The Indian Demonetization Gambit

On the evening of November 8th 2016, the Indian PM Narendra Modi mounted an offensive, one that caught many off guard. Starting the very next day, currency notes of the 500 & 1000 Rupee denominations would no longer be valid legal tender. The high denomination notes can be exchanged by the end of the year, deposited in bank accounts or spent on government utility bills but each such transaction will require an ID proof. In the course of a 40 minute speech, PM Modi touched upon the need to tackle unaccounted and counterfeit money circulation and gave out a strong signal to tax evaders that the state can call their bluff and be a step ahead of them. I was just getting started for the day while on travel out of India and there I knew the first question of the following day’s meeting “How do you expect demonetization to work?”. Damn! I had 8 waking hours to think of an answer while income tax evaders in India counted their cash. I managed to get through that question with some spiel and logic that none of my education had prepared me for. In fact, getting away with the ego bruised was a good result in my own estimate. So, with the ego intact, I spent the better part of the evening watching America vote Trump into the presidency over food and drinks. Fortunately, I’ve had some time since then to compose my thoughts and this post is an effort at working through as many angles. Let me warn you that this is a long note and a mug of strong brewed coffee would surely help.

Before I get ahead, here’s an admission that I wish to make because I don’t believe in double standards. To date, I’ve refrained from airing strong views on politics in my blog posts but shall deviate in this instance. I believe that the Modi government’s move is a positive step, one that derails the Indian parallel economy’s most important survival tool – undeclared cash and counterfeit notes. It also has ramifications for the financing of terrorism from across the border. Yet, as is emblematic of Indian politics, leaders from a multitude of small and medium sized parties came out with their own reasons to oppose the move within a day of the announcement. Voices were loudest at the Indian National Congress that coincidentally has governed the nation for the longest period of time since 1947. The reason cited most often was that demonetization would cause inconvenience to the urban poor and rural folk, who have traditionally been neglected by the banking system and depend on cash transactions almost entirely. Other objections were centered around the use of higher denomination 2000 Rupee notes in the new regime and the process that would potentially ensnare large swathes of India in days to come. The latter was a bone of contention because there was hardly any time before the status of old notes went from legal tender to “sorry, not accepted”. Of course, exceptions were allowed for note usage at fuel stations, toll booths, hospitals and government utilities but it should be quite apparent that such places don’t help the corrupt to convert their undeclared cash into wealth. As reasons to oppose the move dwindled, political opponents and neo liberal commentators pointed to long lines at ATM’s and bank branches to bolster their views. Well, here’s my retort to all those who worry about the abrupt halt and suddenly develop strong economic opinions on how things ought to have been, while all they’ve done is searched Google and come upon instances of older (mostly dating to the 1800’s) time bound demonetizations in the US and a handful outside.

“You have the context all wrong and random events in economic history should not be relied upon without knowing the back story.”

Those regular demonetizations that figure in Google searches were not meant to harm anyone or take the wind out of anybody’s sails. To ensure that everyone had a chance to redeem old currency, legacy notes were gradually replaced with new ones, sometimes going on for decades at a leisurely pace. The current drive in India aims to do right the opposite. It aims to assertively break the back of the beast that is India’s robust parallel economy and it’s fuel – unaccounted cash, popularly known as black money. To get this effect, the clock is the government’s enemy and nothing but a sudden start and quick end can work. I’m reminded of a quote by Carl Von Clausewitz, a Prussian general and one of the greatest military strategists of all time.

“The backbone of surprise is fusing speed with secrecy”

Indeed, military strategy will also indicate that chaos in this case is not failure but a sign that damage is being inflicted. I’m not surprised at seeing long ATM lines. In fact, the sight of normal folk standing patiently in queue for new notes is proof of a very interesting postulate. Behavioural economists have shown that a significant percentage of people are not rational agents as the neo classical view of economics would make believe. That we’re as a group willing to pay real money or forgo something to punish people who take from a common pot but don’t contribute to it, especially when they have the means to do so. That fairness matters and we’re often willing to sacrifice economic well-being to enforce it.

I believe that some reservations on execution related risks are fair. That said, one ought to realize that the Reserve Bank of India is strongly in command of the process and they surely are not an incompetent bunch. Also, “the perfect is enemy of the good”.

Now, that I’ve made my stance on demonetization clear and with that also established my right of centre leaning, it’s time to pivot to other angles of the debate.

Framing the discussion

Let’s start with some basics and trust me, a lot of the data was confined to the archives until very lately. Surely not uncommon in a country where the parallel economy is recognized as a scourge but not worthy of scandal.

  1. India happens to be one of the most cash-reliant economies in the world with 87% transactions in cash. The cash economy is estimated to be roughly 23-28% of the economy (World Bank & others)
  2. The currency stock is worth 12% of GDP and half the value of bank deposits
  3. While rough estimates do exist, no one knows for sure how much black money is hidden in India and overseas. Estimates themselves range from $400 billion to more than $1 trillion.
  4. The black economy, which includes most of the cash economy as also black money that finds its way into other asset classes like gold and property (especially land), is significantly bigger – as high as 50% of GDP by some estimates
  5. India’s unorganized segments that fall outside the taxman’s gambit employ a huge chunk of the labour force (between 75-90% by some estimates) and are almost entirely driven by cash. They run parallel to the formal segment in a variety of sectors – consumer, retail, real estate & construction, agriculture, household services etc
  6. The total value of old 500 and 1000 Rupee notes in circulation (outside of the banking system) is around Rupees 12.2 Trillion. This accounts for roughly 85% of currency and notes in circulation or narrow money. Worth noting that the cash will now have to pass through banking channels to attain legitimacy. This makes the demonetization exercise the most aggressive ever, almost unprecedented in a time of high GDP growth

So, how is the present demonetization likely to impact the economy and importantly, how does one reconcile with cynical but valid counterpoints that consider it a temporary solution at best.

Positive macro benefits of the move

The term – black money in the Indian context refers to money generated via legitimate transactions but hidden from the authorities to avoid tax. The use of physical cash figures prominently in avoiding the audit trail. It’s only fair that we begin with the war on black money and the underground economy that runs on it because this move was targeted at crippling the same. There is no doubt that a level of pain, never before felt, will be inflicted on the black economy over the coming months. Of the old Rupee 12.2 Trillion worth (~ $ 182 Billion) 500/1000 notes in circulation, around 30-40% can be attributed to the black economy. Taking the mid-point of 35%, we arrive at a figure of ~ 4.3 Rupee Trillion ($ 64 Billion). There’s no doubt that consultants who travel back and forth on the black money value chain will find ways to save some of this. Even if one were to respect their expertise and ascribe a 50% save rate, the written off quantum is ~ Rupee 2.15 Trillion ($ 32 Billion). Yes, that is by conservative standards, a figure consigned to peanut wrappings (FYI, toilet paper is more sensational but we Indians really don’t relate well to ass wipes). Find me a middle class, sane Indian who considers this small fry. It’s a kick aimed at the nuts of the black economy.

But wait….what about the black economy itself? In a 1972 research paper, the Nobel Prize winning economist Kenneth arrow wrote

“Virtually every commercial transaction has within itself an element of trust”

When a trust deficit enters the equation, there is always pressure to jettison long held transaction systems, in this case the entire supply chain that processes cash without leaving a trail. Still on the topic of trust, the government has always been a step behind on enforcement owing to the agility of players who fashion loopholes and sustain black money flows. For those who continue to benefit from the black economy, the move, coming as it did after decades of inaction has been a big blow. Besides taking an immediate write off, they’re staring at an imminent depression in their business for months until the circulation of currency reaches even close to earlier levels. I’ve been at a loss to find gory examples that describe the loss. The scene in Francis Ford Coppola’s masterpiece – The Godfather, where a Hollywood producer sees his decapitated horse lying next to him is close enough.

My view is that no amount of ingenuity will help resume “transaction confidence” in the near term but one should not write it off altogether. There are analysts who argue that this move has only impacted the stock of black money. That flows will resume with new currency in due course. They’re right in assuming so. That said, one also should consider the trade-off involved because the vigour with which flows resume is going to depend a lot more on perceived loss aversion. The word plumbing is routinely used in the context of finance. Like plumbing in our homes, financial plumbing is vital but unglamorous and forgotten until something goes wrong. The black economy has its own plumbing, an entire infrastructure that underlies transactions by moving physical cash around. Demonetization just dealt a massive blow to it. The stink in there can be measured by a thought experiment. Prior to November 8th, the government had a four month amnesty scheme in place until September 30th. The Income Declaration Scheme 2016 unearthed undeclared income and assets worth Rupees 652.50 Billion (~ $ 10 Billion) that would be subject to penal tax at the rate of 45%. As per sources, collections weren’t robust enough. And this was probably true because evaders were short of benchmarks to seriously contemplate potential losses in a non-compliant scenario? Well, if the same amnesty scheme was to re-open in 6 months, expect a full house. I think this is the game changer. Behavioural economics lays a lot of emphasis on the theory of “loss aversion”. People are intrinsically afraid of losses. When compared against each other, they hate losing more than they enjoy winning. Where a loss could be ruinous or would threaten their lifestyle, they’d normally dismiss the option completely. Black money flows will in the near term bear the brunt of “loss aversion” and in all likelihood be the preserve of extreme risk takers alone. Meanwhile we should see an increase in tax compliance, collections and an improvement in the tax to GDP ratio. Indeed, the government may be blessed with some headroom to reduce the income tax rate. This is bound to increase disposable income and spur consumption demand in the medium to long term

Another net positive is that flows of money through the banking channel will improve significantly. As I compose this post, it’s raining deposits at Indian commercial banks. Sources place collections within a couple of days at around Rupees 6oo Billion (~ $ 9 Billion). The largest lender, State Bank of India accounted for nearly 60% of this. Most of these are low cost current and savings account (CASA) deposits on which banks pay an interest of 2-3% per annum. One should expect to see a surge in bank profits over the medium to longer term as their spreads get better on lower cost of funds. In fact, transmission of monetary policy was a big cause of concern for the RBI until the last policy review. Repo rate reductions were not causing bank lending rates to fall commensurately. Here in one swoop, flush with liquidity, banks have started dropping lending rates.

If the business press in India is to be believed, the real estate market will have to face the consequences of their own undoing. Some go so far as to paint a dismal scenario. I don’t think that’s entirely true. For the record, over the last decade, most large developers have institutionalized their finances. Even tier 2 players have raised capital from private equity and structured debt offerings. For them, dealing in cash has always been a liability. With an increase in size of the formal mortgage financed market for home sales, their cash collections have declined. What troubles them is the preponderance of cash in the land acquisition market, which is largely within the informal economy. As liquidity (in the form of a currency squeeze) dries up over the coming months and confidence in the black economy’s financial plumbing falters, we should expect land acquisitions to become cheaper. I foresee larger and mid-tier operators to benefit at the expense of landlords. Now, the jury is still out on whether home buyers will have a jolly good time in the following months. Well, the secondary market for homes has traditionally used cash, so that income could be hidden from capital gains tax. Expect a course correction as volumes move away from the secondary market, causing prices to decline. Primary market home prices will also be impacted but to a significantly lower extent. However, even this should help the formal sector provided the volume of home purchases increase.

Elephant in the Room

The elephant in the room is undoubtedly the Indian consumer. Unlike China India is not a heavyweight exporter and neither are we addicted to credit fueled investment (praise the lord). Consumption is the backbone of aggregate demand. Assuming that flows from the unorganized sectors (those that deal largely in cash) and the black economy will suffer, velocity of money shall take a hit and ripple effects shall be felt on consumption through the money multiplier. I’d reckon that this will be valid only for a brief timeline as legitimate currency gets back into circulation. For a brief period, consumption will be impacted as we’re already seeing a disruption in trade and supply chains.

John Maynard Keynes talked about the importance of “Animal Spirits” to stimulate an economy. Writing in his General Theory, he says

“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

Amidst the uncertainty that is inherent in the post demonetization regime, there is indeed a risk that the economy’s animal spirits will take a beating. It is but natural for entrepreneurs and employees in the informal economy to boost their savings and curtail an urge to consume and invest, fearing a recession. The government, as the single largest beneficiary of the exercise, will have to cushion the impact by increased spending because a short and sharp recession is an event whose probability just increased.


Lo and behold, we’re seeing a new architecture taking shape. I believe that demonetization is one of many compliance enhancing cleanup drives that we’ll see from this government. While this one is sensational, others shall fly under the radar. A price will be paid in inconvenience, and one has to hope it is short term pain. The sense of aggravation would have been acute before the days of Jan Dhan, Aadhar, Direct Benefits Transfer, mobile banking, mobile wallets, new payment bank licenses and other financial inclusion concepts. Despite the risk of a short recession, I view the move as a long term positive for a multitude of sectors – financials, Industrials, Real Estate, Commodities and Energy. The next 6 months will be very interesting and I hope to keep you posted. Ciao!

P.S: If you managed to get to the end of this note, the coffee still tastes good and you don’t feel sleep deprived I’d surely appreciate a share.


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