Demonetisation: Revolutionary Step Or Historic Blunder?

The Modi government's hit on black money may well go down as one of India's biggest economic blunders, or his greatest achievement. How quickly things will normalize remains to be seen. Whether one agrees with the move or not - it's implementation has surely been bungled badly and the collateral damage is likely to be heavy. 

Where did this idea originate? Surely the government's key economic advisors would have advised against it. Demonetization is usually associated with decrepit economies with hyper-inflation, such as Zimbabwe recently and Argentina in the past. The Argentine government demonetized several times in the last century and even changed its name from peso to austral and back to the peso - but each time it further reduced confidence in the currency. Myanmar, Ghana, the former Soviet Union, Nigeria and Zaire have also demonetised leading to devastating economic consequences. But in all cases, often done by military dictatorships demonetisation eroded confidence in the currency.

It is therefore surprising that a reform minded widely popular democratically elected Prime Minister has now resorted to demonetization - an instrument that has such an odious history. Even Arthakanti , the NGO in Pune from where the idea ostensibly emanated is distancing itself from a ham-handed plan to withdraw 85% of the country's currency overnight.

There is likely to be a one time stock effect on those who held black wealth or " Kala Dhan" in cash. But much of it sits in gold, real estate or is offshore. Estimates of Kala Dhan range, but the most commonly accepted estimate is around 50 % of GDP. Demonetization only affects black money not Kala Dhan. It's hard to get accurate estimates of how much of it is in cash, but estimates from previous raids show that it is in the range of 5-6 percent of Kala Dhan. Cash is easily transactable but because it's bulky it's hard to hoard too much of Kala Dhan in cash. So we are talking about 2-2.5% of GDP which is held in black money. If the government nets half of it through the demonetization , it's around 1- 1.5 % of GDP.

This is not insignificant but still leaves the bulk of Kala Dhan untouched. This is a stock effect - but the flow of resources into Kala Dhan is unlikely to be affected by demonetization and in fact over time even less of it will be held in cash, and more of it will be held in gold, real estate or shifted off shore.

The collateral damage from this move could be huge both economically and politically. The poor are already suffering - especially those in remote areas without easy access to banks, post offices and even the Information on what they need to do. The elderly may also be affected as they don't have the energy to handle the crush in banks and the long lines. But even more long lasting damage could be to trade and business in sectors where much of business is conducted in cash- especially in the informal sector and in rural areas which makes up close to 40% of the GDP.

The non bank financial sector on which many SME's rely for their short term finance have also been hit hard. As a result of the negative monetary shock the effect on the economic growth in 2016-17 could be as high as 1 - 1.5% of GDP which will neutralize any of the one-time gain from the demonetization. If an economic recovery was on its way , and good monsoons were going to lift up the rural economy, it's now delayed even further.

It is claimed that India's cash to GDP ratio at around 11-12 % of GDP is too high. But comparisons are made with countries at much higher levels of development , with much smaller rural and unbanked populations. China has a cash to GDP ratio of around 9.5 %of GDP , Germany at 8% of GDP and the US at around 7.5 % of GDP. In any case there appears no correlation between corruption and the cash to GDP deposit ratio. Nigeria widely regarded as one of the most corrupt countries has a cash to GDP ratio of only 3% of GDP, as faith in the currency has eroded badly.

The move will surely hit the fake currency (jaali notes) - those ostensibly coming from Pakistan or produced internally. But only temporarily as this is a short term effect as the new notes could also be reproduced soon. The challenge is to produce better currency which makes it harder and more costly to reproduce.

The Modi government was portraying India as the world's fastest growing economy. Even the new US president Donald Trump , during his election campaign , cited India as an example of dynamism. There was talk of making the rupee convertible within 5-10 years. Just as things were looking up , India suddenly looks like a decrepit economy with long lines of people desperately looking for cash.

In hindsight , to weed out black money more comprehensive reform is needed. It might have been better to go after sectors in which black money is known to be in heavy use such as real estate transactions, the movie industry, gold and jewelry, weddings and other "benami" transactions. Election financing is also heavily dependent on black money and needs a clean up. New notes could have been introduced , with old ones gradually phased out. Without cleaning up the reasons for black wealth just demonetizing will not address corruption or eliminate the black economy. Only less of it will be transacted in the Indian Rupee.

The Modi government should focus on getting a genuine economic recovery and job creation. More such ill thought through, badly implemented and moralistic policy prescriptions will get us back to the Hindu growth rate of 3-4 per cent of the 1970's and 1980's. Now that would be ironic for a BJP government.