A moderate view on Demonetization

For some time now, the first post I invariably see when I logon to any social media platform is that of someone criticizing the government for demonetization and calling it a failure. It is funny to see people who have started their own ventures and have been cash strapped for a while calling the move a failure without realizing the direct benefits that will accrue to them. The reasons for calling it a failure have predominantly been on two grounds – the implementation and the gap between the estimated and deposited amount.

Before we go any further, it is important for me to express my position on the issue lest people mistake this to be a pro BJP or pro right wing view. In a world where it is increasingly fashionable to be anti-establishment and anti-right, one must be clear on where one stands.

I believe it is still too premature to decide whether or not demonetization is a success.

We must realize demonetization is a process larger and more complex than a simple act of not recognizing certain notes as legal tender and collecting them. To conclude whether or not it is a failure, we must wait for official data to come in. Those of you who feel that this data will be fudged or tampered with, I suggest you stop reading this post at this point. Convincing you by reason is beyond me. However, those of you who have an academic zeal or curiosity to know more, please do read on. I encourage you to write to me with your opinions. It is only through such healthy debate that we grow rather than decreeing something because we are blessed with the ability to communicate.

In an age of transparency, it is possible to cross verify government data with the use of multiple indicators and proxy indicators and establish with a certain degree of confidence whether the numbers are realistic. Economists often do this to gauge what is happening in an economy or a part of the economy.  In a world with huge government debt and rating agencies, governments are extremely cautious with their data.

This article is divided into two halves. The first will relook the issues on which this move is being considered a “failure”. The second will look at the impact of such a move on the overall economy given the current macro-economic situation in the country.

PART – I

While it true that there is scope for improvement in the implementation (something which I have also called out from time to time), the main reasons cited for the apparent failure of demonetization are as follows:

  • Multiple changes in the notifications
  • The banks’ (and by extension the government’s) inability to meet its declared promises (for the lack of a better word) – relating to withdrawals, etc.
  • The unfortunate demise of many people while waiting in queues to withdraw cash.
  • Rural economy being disrupted
  • GDP slowdown

I think we all agree that we live in a country where people are inclined to ‘jugaad’ their way through. Jugaad is possible when there is scope for interpretation and incompleteness in a particular framework. If one has ever read a government document, one can appreciate that the document provides for any and all possible outcomes of the issue at hand and provides a course of action for each of them (I urge you to read the “common norms” laid out by the government for skills training to get an understanding. This issue is simple and would be easy for people to understand). As and when the government finds people trying to find ways around the given norms, it has to adapt to ensure the misuse is minimized to the extent possible.

Provisions to allow for withdrawal of funds. It is important to also understand that there are multiple ways in which two parties can transact (irrespective of whether they are in a rural or urban setting). There have been multiple cases filed in the courts. Some individuals have gone on to cite the bank’s inability to provide the promised amount of currency as a breach of contract citing various verdicts. I am not student of law. These arguments would be true in the normal course of business. However, these are extraordinary times. We must allow for some leeway during such periods.

The death of any living being is a matter of concern. The loss of one person passing away is felt a many people who survive him/her. However, it is important to go one step further and ascertain the cause of death and not simply link it to causals that aren’t medical.

While these issues are undoubtedly serious, they are not the parameters on which one must judge the success or failure of the move.These are problems which the highest levels of the government would have foreseen. Most of them are obvious and were called out as early as 9th and 10th November. Consulting companies scrambled to be the first ones to tell their clients and the media what the possible effects would be. In a situation where ordinary citizens can predict what would happen, the government with its vast resources and extremely accomplished personnel would surely have foreseen much more. It is important for us to continue to highlight the areas where the government has slipped and provide possible solutions rather than considering the entire move a failure. We must keep in mind the parameters of success or failure are different. The factors to be considered during such an exercise are:

  • Intention and its ability to realize the intention
  • Comparing the possible outcomes with the actual outcomes
  • While we consider the outcomes, it is also necessary to consider those which are implicit and unspoken due to various constraints

PART – II

It is important to look at the macro-economic environment in which the country currently operates. Some of the major issues have been:

  • The banking sector has been in trouble for some time:
    • Banks have lost huge amounts of money due to NPAs
    • Due to huge write offs, banks have been more risk averse and hesitant to lend money
    • Banks have declared their inability to pass on the reduction in interest rates by the central bank dude to high costs of maintaining deposits
  • The shadow economy
    • Large amounts of cash being moved around to fuel real estate transactions. Part of the payment is made in “white” and part in cash. This has been a standard practice for some time.
  • The government’s push to encourage manufacturing, entrepreneurship, commerce.
  • The government’s commitment to reduce tax rates and the tax burden while increasing expenditure

By understanding how demonetization affects each of these, one get a larger picture about the move.

Before we go on, let us briefly understand how credit creation works.

This is what a simplified balance sheet of a bank looks like

demon-1

When we deposit a sum in the bank, part of it is kept aside in the form of reserves and the rest is loaned out. The amount that is issued as a loan is in fact kept in an account opened for the borrower. This amount is then treated as a deposit. As is the case with deposits, after providing for reserves, the remaining amount is loaned out and deposited into another account. This endless cycle is what fuels the economy. Let us look at a numerical example to understand how this works:

An initial amount of ₹100 is deposited in the bank. We take the CRR and SLR to be at 25% cumulatively.

demon-2

An initial deposit of ₹100 can create ₹404.73.

Now let’s see what ₹12.44 Lakh crores can do. Let’s consider 3 scenarios:

Scenario Description Amount (Lakh crores)
1 The entire money stays in the banking system 45.41
2 Only 50% of the initial amount stays in the banking system 33.54
3 50% of each successive round stays in the banking system 24.00

Lakh crore has become the default unit these past few months. People have forgotten the value of a few lakhs and crores. If we were to represent the best-case scenario (scenario 1) in terms of Gross State Domestic Product (GSDP) of various states, it would look something like this –

demon-4

It would approximately equal the GSDP of all the special category states (7 sisters, Sikkim, J&K, Himachal and Uttarakhand), union territories (Delhi, Puducherry and the others) and 11 general category states.

Pushing this cash into the banking systems has the following benefits:

  •  

    Huge amount of credit is now available to give the necessary push to the economy (specifically the manufacturing sector which is the government’s focus area). As banks are now sitting on money, they will be forced to step up lending. If banks are able to increase the quality of their loans, a future NPA crisis can be averted. One cannot wish away NPAs. They are part of the cyclical nature of the economy. However, they can be reduced by not repeating the same mistakes.

  • It eases the NPA problem. A simplified explanation would be as follows – Loans are considered to be the bank’s assets. When there is a rise in NPAs, the assets side of the balance sheet shrinks. The liabilities side of the balance sheet continues to remain the same/grow (deposits are accumulating interest and the owner’s equity is constant). In such a scenario, the banks need to increase their assets side. This can be done either by increasing their deposits or by the owner infusing more equity into the bank. The government has been injecting capital into the banks. However, that amount in nothing compared to what our deposits can do for the system as a whole.
  • It allows for better monetary policy transmission. As the cost of borrowing has reduced, banks are now able to pass on the central bank’s reduction in rates. Banks have already reduced rates.

 

It is a well-known fact that India has a very low tax compliance rate. Less than 4% of the population filed their tax returns in 2014-15. The amount of people who pay tax will be significantly lower than this. By forcing people to deposit a large part their money into the banks, the tax net widens significantly. This leads to an increase in tax revenues. The finance minister in a statement said that revenues from indirect central taxes have increased by 26.6%. The net increase in direct taxes after adjusting for refunds has been 13.6%.

Ensuring compliance is the most critical step in the success of demonetization. The government must increase tax compliance in the face of internal and external constraints. As a large number of accounts wouldn’t have seen much activity, by defining focused rules, it is possible to pick account which are suspicious. Many people have already received notices asking for them to justify the large deposit during the demonetization period. Reviewing these responses and ensuring that innocent people are not harassed and various rackets are uncovered will be a daunting task. The department also has to overcome internal constraints such as corrupt bureaucrats and understaffed divisions among other things.

Rather than calling the government’s action a failure without data, we must aspire for something bigger as a nation. We must hope that the government does so well, that we ALL vote for the ruling government. It is important to understand that the government’s failure is our failure. Wanting the government to fail is like wanting the pilot to crash the plane we all are on. This doesn’t mean we don’t call out the government for a misstep. We must. It is our responsibility as citizens of the nation. But we must be careful not to prematurely call something a failure without looking at the result.

GSDP figures are for FY 13-14 at current prices

Data source- https://data.gov.in/catalog/capita-state-domestic-product-current-prices

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s