India’s object lesson in how not to demonetize

It is something of an article of faith amongst investors in Emerging Markets that economic crises in those markets are at once inevitable and unpredictable: they frequently occur in places where you wouldn’t normally bother to look too closely.

Imagine for a moment that you are the CEO of a company making chocolates. It’s the best in the sector, growing fast and well-leveraged. You have a working capital gap, but it is manageable when compared to your banking lines. Then, one fine day, you decide to change how your workers are paid: from cash in their accounts to packets of chocolates that they have to hawk in the nearby malls. You argue that this makes your employees more invested in the company’s success, whilst also broadening potential sales channels, thereby improving revenues over the long term. Furthermore the theoretical value of the packets of chocolates is the same as the money previously paid to employees; so, really, where’s the harm?

To your surprise and disenchantment, however, you suddenly notice a sharp decline in productivity, workplace attendance and product quality. Pretty soon, you have to shut your factory and are left ruing your decision.

This is not dissimilar to what has just happened in India, where at the beginning of November the government decided to “demonetize” (i.e. declare invalid) the country’s two highest denomination notes (Rs.500 and Rs.1000) in circulation. To fully understand the implications, however, it’s essential to grasp the motivations and the mechanics.

A difficult task at hand

The move essentially targeted some 85% of the banknotes in circulation, or roughly US$225bn of actual physical currency, representing just over 10% of the underlying US$2 Trillion Indian economy. It is estimated, however, that cash was being used for 95% of transactions made in the country.

That in turn implies that the velocity of cash – the speed at which it moves move around the system – was around 8-10x depending on denomination. In contrast, economists have estimated that ‘broad money’ i.e. non-currency-based money transfers, had a lower velocity at closer to 6x – in other words, people transferred money between accounts and companies roughly once every two months.

This is very important. As an underdeveloped economy, India simply did not have the systems in place to deal with counterparty risk. In cash transactions, you don’t have to take anything from the person sitting opposite you except their cash; in more developed systems, you have to take ID cards, bank statements and proof of address along with the mode of payment (cheque or credit card). In cash transactions, the currency acts as your ID card, bank statement, proof of address, etc.

Trouble is, that’s not how developed economies work. When most transactions occur through cash, authorities can lose out in the following ways:

• Lack of information about what’s actually going on around the economy
• Tax leakage, as people can (and do) under-report transactions
• Lack of wealth information (as you don’t know what the value of assets is)
• Income inequality (you don’t even know who is making money)
• Inefficient disbursements of welfare payments by government (including leakage to rentiers)
• Fake currency
• Money fueling terrorism, drug smuggling and prostitution rackets
• Money being used for legitimate economic activity but with tax avoidance as the primary motivation (primarily in the real estate and jewelry sectors)

The government certainly had cause for complaint – the total number of taxpayers within the revenue net (i.e. those paying federal income taxes) in India is estimated at under 30 million, in a country of 1.25 billion. That’s less than 2.5% of all people, worse than the numbers posted by various other countries facing economic crises, including Greece (where under-reporting of income was more common than not reporting at all) and Argentina.

Given this context, it certainly made sense to think that, at some point, the system would need a massive overhaul. Granted, few thought India’s ruling BJP would enact such reforms because the primary beneficiaries of the cash economy – small traders, businessmen and self-employed – have tended to form the base of the party’s support. In the event that didn’t stop prime minister Narendra Modi – but his government has taken an overly complicated approach.

• All higher denomination notes were immediately -canceled
• New Rs.2000 notes were introduced but not widely made available as they were smaller than the outgoing Rs.500 and Rs.1000 notes and therefore couldn’t fit into ATMs without retrofitting
• To avoid banks running out of cash, daily withdrawals were essentially rationed
• Deposits of up to Rs.250,000 were not questioned – but anything over that had to be automatically reported to the tax authorities. This meant banks had to fill forms immediately on receipt
• Banks had to report daily cash movements from every branch and ATM location to the central bank, flagging up accountholders who appeared to exhibit suspicious behavior
• While there were multiple exceptions to the rules around the use of old currency notes, the Reserve Bank of India (RBI) continued to modify its rules on a daily basis in an effort to plug holes. This meant processes and limits were updated frequently, leading to further confusion

Since the policy began, some 80-85% of old currency notes have come back into the monetary system. New notes are being added daily but the printing presses really cannot keep up with the demand – queues are still in evidence across the country (but more pronounced in the north). Therefore, only some 35% of the value of the old notes has so far been returned to circulation.

Why it’s all gone wrong

Even the best ideas can be let down by poor execution, and this has certainly happened in India. The problems have fallen into three categories:

• The lack of an institutional framework
• Mathematical problems
• Logistical and infrastructural difficulties

On the institutional side of things, India has seen a steady erosion of many of its institutions over the past 30 years as economic reforms have pitted the country’s burgeoning private sector against the generally staid and slow-moving government sector. Public sector banks, for example, have far fewer automated teller machines and have invested less in workplace automation compared to private sector banks. This has inevitably led to long queues as banks have taken inordinate periods of time to deal with relatively simple requests.

Perhaps more pertinently from an institutional perspective, India’s lack of any robust national identity card system (the government introduced a new card a few years ago that is widely accepted but not considered foolproof) means that counterparty risk on payments cannot be easily dealt with when pure cash isn’t an option, as explained above. The ancillary problem this creates is that small traders and the self-employed use cash primarily as working capital – therefore, cash was neither being hoarded nor saved, it was simply being deployed as working capital.

For the RBI to miss these important aspects of the economy would be perfectly understandable – readers know well that I hold little respect for the economic credentials of central bankers around the world. But what is less clear is why the BJP-led government would make a mistake of this magnitude that affects its core constituency.

Next is the mathematical problem at the heart of this mess. With new Rs.500 notes being largely unavailable to date, consumers are left holding denominations of Rs.100 and Rs.2000 as old Rs. 500 and Rs.1000 notes can no longer be used for transactions. This is a problem – the multiple of 20 between the two widely used denominations (Rs.100 and Rs.2000) means that getting “change” is virtually impossible – there are simply not enough Rs.100 notes in circulation relative to the number of Rs.2000 notes in circulation to allow this. In other words, for every Rs.2000 note issued, the RBI should also have made available at least 10 new Rs.100 notes. Instead, it seems to have focused all printing activity on the Rs.2000 notes to compensate by value the Rs.500 and Rs.1000 notes taken out of circulation – even though value isn’t the core problem; rather, utility is, given the issue of counterparty risk raised above.

Chalk that up as one more case of clueless central bankers damaging the real economy.

The third aspect of the problem – logistics and infrastructure – is perhaps the easiest to understand and indeed, sympathize with, given India’s size and underdeveloped financial systems. Still, that basic infrastructure simply failed to deliver enough new notes.