India: a rocky demonetisation ride

Nearly three months on, the jury is out on whether India’s demonetisation exercise has involved more pain than gain. The policy was introduced suddenly and unexpectedly on November 8 last year – the day when Donald Trump’s election victory in the US was making news. India’s prime minister, Narendra Modi, announced that from midnight all 500 rupee (US$7.60) and 1,000 rupee (INR) notes, or 86% of the currency in circulation, would cease to be legal tender.

India’s citizens and businesses were informed that they had a 50-day period to late-December in which to redeem their cancelled banknotes, which would subsequently become worthless. Indeed, by the end of 2016 the Reserve Bank of India (RBI) had been able to recall most of the entire stock of INR500 and INR1,000 notes.

However, in the intervening period the impact was predictably devastating, with as many as 95% of all transactions in India still conducted in cash and nine in 10 vendors unequipped to accept anything other than cash. Add to this the fact that around 85% of the country’s workforce is paid exclusively in cash and nearly half of the population doesn’t have a bank account.

The outcome was alarm as millions of Indians rushed to banks, automated teller machines (ATMs) and foreign exchange counters to exchange their higher-denominated notes. Many who applied to the RBI were turned away, as the central bank said that it would only exchange notes for non-resident Indians (NRIs) or individuals who were abroad during the 50-day demonetisation period.

Data suggests that India’s economy – now the world’s sixth-largest – took a substantial hit in the last two months of 2016, with many smaller businesses closing down and retail sales contracting. According to data provider the Centre for Monitoring Indian Economy (CIME), firms’ investment proposals in the fourth quarter nearly halved from INR2.4 trillion (US$35bn) previously to INR1.25 trillion, while corporate credit growth fell to its lowest rate since the mid-Eighties.

The human cost was also severe, with reports of families struggling to buy food, weddings cancelled and hospitals turning away patients who had only the old banknotes.

The reason for the dramatic action has less to do with pushing India towards a cashless society and more with clamping down on undeclared income, tax evasion and counterfeit currency. As the official announcement described it, the aim was “curbing financing of terrorism through the proceeds of fake Indian currency notes (FICN) and use of such funds for subversive activities such as espionage smuggling of arms, drugs and other contrabands into India, and for eliminating black money which casts a long shadow of parallel economy on our real economy”.

The plan also involves the replacement of the cancelled notes with new INR500 and INR2,000 notes but distributing these and getting them into circulation appears to be a slow process. The replacements are distinct from their predecessors, being of different size and of a different design.

Economic growth: a blip or a dent?

Despite the dramatic headlines in the weeks following the government’s move, its impact on the Indian economy appears to be less than that on ordinary citizens and small businesses. A year ago, India was setting the pace globally for gross domestic product (GDP) growth, with an annual rate of 7.6%. Projected growth for the fiscal year ending March 2017 has now been trimmed by half a percentage point, to under 7% from a rate of 7.3% in the last full quarter before demonetisation – although increasing oil prices and a stronger US dollar over the period also contributed to the downgrade.

Société Générale has reduced its forecast for GDP growth over the next two years, albeit from a high level. For fiscal 2017, which runs to March 2018, it projects a rate of 6.6% against 7.3% previously, with a lesser reduction – to 7.2% from 7.7% previously – the following year.

SocGen has cited a study by the All India Manufacturers’ Organisation (AIMO), which reported that micro and small scale industries suffered 35% job losses and a 50% fall in revenue in the five weeks after demonetisation was introduced. AIMO added that such is the reliance by these firms on cash transactions that by March the fall in employment could have risen to 60% and the drop in revenue to 55%.

However, the Indian government’s chief economic adviser, Arvind Subramanian, has expressed confidence that the adverse impact on GDP will be “transitional” and demonetisation will prove beneficial in the longer-term if it reduces the potential for corruption and the number of cash transactions that often circumvent the payment of tax.

In the meantime, India has limited space for fiscal manoeuvring to offset the impact on smaller firms, with government debt well about the levels of Asia’s other emerging markets. The International Monetary Fund (IMF) estimates India’s public debt for 2016 at 66% of GDP, against only 38% for fellow BRIC economy China, 55% for Malaysia and 43% for Thailand.

What government funding is available could be prioritised to rural economies, which have been hit hardest in the past three months, and infrastructure projects according to a report from Goldman Sachs. The investment bank expects increased investment in irrigation, low cost housing, and electrification; in line with promises made by Modi in a recent speech, which included loans for low-cost housing and interest rebates for farmers.

Further ahead, how serious is the prime minister in lessening India’s reliance on cash? The RBI has been sending out decidedly mixed signals, declaring its support for electronic payments and a more digitised society while recently repeating its warning from two years ago on the use of Bitcoin, following a recent resurgence of interest in the virtual currency since November.

“The RBI advises that it has not given any licence/authorisation to any entity/company to operate such schemes or deal with Bitcoin or any virtual currency,” the bank declared. “As such, any user, holder, investor, trader, etc., dealing with virtual currencies will be doing so at their own risk.” At the same time, the RBI and other major Indian banks are researching and developing blockchain-based applications.

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