The govt. has called the current demonetization move as a “surgical strike” on black money - building up on the military strike on Pak earlier - unleashing yet again the patriotic sentiment of the people. The Supreme Court averred that it is actually “carpet bombing” while hearing a PIL requesting for staying the move; a stay has not been granted though. Kejriwal & Mamata Banerjee, the two leaders with aspirations of leading an anti Modi front, have issued an ultimatum to the govt. to reverse the move in 3 days; perhaps protests shall follow.  As Abhishek Manu Singhvi put it eloquently, we are in a “scrambled egg” situation & recovery of the egg is, therefore, ruled out. It would therefore be prudent to think on way forward to ease the inevitable pain.  

That the demonetization plan was ill planned is a fact. How will once explain the spelling mistakes on the 2000 rupee notes?  Earlier we had news reports on Marathi misspelt & now it is Urdu’s turn. Terror funds have dried up says MOS Home Ministry, Kiran Rijuju & perhaps Naxals are hand tied. Relative peace in Kashmir, as per analysts, though could either be attributed to the shortage of Rs 500/- notes paid daily to the demonstrators or temporarily suspended due school examinations underway; only time will tell. Other details of whether demonetization is good or bad is analysed in the following article.

http://meetrk.blogspot.in/2016/11/demonetization-in-india-good-or-bad.html

As per an India Today report, India has a capacity to print 26.66 billion notes per annum in two shifts across 4 currency printing presses: Nasik (Maharashra) & Dewas (MP), Salboni (WB) & Mysuru (Karnataka).  India has demonetized 15.7 billion 500 rupee notes & 6.8 billion 1000 rupee notes; Arun Jaitley has indicated that there are no plans to re-issue 1000 rupee notes unlike the 500 rupee notes.  Therefore, if the 2000 rupee note replaces the 1000 one, we need to print 3.4 billion notes along with 15.7 billion of 500 notes for replacement. If the printing presses work for 3 shifts they can print 40 billion notes per annum & printing the 19.1 billion (15.7+3.4) would take about 6 months. Clearly currency worries would not end on 30^th Dec as the PM would like us to believe even if we incorporate the news that the 2000 rupee note printing started at Mysuru from Sept.

What are the options then?

Religious Trusts: The govt. has persuaded religious trusts to deposit small change into the banking network to help liquidity which is unlikely to be a successful intervention since only 14% of the overall cash economy is in small denominations & not all of the same lands up into places of religious worship. 

Mobile Payments:  87% of Kenya’s GDP is transferred vide “mobile money” & it would seem an enticing opportunity for replication. However, It is pertinent to note that while India has over 1 billion of its 1.25 billion population, with mobile connections, urban tele-density is about 150% while rural tele-density is only about 50%; clearly, 150% penetration in urban indicates multiple SIMs with the same person which alludes to the actual mobile penetration being less than a billion while rural penetration at 50% indicates that many are yet to be incorporated into the mobile revolution. Incidentally, 68.8% (86 crores) of the Indian population resides in rural which means about 34 crore people have no mobile connections. Perhaps they belong to the BPL (Below Poverty line) segment.

Furthermore, overall tele-density in states like Bihar, Assam etc. is under 60% & hence mobile option in such states is rather limited – rural or urban. Thus mobile payments or wallet options is thus a slow burn.

Use Plastic: As per the RBI, at the end of Aug 2016, India has 71 crores debit cards & 2.6 crore credit cards. India has about 25 crore households & the debit card fig indicates that each family has at least 2 cards; however averages mislead. It would be safe to assume about 30 crore people to be BPL (Below Poverty Line) – despite various figs being bandied about - & in all probability many of those people would not have either a Jan Dhan account of a RuPay card activated.

Even if the above argument is disproved, one cannot wish away the paltry count of ATMs & POS machines in the country.  As per the same RBI data, end Aug’ 16 India has 2.02 lakh ATMs & 14.6 lakh POS machines; 1/3^rd of India’s 2 lakh ATM are based in the top 60 cities & 60% are located in urban.  Clearly the rural economy would go cashless for many more days for their inability to access the bank network - branches or ATMs.

In Aug’16,  71 crore debit cards were used to dispense 2.19 lakh crores from ATMs & 0.18 lakh crores from POS machines vide 7.5 crore transactions & 1.3 crore transactions respectively indicating that less than 10% of the people could be using the cards; clearly, these people need to be educated on how to use cards. 2.6 crore credit cards have a better story but their nos. are small; they were used to dispense 0.03 lakh crores from ATMs & 0.25 lakh crores from POS machines vide 64.63 crores & 83.95 crore transactions respectively.  Thus machines would dispense only 2.65 lakh crores of the 14.5 lakh crores cash notes being demonetized; surely, the current infra would be inadequate to handle the additional rush. Add to that the fact that there are only 2000 engineers to re-calibrate the ATMs to dispense the new 2000 note implies that many of the ATMs are currently forced to dispense only 100 notes leading to the proliferation of serpentine queues; safe to assume that it would take 3-4 weeks for the recalibration work to conclude. 

Activating the 1.2 lakh banking correspondents, inadequate in number though, is a solution but the process would be excruciatingly slow.  Logistics problems abound in supplying cash even to the 1.5 lakh post offices across the country - 89.9% of which are in rural.

Go Online: Govt. has already asked PSUs & central govt. departments to make all payments possible online. Responsible citizens have also started doing the same which needless to say is welcome.

   

Engage additional Printing presses: Since reversal of the demonetization decision is foolhardy, the only option left is to arrange for printing across presses across the world; security however could be compromised.

Conclusion

If 25% ($500 billion) of the $2 trillion Indian economy is “black” & 50% of the $217 billion in value of 500/1000 notes are assumed to be part of the parallel economy, it is unlikely that the entire money would be forfeited. The govt., perhaps, believes that if about $40-50 billion is forfeited & the RBI transfers the same as a dividend, the same could be used for pump priming the economy. While the aim is laudable, lack of cash for 6 months would ensure that the infra projects, even if announced, would fail to take off.

The rural economy which is largely a cash based one would be in shambles.  APMCs (Agricultural Produce Marketing Committees) at many places have started refusing to buy edibles since liquidity squeeze at the destination markets have effected payments. Farmers now have an option to either sell directly to the consumers, perhaps, at huge discounts or allow the vegetables & fruits to rot. The situation would worsen once the Kharif crop is harvested; it is probable that prices would drop or farmers store till liquidity eases. Purchasing power in either case, in rural would be an unfortunate casualty.

The industrial situation in urban is deteriorating rapidly. MSMEs facing a cash crunch have started retrenching labour which could start an unfortunate spiral of migration back to the villages. Production is surely going to drop effecting exports further. The drop in GDP during the next 3 quarters, including the current one (Sept 2016 - June 2017) is therefore a certainty.

While demonetization was a politico- financial move – to break the back of political financiers, largely of the opposition apart from sending across a signal to the electorate that the govt. is serious in tackling black money - the lack of detailed planning to ensure a smooth transition is a worry.  Needless to say, the path to hell is often paved with good intentions.

Demonetization in India : Good or Bad?

PM Modi - who has an uncanny knack of managing the media narrative - announced on 8/11 that the 500 & 1000 rupee currency notes are being demonetised at the stroke of midnight; the media which was till then closely following the US elections was forced to immediately shift to a domestic capsule. Defense Minister, Manohar Parrikar, said later that this move would impact the opposition parties in the impending state elections; clearly, this action was not bereft of political motives. The spin on terror financing from across the border, though true,appealed to the patriotic sentiments of the people.

As per Ambit Capital about 1/5^th of the $2 trillion dollar Indian economy is “black” while others have pegged it at a more ambitious $1 trillion dollar (50%) parallel economy; safe to assume 25% ($500 billion). India’s cash economy is about 17 lakh crore rupees ($250 billion) & 86% of that – 14.5 lakh crore rupees ($217 billion)  – is in the form of 500 ($120 billion in value & 15.7 billion in no’s) & 1000 ($97 billion in value & 6.3 billion in no) rupee notes. As per the finance ministry, during the period 2011-16, while currency notes circulation increased by 40%, 500 rupee notes increased by 76% & 1000 rupee notes by 109%, suggesting that higher value currency notes might have an important role in India’s black economy. Since all the 500/1000 rupee notes are not “black” money & if we assume about $100 billion (about 50% of the 500/1000 notes in value) of such notes as “Black” this is only 25% of the $500 billion black economy. Clearly, more of the “black” money is not in a cash form.

With interest rates low, internationally, Indian black money is not hoarded in Swiss Banks but has “round tripped” to India vide the Mauritius & Singapore routes.  Participatory notes (PNs) – the opaque financial instrument – that helps people invest in the stock market without revealing their identity, is the other culprit. As per a Credit Suisse report the top 1% of Indian population hold 53% of wealth & the top 10% hold 76%; surely, if the black money has been invested in real estate, housing, gold, precious stones & securities, would it not make more sense to target the top 10% rather than inconveniencing the entire population?.

The cost of production of Rs 1000 note is about Rs 3.2/-, Rs 500 is RS 2.5/-, Rs 100/50 note is Rs 1.8/- & for Rs 10/- is Rs 0.96/-. Thus reprinting the same of of 500/1000 notes withdrawn would cost about Rs 6000/- crores. If all the 500/1000 notes are replaced with Rs 100 notes it would cost Rs 25400 crores; however the same is unlikely since some of the money would is re-issued in the Rs 2000 note form. Chidambaram has pegged the cost of transition at anywhere between 15-20000 crores & has argued that the action undertaken by the govt. should achieve at least the breakeven value.

Positives of the move:

Indian savings rate which about 37% of GDP in 2007-08 has dropped to 29% now while China is around 50%; a high savings rate can spur investment creating more jobs in the bargain. Since agriculture is a political hot potato that is not taxed, India has the dubious distinction of only about 5.5 crores(4%) filing income tax returns of which only 1.25 crores (1%) actually pay income taxes & another 1.25 crores pay TDS (Tax deduction at source); demonetization is a route to force those outside the banking net to come to the banks for conversion, thereby leaving a financial trail; if in the bargain savings rate increases it would be a double whammy. Bank account seeded with Aadhar could be used by data analysts later to spot rich farmers & track them.

Indians are experts at “Jugaad” & it was not surprising to read in The Hindu that some politicians of Kolar have distributed 3 Lakhs each to commoners as an interest free lean for 6 months with the directive to get the same exchanges at the banking networks; India Today carried a report where touts offered to exchange the notes at a 40-60% discount.  The govt. seems to have moved in quickly to stem the same by introducing a 200% penalty which implies that a person in the 30% bracket shall pay another 60% as penalty, leaving only 10% as white money. Penalties have the potential of increasing taxes for a govt. 

The most positive aspect of a shrinking cash economy is less cash chasing goods & services which translates into reduced inflation & hence interest rates, a key demand from the corporate sector.

Negatives of the move:

P Chidambaram has argued that fake notes account for 0.07% of the entire cash economy & hence using a sledgehammer approach is unhelpful.  For those who have attributed this as a step to tackle terror, data suggests that fake currency from Pak flowing into India vide the Nepal & Bangladesh routes is about 400 crores per annum only – a pittance.  

As per the National Institute of Public finance & Policy report released in 2012, when the Janta govt. in 1978 withdrew the 1000, 5000 & 10000 rupee notes only 15% of such notes were exchanged for fear of penal action. Burma implemented it badly in 1987 leading to riots & a coup followed in 1988. While a coup is unlikely in India the social situation should be closely monitored.

As per the former chief statistician of India, Pronab Sen, with 86% of value of money in circulation withdrawn, the economy will have to make do with only 14% of money in circulation at least for two weeks, until when there are restrictions on withdrawing money would ease, effecting a chain reaction that could drop GDP growth by 1% this year

Conclusion

Modi had promised in his election rallies that he would tackle black money struck abroad & usher in 15 lakh into every bank account which Amit Shah later attributed to as an “chunavi jumla”; this statement had been attacked by the opposition & has effected the image of the BJP & the PM. Non action in the HSBC accounts case has convinced some that the govt. is not serious in bringing the issue to its logical conclusion. The spin doctors of the govt. would argue that the income disclosure scheme announced by the govt. in the last two years has netted about 75000 crores & the current move is an extension of the same resolve to tackle the parallel economy.

If the PM is indeed serious he should immediately announce that the BJP shall declare every paise collected as electoral funding on its website unlike the current practice where parties hide behind the clause in the Representation of peoples act that mandates declaration of only amounts above Rs 20000/-, ensuring that about 80-85% of collections remain undeclared. That would not only lead to an image boost but usher in genuine electoral reforms.

The reintroduction of the 500 & 1000 notes is questionable & the introduction of 2000 notes surprising. If indeed black money is stored in the form of high denomination notes, making it easier by launching a 2000 rupee note is perplexing.  

Cash to GDP ratio in India, as per a MINT report, is 10.86%, much higher than other major economies at 4%. If the intention of the government’s move is to transition to a cashless economy, creating infra should have been the first step.  The POS terminals, mobile wallets & ATMs per million of population is much less in India as compared to other economies. NSDL was inaugurated in 1996 & it rolled out infra before SEBI pushed for dematerialisation. Incidentally, UPI (unified payment interface) system is likely to be fully operationalized only by January 2017.

Clearly, the measure is meant to send across a signal to the population that the govt. is indeed serious in its intentions. It is also a political strategy to hurt the treasury of other political parties in the impending elections. Surely, the PM proves again that he is politically astute even though he is a self-confessed economic illiterate.