Modi’s gamble: India’s demonetisation drive

The following blog post is now available at Griffith Asia Institute.

The Indian economy might experience a sharp growth slowdown next year. This has to be attributed to a dramatic decision, announced personally by the Indian Prime Minister Narendra Modi, to scrap Rs 500 and Rs 1000 notes. Thus, on 8 November, at the stroke of midnight – to evoke a Nehruvian expression – these notes ceased to be legal tender. The government gave its citizens until the end of the year to exchange these notes for new ones at post offices and banks, but the extant notes were instantly rendered worthless because they were no longer legal tender beyond 8 November. The primary goals were manifold and laudable: to strike a blow against counterfeit currencies which typically targeted these notes, to come down hard on all those who held their ill-gotten, tax-avoided wealth in ‘black money’, to act as a deterrence against terrorists and criminal organisations who apparently relied heavily on these banned notes.

While the cheerleaders of the government celebrated this bold action and ‘surgical strike’ against real and perceived challenges that were allegedly endemic to the Indian economy, the ‘shock and awe strategy’ unleashed chaos as millions desperately lined up at post offices, bank branches and ATMs to exchange the banned notes for new ones. The scrapped notes, after all, accounted for 86 per cent of currency in circulation and 51 per cent of the money supply. The postal and banking system was simply unable to cope with this unprecedented ‘policy surprise’.  It might take several weeks – or even months – before the cash crunch is eased. Meanwhile, demonetisation has inflicted a great deal of hardship on the poor and the vulnerable and those of modest means. Scores of deaths have reportedly occurred. Hence, some Indians have paid the ultimate price for a policy experiment whose long-term goals may or may not be met.

The rather adverse consequences of such a major monetary shock is understandable. India is still a cash-intensive economy and its very large informal economy or unorganised sector as well as other activities, such as real estate, agriculture, the hosting of weddings are heavily dependent on cash transactions.

India’s dramatic demonetisation has attracted world-wide attention and has become the object of robust critique by many Indian and non-Indian economists. It has attracted scathing editorials in such august publications as the New York Times and the Guardian. Kaushik Basu, former World Bank Chief economist, questioned the wisdom of such a move, arguing that the costs will outweigh the benefits. Others – such as Larry Summers – were alarmed by the ‘most sweeping change in currency policy in the world in decades’. Even those – such as Kenneth Rogoff – who support the government’s long-term goals are clearly concerned about the unfolding short run costs.

Provisional estimates on the impact of  demonetisation  on GDP range from modest to major. HSBC has released estimates which suggest growth to be as much as 1 per cent lower in 2017 than the current 7 per growth rate. N.R. Bhanumurthy from the respected National Institute of Public Finance and Policy suggest similar numbers. The Ministry of Finance reportedly has a forecast of 5.5 per cent growth rate in the final quarter of 2016.

Perhaps the most pessimistic scenario is offered by Ambit Capital which has warned of growth grinding to a halt by the second half of 2017 and for growth in 2018 to be no more than 5.8 per cent. Ambit Capital points out to a permanent decline in the size of the informal economy by about 20 percentage points within the space of a year! Given the fact that the informal economy accounts for 79 per cent of employment in India, this is a staggering case of enforced structural change that will destroy the livelihood of millions unless they can find alternative sources of employment in the formal sector.

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