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Uploaded on February 1, 2017

Demonetisation and it’s implications on business, society and the political economy

Amir Ullah Khan

What is demonetisation? An unfamiliar term became the flavour of the season this winter, replacing surgical strikes and fake encounters. The first point to be noted in this discussion on demonetisation is the tendency now to invent catch phrases with unfailing regularity these days. There are regular new additions to our vocabulary. Beef bans. BMKJ. Digital India. Smart Cities. Yoga day. Bullet trains. 15 lakhs in each account. Strong rupee. 12 million jobs. Patel statue. Neutralising terrorists. New education policy. Sedition. Each term is ephemeral, lasts a few days till a new one takes over.

Back to Demonetisation. It is the process by which currency notes are declared illegal. While it sounds simple and easy, it is actually much more serious. What is money and how important is a currency note? It is a store of value, only because the recipient and the issuing authority have a moral contract they enter into. A ten rupee note is not worth a fraction of the value in real terms. It is valuable only because it promises to pay the bearer the sum of ten rupees whenever demanded. By declaring 86% of cash in the country illegal, the government not only withdrew its promise but also caused serious agony to the poor.

Ratan Tata has tweeted that the government must compensate the poor who are suffering. The entire exercise within the government has unfortunately become an irrational, emotional and moral issue. There is no economic argument being advanced. It is apparently not even a political issue. The PM’s friends are also pointing out to the fact that it is his core constituency, the small trader, who has been hit the worst. The explanation being extended is that some collateral damage will accrue. The fact that people are not rioting and have not taken to violence is being seen as proof of the success of demonetisation.

However, the money crisis rages on. People are still standing outside ATMs and banks trying to withdraw money from their own accounts. So what, asks the Prime Minister? Can’t you make small sacrifices for the larger good? This large-scale experiment has now become a moral science class. Don’t we stand in uncomfortable lines at airport security? Aren’t we uncomfortable waiting in queues at temples in Tirupati? Why can’t we do the same here?

There is a basic problem with this argument. When you go to the airport, you know there will be discomfort. You choose to travel by air knowing fully well what treatment awaits you at the airport. In the money example, people deposited their money in banks knowing the money is safe. They were promised that they could withdraw as much of their money whenever they wanted to. The machines that banks have put up are clearly called ANY TIME MONEY machines. Now, can the PM take all this away, unilaterally?

The argument for queues at dargahs and temples is the same. People go willingly and voluntarily to ask for something that is not theirs. The wait wasn’t announced unilaterally, after the contract was signed. Indeed, the government has the sovereign right to change laws and guidelines, but not arbitrarily. It can say that it will not print 1000 rupee notes henceforth, but when it declares existing notes illegal, it is going back on its promise to pay the bearer the sum of one thousand rupees.

The moral issue

The other moral dimension is far more critical. It questions the basic definitions of ethical behavior. In management classes, one of the first questions that students are asked is, what constitutes ethical decision making? The case study used to teach this is based on two hypothetical situations. In the first scenario, there is a room that has 99 innocent people and one dreaded terrorist. The question for you - should we bomb the building and kill the terrorist? In the second scenario, if there are 99 terrorists and one innocent person, will you bomb the building and kill all?

In most civilised democracies, the answer to both the questions is NO. Innocents cannot be sacrificed. Killing or hurting innocents is what terrorists do, to reach some exalted goal of freedom or some basic aim of extorting money. The state cannot do the same. The withdrawal of legal money by the government tests this hypothesis rather starkly. Millions of innocent bank customers must suffer so that a few black money hoarders may possibly be caught off guard.

Each citizen is being told that he should stand in queues to withdraw his own money. This will contribute to national growth, the propaganda machinery insists. There is obviously no economic argument being forwarded, as the economics of demonetisation is indeed complex. At least three prominent economists across the world, Kaushik Basu of the World Bank, Larry Summers of Harvard University and Ruchir Sharma of Morgan Stanley have categorically declared that Prime Minister has made a big mistake. There is no serious analyst backing this move. The PM is supported by acolytes within his party and by his old friends like Baba Ramdev.

There still seems to be some middle-class consolidation behind this whimsical move. The middle class is not impacted. But it sees a lot of poor people standing in line, either for themselves or for their bosses. What the middle class must ask is - Where are the big black money hoarders? Why did the RBI see a huge increase in large denomination deposits between April and September 2016? Have those with black money, the jewelers, politicians and the real estate dealers, already converted their money?

Can a government renege on sovereign promises and guarantees?

Kings and treasuries make a solemn promise to respect their guarantee. The promise is not conditional, is not made only for good times. The backbone of a financial island system is the trust that currency notes are backed with. When this trust breaks, chaos emerges. Gold becomes popular and expensive as it has intrinsic value that is not dependent on a capricious state.

The United States is a great case in point. It started issuing currency notes in 1862. The economy has seen huge amounts of tax evasion, of dirty money made in drug deals, money laundering worth billions and tons of counterfeit money. However, in the last 150 years and more, the Federal Bank has never withdrawn any denomination it has ever issued. The state has gone after tax evaders. It has made the Internal Revenue Service a powerful institution backed by strict laws. Banks work under strict guidelines. Most importantly, electoral reforms have ensured that political parties cannot collect unaccounted money and find it nearly impossible to spend unaudited amounts of cash.

That underlines the problem with this latest executive action taken by the Prime Minister. It hits at the base of our momentary policy. The trust in money, particularly in high-value notes is shattered. What stops Prime Minister Modi when he wins his fourth term in 2028 to declare the 2000 rupee note illegal and replace it with a 4000 rupee note. Banks then will only allow us to change 8000 rupees a day for the next three days.

A few questions emerge after the Prime Minister took it upon himself to make this announcement. What happened after the Morarji Desai government did the same forty years ago? Black money is estimated to have grown more than five fold after large value notes were declared illegal then. At that time, the decision came with a law that was passed in Parliament. This time the entire episode was cloaked in secrecy. What does this secrecy achieve except by way of putting millions through misery and pain?

In any case, the IT department is monitoring large deposits and big transactions with jewelers and real estate brokers. Zimbabwe and Philippines, two countries that announced demonetisation recently, did so over a period of six and three months respectively. Money continues to be legal tender through the transition and after old notes are replaced, they become illegal. Those who still stash them fearing action lose all value. The European Union allowed it's citizens nearly two months to move from national currencies to the euro in 2002.

In management strategy courses and in lectures that discuss ethical behaviour, there are a number of case studies where students make choices. Would you bomb a building that has two terrorists and a hundred innocent people? Would you go back on a promise if it is opportune to do so and you won't get caught? Similarly, does a democratic state have the right to induce suffering among innocent people to catch a few evaders of tax? Unless it is a matter of life and death, it's very unlikely that modern jurisprudence would allow such leeway.

The court will need to look into some of these issues when it does take this issue on. Is this not an action that needs to be passed in Parliament through a money bill? Does this action threaten a citizen's trust in the government? Can the Prime Minister through a fiat decree declare a sovereign guarantee null and void? The court may very well give such legislative powers to an elected government, but the harm to monetary policy is substantial. Unless this was done to deflect attention from the embarrassment in Bhopal, this looks like another spectacular goal.

All cash is not bad

The simplistic logic that is being used is that cash is bad, and is illegal. That is a clear fallacy, cash is by itself just a store of value. It becomes illegal when used for drugs or for terror or when earnings evade tax. The villain is not cash, it is the one who abuses tax provisions and exemptions. That is where the treatment must be targeted. Else it is like the measure Modi’s arch rival implemented for treating pollution, banning odd and even number cars on alternate days. Traffic is not the villain, it is polluting technology.

The argument that seems to have won over the middle class is that this move to declare 500 and 1000 rupee notes will hurt Pakistan where many people believe counterfeit currency is printed. It will also seriously impact terrorist cells and drug smugglers who use fake money. There is merit in this argument, but the amount of counterfeit money is far too little, by any estimate. Also, there is no reason for fake currency suppliers to stop, they will now print new bills.

Of the 90 billion Indian currency notes in circulation in 2015-16, only 0.0007% were detected as fake, according to the RBI. The value of these fake notes in 2015-16 was Rs 29.64 crore. In 2015, 0.88 million fake notes worth Rs 43.8 crore were seized, according to the National Crime Records Bureau data tabled in the Lok Sabha. Rs 27.8 crore was seized until September 30, 2016, according to the same data. The amounts are clearly far too little to be seen as the justification for such widespread misery.

This dictatorial move on part of the Prime Minister can therefore not be defended on logical and economic grounds. It will continue to be an emotional argument. People will be asked to behave morally, in the now fashionable spirit of nationalism. They will be pushed to feel guilty, for not doing enough to help the nation rise to greater heights. The Niti Aayog will protest; the government is not silly, it says. It knows what it is doing, even if it is unable to explain the same. The Prime Minister therefore will have to cry and shed some tears, to make his sentimental point.

The currency issue - A confused government takes ad hoc measures

It is going to be twelve weeks since demonetisation was forced on Indian citizens and a good time to know the experiences of common women and men from across the country. Speaking to people across the country sends one into a tizzy. A political analyst in Uttar Pradesh, not a BJP fan, insists the aura is not dimmed and that the party is winning 300 seats of the 403 assembly seats where elections are due soon. Hyderabad seems to be relatively untouched - a number of eateries continued to accept old 1000 and 500 rupee notes for the same size of dishes as before.

One US dollar was reportedly selling for Rs 126 if purchased in exchange of old notes. The dirham was at the same time allegedly trading at Rs 42. Both at roughly twice the formal rate. But the best exchange seems to be in the neighborhoods where a thousand-rupee note fetched Rs. 700 in rupee 100 notes. It is a moot point on who these money changers were and what they did after amassing the demonetised notes. The mystery is in the details of their identities which the government and the IT department supposedly has a good understanding of.

There is another route that people with excess cash were taking. College students with bank accounts were roped in. Each student deposits Rs 2.5 lakhs in his account. The student can retain 30 per cent and return 70 per cent sometime later. Corporate hospitals apparently were showing huge increase in workload through patient admissions for expensive surgeries. People were paying credit card bills in cash. Religious organizations and charities got large cash donations in old high denomination bills. While all this is in the realm of gossip and conjecture, what is for sure is that this one policy decision has recruited every single resident.

State governments reacted in various ways, passed some strange orders. The UP government announced that the state will accept old notes. The Telangana government extended this facility till at least the 24th of November. The Maharashtra chief minister had exempted Marathi theatre performances from the demonetisation. The Bihar chief minister came out in full support of the move, breaking ranks from an otherwise united opposition piling pressure on the Treasury benches in Parliament. Bill Gates clarified that he had not supported demonetisation as reported in the media. Two of the government’s allies, the Shiv Sena and the Akali Dal are with the opposition on this issue. Could anyone ever imagine Trinamul Congress walking side-by-side with Sena to visit the President of India!

Cinema producers were complaining as the audience had disappeared. Wage labour had been laid off at construction sites. Wholesale markets for agriculture produce(mandis) were reportedly deserted. The North East is always ignored and normally is insulated from policy problems in the rest of the country. But the situation seems to be just as bad. Automobile sales agents stated that business had completely dropped. The problem with money continues with ATMs running empty and people struggling to get hold of some cash.

There are rare conversations today, across the country, that do not discuss legal and illegal tender. The timelines are vague and getting further uncertain.

The Prime Minister at 8 pm on the 8th November had declared 500 and 1000 rupee notes illegal after midnight. However, they continued to be used, with government approval, at a number of authorised establishments. Then there was a sentiment in the air that it was a matter of days or maybe a couple of weeks. The home minister said one month while the Prime Minister said 50 days of waiting before the pain goes. Some analysts are saying this will continue till March 2017. Those who have got the new Rs.2000 notes are struggling to buy a liter of milk with it.

What is not clear is the people’s verdict. The middle class as always seems to have bought the patriotism argument. There is some pain that all of us must go through to cure the economy of its ills. Standing in queues at banks and ATMs is being seen as expressing solidarity with the soldier who battles at the border. Terrorism is being defeated, says the home minister, asserting that terror strikes have dramatically reduced after the announcement.

Indelible ink was used to prevent people from joining the bank queues repeatedly. Withdrawal limits have been announced and changed resulting in confusion all around. Even the biggest fans of the establishment and all those who think the Prime Minister can do no wrong are bewildered. The implementation, even they agree, has been chaotic. However, they continue with this blind belief that after the painful transition, the economy will boom. Unfortunately, economic policy cannot be made on fanatical grounds.

The fake and the black economy

The idea behind demonetisation is arguably understandable, even if it is contentious. Such schemes have not worked in the past, but a political commitment had to be honoured. The question is not whether the government was right, the concern is on why it adopted this chaotic and surreptitious approach. What was the need for creating this chaos and penalising honest citizens who believe in Indian money and trust in the Reserve Bank? The argument was that India’s cash based system needed to be transformed. At 12%, the cash economy in India is more than twice its counterpart in Brazil and about three times the proportion in the United States. India should also get rid of counterfeit currency and fake notes that have been coming in through the Chinese and the Pakistani border.

The World Bank has estimated the size of shadow economy to be 23.2% in 2007; and eight years later one would expect it to have increased further both in percentage and in absolute amount. How much of this gets impacted by the government’s move is the debatable point. But the real issue is how has the common man affected by it. The current demonetization has adversely the poor, wage laborers, small business, rural small farmers, women and minorities. This demonetization can well trigger a recession; while not addressing the giant level black or shadow economy. This affect only those individuals who maintain cash; but those who have already invested and converted into say an asset, business and in gold or jewelry are hardly affected.

In the case of this demonetization move, we are now left completely clueless on why the 500 and 1000 rupee notes were withdrawn. The Prime Minister in his famous 8 November address declared…”To break the grip of corruption and black money, we have decided that the 500 rupee and 1,000-rupee currency notes presently in use will no longer be legal tender from midnight tonight, that is 8th November 2016. This means that these notes will not be acceptable for transactions from midnight onwards. The 500 and 1,000 rupee notes hoarded by anti-national and anti-social elements will become just worthless pieces of paper.”

Unemployment in India

Why did the PM announce demonization then? If it did not achieve anything and caused so much trauma, what was the reason for this move? Some people have argued that the PM needed to do something drastic to move the public gaze away from various unfulfilled promises. Some say that this was done to debilitate the opposition in UP and leave it cashless as it prepares for the election there. It will be difficult to get at the actual reasons now. One possible reason that suggests itself is rising unemployment and the need to divert public attention from the lack of job creation.

India’s jobless growth is now getting to be really problematic. The last year saw new jobs grow at their slowest. While we needed at least one crore new jobs to be generated last year, we could only get about one and a half lakh new jobs during the entire year. This is paradoxical as India has been the fastest growing economy in the world this year. The Prime Minister has often underlined the fact that India is the most favourite destination for foreign direct investment.

How does one explain this trend of jobless growth? It is true that a large number of jobs are being lost to automation. According to the World Bank, automation threatens 69 per cent of the jobs in India, 77 per cent in China and 85 per cent in Ethiopia. The World Bank says that technology could fundamentally disrupt the pattern of traditional economic path in developing countries. Mechanisation has ended a large number of manual jobs across the world, not just in the United States.

The forecast is an eye opener for all those who are planning their careers after school now. Most traditional jobs are not going to exist ten or twenty years from now. Accountancy is already facing this problem. Travel agents have already been replaced by websites that do much more than what travel offices could have done earlier. The auto sector is waiting to see if driverless cars will be the norm a decade from now. In any case, with organisational structures changing so much already, there is very little use for supervisors and that cadre anymore.

In India however, the problem is not just restricted to technology and mechanisation. The first big problem is the ill health and malnutrition that afflicts many of our children. The World Bank’s president points out that India is in a situation where 38.7 per cent children suffer from stunting. Which means that the country is literally walking into the future with 40 per cent of its workforce probably unable to compete in the global digital economy, whereas China over the years has brought it down to very, very low levels.

Secondly, it is the educational outcomes that must be blamed. Poor-quality schools, colleges and universities produce unemployable graduates. Skill development and training is scarce and therefore a large proportion of the workforce, nearly 90 per cent of the total, does not possess vocational skills. Dropout rates are high, school syllabi are archaic and technical institutions are far too stringently regulated to allow faculty the space to innovate and catch up with today’s technology.

Third is the gender dimension. India has the dubious distinction of being among the 20 most difficult countries for women to work in. Over the last ten years, while women all over the world have joined the workforce in large numbers, in India the number of working women has sharply declined. While 37% women worked in 2005, today the figure is down to 27%. Paradoxically, India now has the largest graduate female population that is unemployed. Sixteen million women graduates in 2011 and 21 million today are jobless and this is a serious situation that speaks ill of the socio- political environment that exists today.

Of course, the story is the same for the Scheduled castes, Scheduled tribes and Muslim populations. Unemployment among Muslims is the highest among all socio- economic groups where only one-third of the community has regular jobs. As a result, more than 75 per cent of the rural Muslim population now is counted as poor, with poverty among Muslims in urban areas being double that of the national average. In terms of educational outcomes, Muslims have the lowest enrolment record and only 4.4% of students enrolled in higher education are Muslims.

Elsewhere in the industrial sector, the export oriented units have been scaling down. With a world economy that is close to recession, India’s exports have been falling continuously for more than 20 months now. This is despite the dollar being at 67 rupees. A number of foreign manufacturers have been closing their factories. Prominent examples are Nokia, Lafarge and Essar. Microsoft has shifted its Nokia plant from Tamil Nadu to Vietnam where it finds the cost of production lower and the ease of doing business better.

The upshot is that jobs will now be available to those who are skilled. Especially in new technology that is based on digital empowerment and an ability to work in a highly networked and connected environment. Language skills will be critical, too. Low-end jobs that were available earlier in large public-funded infrastructure projects or in private construction sites will no longer be the drivers of job growth as they were a decade ago. Today employment growth is seen in a few select sectors.

Banking and financial services have been the large employers recently and will continue to employ skilled workers for quite some time. E commerce is another driver of growth accompanied by supply chain firms, logistics and distribution networks. The other two highly-skilled sectors that will now hire larger numbers of workers are education and health sectors where there is a huge paucity of staff and thousands of vacancies both in the private and the public sector.

The Boston Consultancy Group has estimated that healthcare will be able to generate 40 million new jobs by 2020. As against this figure, Nasscom estimates that the Information Technology sector would generate 30 million jobs by 2020. The future will therefore demand that our youth are trained in new methods and in schools and colleges that offer education relevant to the new job market. Mere tinkering of school syllabi, board exams, entrance tests and final assessments is not going to be enough. The Human Resource Ministry has a serious problem on its hands if it continues to focus on ideological issues of teaching Sanskrit or stressing yoga and vedic education.

Universal Basic Income for all – is this the next announcement?

Even as the demonetisation exercise is underway, we have a discussion starting on giving a basic income to all. Indians will all get a minimum salary from the government. The sum being discussed is roughly a 1000 rupees a month. One view is that this will be given to all citizens regardless of their wealth status. The other view is that only those below the poverty line would get paid. There are some who argue that this should be given only to the rural poor.

The argument in favour of a Universal Basic Income comes from a realisation that unemployment is on the rise and therefore getting jobs will not be easy. Despite all good intention, the government has not been able to encourage industry to create jobs. There are nearly one crore new youth who enter the job market every year. Against this figure, the total new jobs created last year was less than one and a half lakhs. The scenario doesn't look promising in the near future, too.

The private sector is not investing to expand capacity, consumption demand is not picking up and the world economy is not encouraging a recovery in exports. On top of all this, there is a fear that automation is going to make new job growth even more difficult. Across the world a large number of jobs are being done by intelligent machines and robots. That is why the concept of a Universal Basic Income is coming up in policy debates across the world, guaranteeing a minimum income to all.

Unemployment creates various problems. The latest manifestation of this has been the huge protests in favour of Jalikattu in Tamil Nadu. An age-old sport that is said to cause great pains and misery to bulls has been banned. However, there has been a severe backlash against the ban, with thousands of youth protesting on the street and urging the government to call off the ban. The huge crowds of protestors has baffled everyone, just as the protests for reservation over the last couple of years.

Youth belonging to the better off communities of Jats in Haryana, Patels in Gujarat and Gujjars in Rajasthan have been demanding caste-based reservation. These upper castes now want to be moved into the backward castes lists as they face a situation where their traditional farming occupation is no longer remunerative and jobs in the formal market are few and far between. The perception therefore is that people belonging to lower castes are getting hold of the few jobs that come about. Large-scale protests are then the only way to urge the government to expand the lists of backward castes.

A basic income will provide the means for the jobless to lead a simple life without being deprived of essential food and clothing. There are two major questions that emerge from this concern. Who is going to benefit from this scheme? Should it be a universal measure that gives a basic income to all citizens and residents? Or should it be restricted to the unemployed and the poor? If it is not universal, the old problem with targeting will surface and only those who are visible and articulate will be benefitted, leaving the actual poor unattended.

If all Indians are paid at the poverty line which is Rs 1090 per capita per year, then the total sum would be nearly 18 lakh crores or 12% of the GDP. If half of this amount is paid, then the government will be spending nearly 5.2% of the GDP. This will be equal to all the subsidies paid by the central and the state governments by way of health, education, electricity, gas, sugar, transportation, railways, kerosene and water. The big question is whether such a major withdrawal of the government from providing basic services can ever be attempted.

If only the poor are paid, the total sum would come to about 3.5 lakh crore rupees. If this method is chosen and implemented, then it could mean the cancelation of all other income transfer schemes. With this, the Union budget does not get impacted. At the moment the government spends about 50,000 crores on the MNREGA and about 2 lakh crores on the Public Distribution System. Will the government drop these schemes after bringing in the UBI? If it does so, then the cash transfer will reach the poor and the large amounts of administrative costs involved and leakages tolerated will be saved.

Nearly fifty percent of primary enrolment in school is still within the government system, and at least a fourth of health care is still provided by a state run health care apparatus, however inefficient and rusty. A sudden withdrawal might be catastrophic. While a billion people are enrolled in the Aadhaar scheme, there are 300 million who still do not have identification. Also with at least half the population still not included in the formal banking system, a Universal Income scheme might have to wait longer.

The challenges in this drastic transformation are also formidable. A large number of subsidies and transfers are done by state governments. The Centre and states must be able to coordinate and together withdraw their schemes to be able to replace them with one income transfer scheme. Also, the complete withdrawal of government from the food market will result in quite a shake-up of the agriculture market leading to major upheavals for famers who are already facing a large burden.

The debate has started, and it will be interesting to see how it goes. Finland has started giving a basic income to 2000 of its citizens. Switzerland might start this activity soon. The Economic Survey is going to discuss this issue in detail. We would need some serious thought on this, not only from economists. What would be the social impact of such a scheme? Will the Prime Minister wait for all constituents to discuss this and come up with a smooth implementation plan? Or, will he again decide to launch this as a surprise move yet again?

There are other steps that are being considered. The PM has said that he would launch a major offensive against those who hold benami properties. Some are holding out the hope that there would be major reform in the political system and no party would be allowed to collect cash donations. There is also a fear that the government will now announce a maximum limit to the amount of cash and gold that households can keep with them. Of course, the one area in which uncertainty continues is when, or if at all, the government would lift the weekly withdrawal limits from banks and ATMs?

The author is Director, Aequitas Research and Visiting Professor, ISB, Hyderabad.