Spinning a web

ON August 30, after almost 10 months of waiting, India finally got to know what happened as a result of its biggest economic adventure, euphemistically termed demonetisation. Tucked away deep inside the Reserve Bank of India’s (RBI) Annual Report for 2016-17 were a few nuggets of information that revealed the travails of the Indian currency, which the central bank, with some cooperation from the Union Finance Ministry and Prime Minister Narendra Modi, had kept carefully hidden away from a nation that went through and is still going through a crisis of unprecedented proportions.

The troika has added newer and newer dimensions to its explanation of the logic of demonetisation as the magnitude of the crisis spreads far and wide. Initially, it was about an assault on black money, which Modi and his supporters claimed was hoarded as cash, especially in high-denomination notes. This explained the November 8, 2016, decision to demonetise high-value currencies—the 500- and the 1,000-rupee notes. The RBI’s report reveals that almost 99 per cent of the two denominations came back via the banks, raising the question, If all the money came back, where is the black money? In fact, if the banned notes in the possession of the cooperative banks and those in Nepal are accounted for, almost all the money in these two denominations are back safely with the government.

Soon after demonetisation, as it became anecdotally evident that most of these notes were returned via the banking system, the narrative of the logic of demonetisation shifted to replacing the evil of cash with the more “modern” digital payments for conducting financial transactions. Still later, when evidence revealed that this was not happening, the narrative shifted to how demonetisation was resulting in improved tax collections or about how “shell” companies were being unearthed as a result of the grand exercise.

Currency system destabilised

But, leaving aside the motives of the government for the moment, what does the data reveal about what has happened to the Indian currency system as a result of demonetisation? In its cover story on demonetisation (“Wrecking the system”, Frontline , December 9, 2016), Frontline indicated that demonetisation was likely to have far-reaching implications for the Indian currency situation. This rested on the premise that the replacement of the high-denomination notes, which accounted for 86.4 per cent of the value of all currency in circulation in March 2016, by new Rs.500 and Rs.2,000 notes is likely to seriously distort the Indian currency regime. The latest RBI data affirm these apprehensions in good measure.

Before demonetisation, the 500-rupee note was the central pivot of the Indian currency system, accounting for almost 48 per cent of the value of all currency in circulation. In any case, if the logic of demonetisation was to reduce the scope for high-denomination notes in circulation ( ostensibly, to fight the black money menace), it did not make sense to replace the 1,000-rupee note with one that was double its value.

But this is exactly what has happened as a result of demonetisation. The RBI report shows that demonetisation has resulted in the 2,000-rupee note occupying the role of the central pivot in the Indian currency system. While the 2,000-rupee note accounts for a little more than half of all value of currency in circulation, the share of the 500-rupee note has fallen from a little less than half of the value of all currency to just over a fifth (see accompanying charts).

As the impact of demonetisation resulted in massive dislocation of lives and livelihoods of a kind never seen before, it became clear that the only plausible reason for the introduction of the 2,000-rupee note was to quickly pump currency into a system that went through a sudden deflation, like a tyre of an aeroplane travelling at great speed on a runway. What the RBI data reveal is that the introduction of the 2,000-rupee note has seriously distorted the currency system. More importantly, it seriously undermines the stability of the Indian currency system. In short, demonetisation may well be a work in progress for some time, although nobody knows for how long, simply because of the troika’s insistence on keeping information that ought to be in the public domain secret.

Three important factors stand out in the RBI’s report. The first is the stress introduced by the dominance of the 2,000-rupee note. The second pertains to the manner in which smaller currency denominations have had to carry the burden imposed by the whimsical and illogical introduction of the 2,000-rupee note. The third important dimension revealed by the report is the serious impact the continued compression of cash in the Indian economy is likely to cause.

The portrayal of cash as the last refuge of the Indian scoundrel demonstrates an utter lack of understanding of either the nature of the Indian economy or how the majority of Indians earn their livelihoods. Cash was clearly the lifeblood for small businesses and, the importance of the 500- and the 1,000-rupee notes, especially the former, was critical. Also, as anyone with an understanding of the basics of a currency system would know, there is a logic in the alignment of various currency denominations in a system. What is clear now—as critics had warned soon after demonetisation—is that the 2,000-rupee note has seriously warped the alignment of currency denominations, probably irreparably, unless the pink note is sent into oblivion.

Recall that the distance in value between the 500 and the next highest denomination has become threefold after demonetisation. The reckless abandon with which this note was introduced, simply in order to overcome the problem caused by a self-inflicted policy, has meant that a significant proportion of all other currency denominations—not just the new 500 rupee—are simply present to support the slothful 2,000-rupee note. The common refrain of ordinary folk that they “don’t have change” for the new note reflects this reality.

In other words, every other denomination has had to bear a part of the load imposed by the new 2,000-rupee note. In March 2016 all smaller denominations—from the two-rupee to the 100-rupee notes—accounted for 13.6 per cent of all value of currency in the system; a year later, their share in the currency system almost doubled, to 26.6 per cent. As expected, the 100-rupee note carried the heaviest load, its share having increased from 9.6 per cent of overall value to almost one-fifth of all value of currency in circulation. If, as is evident, a higher proportion of the smaller-denomination notes was merely providing “support” to the biggest denomination, it has two serious implications. First, it means that not all the notes of smaller denominations have been available for actual transactions by millions of people but have been merely providing “passive” support to the biggest denomination that has been demonstrated to be lethargic in a cash-starved economy.

The second implication of this severe imbalance in the currency system is that it is no longer stable. The rumours of the possible reintroduction of a new 1,000-rupee note certainly cannot be ruled out because even votaries of the Modi government such as S. Gurumurthy, a well-known Rashtriya Swayamsewak Sangh ideologue, had once claimed that the 1,000-rupee note would be back in a new avatar. Given that the 2,000-rupee note is a serious nuisance, there is certainly a case for bringing the 1,000-rupee note back, but Modi would hesitate simply because it would appear to signal a defeat of the logic of demonetisation. Nevertheless, irrespective of what happens on this issue, the fact is that the currency system remains unpredictable. Given that predictability and stability are among the cardinal virtues of currency governance anywhere in the world, Indians will remain in fear of the unknown for yet some time.

While the widespread shortage of cash—and of the kind people wanted for their daily transactions—hit large swathes of occupations across the country, what was not known was the extent of this shortage. This closely guarded secret is now available in the RBI’s report, and it reveals a problem that none in the troika appears to be addressing. In March 2017, the total value of currency in circulation was a little over 13 trillion rupees, a decline of a whopping one-fifth of the value of all currency in circulation in the previous year. This spectacular drop in the value of nominal currency in circulation suggests a decompression of unprecedented proportions (see table). Recall that the value of currency in circulation increased by almost 15 per cent in 2016 compared with the previous year, and remember that a growing economy needs more nominal cash values to accommodate the growth in incomes (gross domestic product). Obviously, the severe decompression caused by the withdrawal of cash would have affected especially those who were dependent on cash for their transactions.

A quick calculation based on alternative scenarios is revealing. If one expects the currency in circulation to grow at the same pace as it did in 2016 (14.88 per cent), the currency system ought to have had 18.858 trillion rupees in circulation in March 2017; instead there was only Rs.13.102 trillion, implying a shortage of Rs.5.756 trillion in the system. A more sympathetic calculation, based on the premise that a 10 per cent increase would suffice—because of the all-out push towards digital payments—reveals a shortage of Rs.4.955 trillion.

The myth of digital bliss

The buzz about the digital payments “revolution” since demonetisation—orchestrated by various actors in government and in the world of business—requires some serious scrutiny. The fact of the matter is that the overwhelming proportion of digital payments in the Indian economy—almost 90 per cent—is concentrated in what are termed Systemically Important Financial Market Infrastructures. These are high-value transactions, which include real-time gross settlement (RTGS) systems; moreover, these include transactions undertaken by government agencies, large companies and business entities. The important fact to note is that the scale of these transactions had been increasing well before demonetisation and, therefore, has nothing to do with the so-called revolution ushered in by demonetisation. The more relevant data for measuring the success of digital payments after demonetisation is how retail payments through digital payment channels have progressed. And these reveal a disturbing picture, although that should hardly be a surprise. The data in the last few months show that after an initial spurt, payments through retail channels such as mobile wallets and prepaid payment mechanisms have been declining. For instance, the latest data from the RBI show that the value of transactions through prepaid payment instruments declined by 20 per cent in June 2017, compared with the previous month. Similarly, the volume of transactions through mobile banking channels declined by 15 per cent over the same period.

What is clear is that these modes of payments were forced on most people in conditions that were extraordinary. So, for some time people used these modes simply because they had no other option. But the idyllic world of cashless transactions was not costless or painless, as people found out sooner or later, no matter how Modi portrayed it (remember Modi’s claim, soon after demonetisation, that even beggars have swipe machines?). So, as the cash crunch eased somewhat, they went back to doing business in the only way they knew and could afford.

Meanwhile, the imposition of the Goods and Services Tax (GST) has imposed an additional burden on the same set of people who are still reeling under the impact of demonetisation. This is because the impact of the GST—just like demonetisation—imposes a disproportionate burden on smaller businesses; in fact, it does more than that by tilting the field away from small business and in favour of large. To a government, demonetisation may be a “success”, but to the rest, it is a night without end.