The fallout of demonetisation: India’s deepening crisis and the struggle for recovery

As details slowly emerge of how unplanned and unprofessionally handled the demonetisation move was, it is clear that the scale of the disaster is only just becoming clear.

Published : Jan 18, 2017 12:30 IST

Farmers at Medha village in Kadi,  near Ahmedabad in Gujarat, feeding tomatoes to livestcok on January 11. Tomato prices dropped after demonetisation, sinking growers into a crisis.

Farmers at Medha village in Kadi, near Ahmedabad in Gujarat, feeding tomatoes to livestcok on January 11. Tomato prices dropped after demonetisation, sinking growers into a crisis.

TWO months after Prime Minister Narendra Modi embarked on demonetisation, the country’s biggest-ever economic misadventure, millions of Indians are still waiting to see the benefits, if any. Meanwhile, although the sheer physical shortage of cash appears to be easing, albeit at a slow pace, datasets from several sources indicate that the economy is sliding dangerously into a deeper crisis.

In the face of evidence pointing to a badly mauled economy—and an even more badly dented credibility of the Modi government—it now appears that the establishment is preparing to pull out all the stops to limit the enormous damage caused by a move that has severely hurt the reputations of institutions such as the Reserve Bank of India (RBI) and of cardinal principles of democratic conduct, such as those prescribing collective responsibility of the Union Cabinet. Modi provided an indication of this in his New Year Eve address to the nation in which he announced a slew of measures. Many of them smacked of tokenism and, properly speaking, may have found expression in Finance Minister Arun Jaitley’s budget, which is due to be presented soon.

Meanwhile, information that has been trickling in provides an insight into the shocking manner in which the country’s central bank has been trifled with by the Modi government. Such information is slow to come because of the completely opaque central bank and Finance Ministry; it comes through the route of a slew of Right to Information queries and in response to questions by parliamentary committees. It has been revealed that on November 7 the RBI was “advised” by the Modi government to withdraw the legal tender of Rs.500 and Rs.1,000 currency notes.

Modi made the demonetisation announcement in a televised address to the nation on November 8. So in effect, the central bank was given a day to decide on the move. The objective of the exercise was to eliminate counterfeit currency, end terror financing and combat black money. As the Modi government shifted goalposts continuously after November 8, the nation’s march towards a “cashless society” became an additional objective. With barely a day to prepare for the move, the RBI was forced to urgently convene a meeting of its board. The board met on the afternoon of November 8, and just three of the RBI’s independent directors attended. However, since the government’s own nominees were present in full strength, there was hardly any scope for sane reasoning.

These revelations give the lie to the claim by several Ministers that the RBI had cleared the proposal. The RBI, on the contrary, hardly had any time to consider the proposal with any degree of seriousness or to provide counsel on the sheer physical challenge of printing enough currency to fill the void that would be caused by the withdrawal of over 86 per cent of the value of legal tender in circulation. The revelations also indicate clearly that Modi, most likely in his singular capacity, drove the demonetisation tank through the political and economic establishment. In other words, the evidence now available indicates that neither the central bank nor the political establishment was even allowed, let alone consider, other possible options to achieve the officially stated objectives of demonetisation.

An opaque regime

Two weeks after December 30, when the period allowed to citizens to surrender their outlawed currency holdings ended, the country is still waiting to know how much has been mopped up. The RBI has said it is still computing the data on how much money has flowed into banks. However, according to the RBI’s own data released earlier, the overwhelming proportion of the old Rs.500 and Rs.1,000 notes are expected to have been surrendered—almost 97 per cent. Ironically, while this would appear to signal a successful campaign, it is embarrassing for a government that has identified the adventure with a “war” on black money. As the RBI and the Finance Ministry continue to peddle the bewildering argument that they need to eliminate “double counting” to arrive at an exact tally of how much has come back into the banking system, one cannot but wonder that a modern nation that prides on its IT prowess should take two weeks and more to compute a final tally. Speculation by diehard sceptics that the undue delay is aimed at allowing the regime to fudge statistics may be forgiven, given the establishment’s own blackout of data that are normally and regularly in the public realm.

Meanwhile, the stubborn refusal by the RBI—and the Finance Ministry—to provide any data on how much of the huge void that was caused by the sudden and massive withdrawal of legal tender has been filled continues. It is significant that the central bank has, during the course of more than two months, not even once made an attempt to inform citizens about how, and at what pace, it is filling the vacuum caused by the demonetisation move in the Indian currency regime.

However, the January edition of RBI Bulletin, published recently, provides some idea of how far the void has been filled. Statistics from the publication reveal that the value of currency in circulation was Rs.9.14 trillion on December 30, 2016, the last day for the surrender of the outlawed currency denominations. Although there is no disaggregated denomination-wise data available in the publication, it shows that only a little over half the value of notes in circulation in March 2016 has been replaced (see graph). No facts have been placed on public record since November 8, but the obvious reality is that the new Rs.2,000 note accounts for the overwhelming portion of this value. This implies that India’s cash crisis is going to end later than sooner. The introduction of the new Rs.2,000 note was an obvious exercise in solving a supply-side problem, one of quickly printing enough notes to stem the collapse in cash values available in valid currency. But its introduction, instead, compounded the problem because additional volumes of currency of lower denominations needed to be printed, merely to provide support to the new denomination that only the desperate want to hold.

Two other pronouncements since November 8 have aggravated the uncertainty about the Indian currency regime’s future. The first, by Jaitley, soon after Modi’s announcement, was the specious plea, backed by no credible data, economic logic or even plain common sense, that the entire value of outlawed currency need not be replaced because Indians, egged on towards a cashless future, would simply need less cash to stay afloat. The other, made by Modi government acolytes, was that the Rs.2,000 note had only a “stop-gap” role to play and would itself be demonetised in due course.

Hemmed in by the extreme criticism that demonetisation has destroyed livelihoods in a wide spectrum of industries and occupations across the country, the Modi government has clearly shifted gears to damage-limitation mode. While Modi’s speech on December 31 was aimed towards this end, it is clear that there will be other moves in the same direction. Among these is the manner in which banks, ostensibly flush with funds in the wake of demonetisation, have been nudged to lower interest rates. There are at least two problems with such an approach. First, banks now have excess cash simply because one of the two taps at its command, the one allowing withdrawals, has been virtually shut for more than two months, even as the other tap, which enables deposits to flow in, has been open. It is obvious that only an extraordinary fiat by the government could have engineered this situation and it cannot last in perpetuity. Second, there is no case for a euphoric welcome to a marginal decline in interest rates. It is not as if large sections of industry, or those engaged in a range of activities, are staying away from investments simply because they are waiting for interest rates to drop. Instead, collapsing livelihoods, shut factories, and migrant workers heading homeward are, at the very least, indicators of extreme distress. At worst, they are an indicator of extreme gloom about what the future holds. To expect that a marginal—and temporary—reduction in interest rates would spur investments is not just a surrender to hopeless fantasy: to the political cynics in the Modi government, it is another “jumla”.

Indeed, the same edition of RBI Bulletin (page 35) cited earlier provides strong evidence of across-the-board decline in credit to industry during the current financial year so far compared with the same period of 2015-16. The only exceptions among the more than 30 industry categories listed by the RBI are tea and road projects. Overall lending by banks to industry has declined by 5.5 per cent in 2016-17 (until November 25) when compared with the same period of the previous year. Among the worst hit are food processing industries, which have declined at an overall rate of almost 16 per cent in the current year. Textiles have declined by almost 10 per cent, petroleum and coal by almost 5 per cent, chemicals by almost 9 per cent, engineering goods by almost 5 per cent, gems and jewellery by more than 7 per cent and infrastructure by almost 7 per cent.

Digital payments and avarice

The recent episode involving some private banks’ move to charge petroleum dealers a merchant discount rate (MDR), apart from the charges they levy on consumers, is an indication of how avarice is a key motive for moving towards digital payments. The imposition of MDR was opposed by the dealers, who threatened to shut pumps across the country in protest. The intervention of the Petroleum Ministry staved off a possible crisis for now, but the issue is a stark reminder of how the Modi government has placed the cart before the horse. Instead of putting in place a regulatory regime for such transactions, which would set the terms on which such transactions can proceed, ensuring privacy, punitive action against wrongdoing by digital service providers and a robust network that would guarantee a degree of certainty in transactions, the government has pushed an unprepared country to the brink of chaos.

Amartya Sen, who had been a critic of the demonetisation drive, pointed out that these days “the RBI doesn’t decide anything”. Two former RBI Governors, Bimal Jalan and Y.V. Reddy, both of whom were at the helm of the central bank at times of serious economic challenges, have also criticised the move. Jalan has pointed out that the extreme haste with which demonetisation was unleashed was rationalised on the specious plea of maintaining secrecy. He has argued that giving prior notice to black money holders would have had exactly the same impact that has been felt since November 8—a rush to deposit the demonetised currency in banks. In any case, the real test of the regime’s ability and will to track and punish illegal wealth holders lies in the efficiency and intelligence with which it pursues and tracks the flow of such incomes. Y.V. Reddy has focussed his attack on the “reputational risk” that the central bank has been put to and about the “damage” inflicted on the RBI’s “identity”.

The immediate impact of demonetisation is certain to be felt in two key realms in the near future. Although the annual budgetary exercise is ostensibly an economic enterprise, it is highly likely that the next edition would bear a heavy imprint of the Prime Minister. More tokenism will certainly be on offer this year as Modi desperately tries to woo a country that has been wrecked by an idea that has exposed the government to ridicule and much worse. Significant tax concessions for industry and wealthier sections of the middle and upper middle classes are likely. Modi’s renewed faith in “populism” will also be driven by the explicitly political need to engage with voters in several States—mainly Uttar Pradesh and Punjab—where his popularity will be electorally tested for the first time after the disaster of demonetisation.

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