The nation got a four-hour notice. The prime minister announced on national television that by midnight all the high-value currency notes would cease to be legal. This was Modi’s Pokhran moment. The similarity with India’s nuclear blast of 1998 was in more ways than one. First, the secrecy, which ensured only a narrow circle knew what was coming. In Mumbai, senior bankers had been summoned to the RBI, for an evening meeting, and were clueless until the last moment about what was coming. The surprise element was crucial.
Second, like the nuclear test, there was the sheer audacity of the decision. It was unthinkable that one of the world’s largest economies would abruptly make 86 per cent of its currency illegal. Just like Pokhran, the world sat up and took notice. Third, just as Pokhran led to sanctions and the drying up of foreign investment, demonetisation had large economic costs. Fourth, the nuclear test led to a bitter debate on whether it was good for India. And whether India had lost its moral authority on nuclear disarmament. The naysayers against the blast were in a small minority.
And indeed, within seven years of the test, the US signed a special civil nuclear deal with India, bringing it out of a three-decade old nuclear apartheid. So looking back, PM Vajpayee’s decision to conduct the test proved to be a net positive. Similarly demonetisation too led to a bitter debate. But in this case the naysayers were in a large majority. The comparison with Pokhran can only be stretched so far. Unlike the Pokhran test, this has affected each and every Indian. If it turns out to be a net positive, that is still in the distant and uncertain future.
The costs of demonetisation were all front-loaded, and significant and quantifiable. The benefits will accrue in the medium-to-long run, are uncertain, and some are even unquantifiable, so it fails the test of conventional cost-benefit analysis. The textbook definition of demonetisation calls for discontinuing high-value notes, with a notice period of 12-18 months. What was carried out here instead was a giant currency swap with no notice period.
The higher-value new Rs 2000 note was introduced. So this is not the demonetisation that is talked about in the G20 circles or advocated by the likes of Kenneth Rogoff, former economics head of the IMF. Since it was a currency swap, and old notes were instantly abolished, while new notes were not ready, it caused a lot of hardship. People had to wait for hours in long lines, over several weeks, to withdraw their quota of new cash. Since commercial banks were flush with old notes, most of that old cash was deposited with the RBI in the reverse repo facility.
The RBI had to pay reverse repo interest (around 6 per cent) to banks. The RBI also had to incur the cost of printing nearly 15 lakh crore of the new notes. Due to these costs, the RBI annual dividend to the government of India dropped by over Rs 35,000 crore. This amount too should be counted as a cost of demonetisation.
It is now well known that the agriculture and informal sectors where cash plays a big role suffered a loss of output and jobs. It is reflected in the slowing down of GDP growth to below six per cent. A one per cent lower nominal GDP growth rate implies a loss of national income of Rs 1.5 lakh crore, and a loss of millions of jobs. This is a huge cost to pay for removing black money, ostensibly one of the prime objectives of notes ban. On that count too, success looks limited, although many accounts with suspiciously high fresh deposits have been identified. Of course, this does not imply that those accounts have black money.
On the positive side was the increase in digital transactions (due to shortage of cash), and an increase in the number of potential taxpayers. The government says that now every rupee has “an address” and is traceable, which was not possible earlier. But given that black money has a tendency to be created all the time, and be converted to benami land and gold, it won’t be long before we have a new stock of black money.
The main lessons of demonetisation were as follows. First, the PM’s word carries a lot of credibility. For weeks, the people supported the PM, and despite their hardship, believed this shock therapy was good for the nation. This was reflected in various surveys. Unlike India, in Venezuela a similar experiment to discontinue high-value notes had to be aborted within 48 hours. The second lesson is that eradication of black money is not possible with a one-off action, however drastic.
It calls for all-round strengthening of institutions and mechanisms, and reducing incentives to create black money. Third, the RBI preparedness was simply inadequate to meet the huge demand for new cash. So better homework is called for. The fourth lesson is the goals of less cash, less informal economy, higher financial savings, and widening of the tax net, need constant, relentless, innovative and gradual policy and institutional pressure. It doesn’t happen with a one-time jolt. Five, the Indian public has a large reservoir of patience, resilience and forgiveness. If they sense honest intent, they might forgive policy mistakes.
India is willing to experiment, up to a point, even at great short-term cost. But mid-course correction is necessary. The sixth lesson is that politics trumps economics, always. Most economists would have advocated against the abrupt-style demonetisation. It was ultimately a political decision, which did pay political dividends. The political narrative was powerful and compelling. Even though on all metrics, the economic benefits fell short of the costs, there was hope, that in the longer term the benefits would come. Whichever side of the optimist/pessimist camp you belong to, this unprecedented and unthinkable demonetisation has been a watershed event in modern India.
(Syndicate: The Billion Press)
Ajit Ranade
The author is an economist and Senior Fellow, Takshashila Institution
Email: editor@thebillionpress.org