06 Jun 2018

Just 18 months after Indian Prime Minister Narendra Modi’s bold November 2016 withdrawal of 86% of the country’s currency from circulation by delegalising 500 and 1,000 rupee notes, ATMs across India ran into an acute cash shortage, sparking panic and the suggestion of crisis [i].

Professor Ramkishen S. Rajan, Vice Dean (Research) and Professor at the Lee Kuan Yew School of Public Policy, National University of Singapore notes, “Narendra Modi has just completed his fourth year in office. These four years have been marked by a number of ambitious reforms as part of what has been coined ‘Modinomics’ in order to ease the cost of doing business in India and weed out corruption within the country.”

The almost-overnight decision to undertake demonetisation is a radical measure, continues Professor Rajan, and one that continues to spark much controversy both within and outside India. “Key questions still need to be answered,” adds Professor Rajan. “Were the costs worth it; could it have been implemented better; how do we judge success of such a measure?”

Although this unforeseen situation has now been reasonably managed, the implication is that the entire process of demonetisation could have been smoother and relatively more effective had more attention been paid to pre-existing governance problems in the system, such as relooking bank liquidity requirements and reviewing regulations. Doing so might have helped the government to identify and plug loopholes and prevented issues like the ATM crunch. Dr Sasidaran Gopalan, Assistant Professor at the Graduate School of Public Policy, Nazarbayev University, believes that “the entire process of demonetisation could have been relatively more effective had they taken some care to sort out the governance problems in the banking system. By not doing so, they sort of put the cart before the horse”.

Fortunately, this is not an unfixable problem. What is necessary now is to take stock of the effects, intended or otherwise, of Modi’s great monetary gamble. What the PM urgently needs to do is to make the demonetisation effort sustainable and leave a legacy for India — possibly in the manner of Singapore’s widely-respected late founding Prime Minister, Lee Kuan

  • Targeting black money

While Modi’s intention for demonetisation may well have been to rein in an estimated US$229 billion worth of undeclared rupees (“black money”) for tax accountability purposes, doing so might not appreciably increase the country’s low tax-to-GDP ratio (16%) — about half the percentage of the OECD average (31%). Concerns include the inadequate follow-up by income tax officials and the underwhelming outcomes of tax amnesty measures.

Furthermore, the latest cash crunch suggests that as a demonetised economy becomes remonetised, problems regarding black money will re-emerge. Given this, it remains to be seen whether the increase in direct tax collections — 12% from April to December 2016 — for the Indian government can be sustained.

For the targeting of black money to really work, Modi has to focus on real estate, gold and foreign currency in addition to Indian rupees. Supplementary measures such as drafting of laws on undisclosed foreign income and assets may help.

  • Too many deposits a bad thing

Modi’s government was actually gambling that a huge chunk of currency would not be returned to the banking system, and the fact that it did was bad news, leaving doubts as to whether black money had been “whitened” or converted into substitutes such as real estate or gold.

More importantly, a large proportion of currency was returned to the banking system instead of being delegalised into oblivion. As a result, the Reserve Bank of India — the country’s central bank — was unable to achieve a reduction in liability and a corresponding increase in net worth. An increase in net worth could have been distributed to its shareholder (India’s Ministry of Finance) as a special dividend and in turn may have led to a reduction in taxes on other economic agents in the country.

  • Exposing shell companies

Out of the 1.5 million registered companies in India, only a third (about 0.6 million) file annual tax returns. Preliminary data suggested that during November and December 2016, immediately after the demonetisation announcement, 12.38 billion rupees (US$184 million) were deposited into the accounts of shell companies. Acting on this, the government has formed a task force to monitor potential financial irregularities through suspected shell companies.

However, the Indian government cannot rely on the one-off demonetisation to stem the future flow of black money. Sufficient resources need to be assigned to the task force to better monitor the financial activity of suspicious entities, and the rule of law needs to be enforced against offenders.

  • Fighting counterfeiting and terrorism

The demonetised Gandhi series of banknotes is, in the Indian context, a reset of high denomination currencies. Delegalising high denomination currencies may help alleviate two extreme threats: the circulation of counterfeit notes and the finance of terrorism. For the former, only about 3.5% of the old currency notes have been identified as fake, indicating that the issue may not be as serious as first estimated. More significantly, the demonetisation seems to have had an obvious impact on the financing of terrorist or extremist activities, judging by the recent dip in violence in troubled states.

With the terrorists choked, Modi should turn his attention to counterfeiting, which has recently hogged the headlines. It is somewhat embarrassing to read news about local banks dispensing fake banknotes from their ATM machines, despite rules and technology already put in place to counter this [ii].

  • The push for digitisation

Paper currency aside, there’s little reason why India should not advance cashless payments technology, especially considering the nation’s collective information technology expertise. Today, India still has a high currency-to-GDP ratio, with 78% of all consumer payments in cash. So, clearly, the primary objective of demonetisation, which was to reduce the share of total currency in circulation and simultaneously facilitate the move towards greater digitisation in payments and financial services, is failing.

Without sufficient government and private enterprise synergy in this area, India’s digital infrastructure has not been able to reach the level necessary to support a move such as demonetisation. Without a viable alternative, the Indian people still depend greatly on cash, as evidenced by the ATM crunch. For ATMs to not run dry, there needs to be far greater financial inclusion across the board. This must be preceded by the creation of a robust digital infrastructure.

No matter how you slice it, the long-term benefits of demonetisation still lie in drastically reducing the unbanked population — a staggering 50% of India’s population — through accessible and easy-to-use financial services backed by a robust digital infrastructure. Without making this an urgent goal, the India government risks negating the short-term positive effects of demonetisation and going back to square one.

Seeing how difficult this task would be compared to merely issuing a decree to delegalise banknotes, empowering every Indian with banking services would be Modi’s true Lee Kuan Yew moment.

Professor Ramkishen S. Rajan is Vice Dean (Research) at the Lee Kuan Yew School of Public Policy, NUS.

Dr Sasidaran Gopalan is Assistant Professor at the Graduate School of Public Policy, Nazarbayev University.

Article written based on The Great Monetary Gamble in India (first published in Asian Survey, Vol. 57 No. 5, September/October 2017; (pp. 833-855) DOI: 10.1525/as.2017.57.5.833).