Medium-term, Modi’s gamble could prove to be a masterstroke

The potential economic impact of India’s demonetization policy must be considered over both the short and medium terms. In the short term, it is more than likely that the economy will hit a brick wall due to the following reasons:

• The cancellation of notes not banked by December 30 represents lost wealth – up to US$30-50bn based on current estimates. Additionally, there will be tax implications for a number of depositors who have previously avoided paying taxes – this could add up to a further US$25bn
• With some US$100bn of currency in suspended animation as new notes are being issued, it is possible that the country sees a sharp drop in economic activity for at least two quarters
• The removal of currency notes also effectively “strands” those asset classes – real estate and jewelry – that previously benefited from the parallel economy, as well as all the sectors that contributed to the same. For example, the real estate sector is closely linked with construction activity, which is – in turn – related to the production of building materials, home furnishings and other products. All of these will suffer
• In contrast, the financial sector is now flush with new deposits. It has, furthermore, opened up vast new revenue streams by providing payment services (fintech, as well as traditional banking services such as debit cards) for the previously unbanked masses
• That said, the financial sector is also likely to see the impact of stalled payments and account delays on its customers. This directly affects areas like receivables financing but also indirectly increases  the overall risk of corporate defaults (many a high-growth EM company has been derailed by payment mechanisms failing in the past)

Medium-term impact on politics and the economy

There are several potential benefits of demonetization in terms of the political economy:

• Firstly, there are probably immediate political benefits for the ruling party. The BJP, which runs the central government, lost state elections in the populous state of Bihar due primarily to the ample cash that was used to pay for votes by rival political parties. While the BJP itself used cash, it was at a material disadvantage compared to the local parties. By taking away the cash cudgel entirely, the ruling party is likely to benefit in upcoming elections in key states such as Punjab and Uttar Pradesh over the next 3-6 months, during which the impact of demonetization is expected to remain high
• There are also populist benefits for the Prime Minister himself. To a large extent, the move is seen by poorer Indians as hurting the rich and the corrupt and has therefore remained popular despite the staggering inconvenience caused by lengthy queues and the loss of livelihoods across vast sections of the population. To the extent that he is seen as a lone fighter against corruption, Narendra Modi’s personal popularity stands enhanced
• The policy has certainly defanged terrorist networks across the country – and specifically in Kashmir, where it turns out that the “youths” throwing stones at the Army had previously been paid Rs.500 for every incident. With the money gone, the stone throwing has stopped.
• “Black money”, or the proceeds of the parallel economy, has certainly become a lot more problematic. Businessmen and traders have reported that both bureaucrats and politicians are a lot more reluctant to demand bribes, as the likelihood of being caught has increased
• Tax collections have increased vastly for the government. The upcoming introduction of a goods & service tax (GST) – a kind of national value-added tax that has been mooted to replace the bewildering array of state taxes on sales and production – is very much enabled by the demonetization exercise. It is likely to bring in more taxes and therefore move the government to a more positive position fiscally.

But why?

The one question that has dominated discussion relates to Mr Modi’s motivation for embarking on this extremely risky step. The main reasons I have heard from local experts are as follows:

• Political legacy – as a likely one-term Prime Minister whose reform agenda has been serially thwarted by Parliament, he is eager to leave behind a lasting political legacy for the country
• Modernization – the Prime Minister honestly believes that to modernize the Indian economy and improve the efficacy of both government programs and monetary policy, demonetization is  required. A necessary evil, in other words, to put the economy on a faster growth track
• Remaking the BJP – moving from its dependence on businessmen and traders, demonetization instead makes the BJP the party of the common man (provided the mooted benefits of the exercise are actually realized)
• Asset prices – Mr Modi has discussed many times in the past the excessive growth of asset prices, especially the cost of real estate against incomes in India. The move against the cash economy is seen as denting asset prices substantially – a 10-20% correction appears on the cards already across major metros
• Anti-corruption – Mr Modi has been feted as a notably scrupulous leader, with no whiff of corruption from his terms as Chief Minister of Gujarat. It is thought that probity in public life has been one of his watchwords and to the extent that the demonetization exercise helps to increase potential costs for the corrupt, it has been the right thing to do

Generally, the view of demonetization among Indians has been positive – which surprised me a lot given the generally negative tone of reporting in the country’s mainstream media. Perhaps like the Brexit movement or the US election of Trump, this is yet another situation where the mainstream media has simply got it wrong about what people want. The enduring popularity of Mr Modi personally despite the apparent economic difficulties imposed on people, has thrown open the possibility that this move could end up being a political masterstroke with longer-term economic benefits.