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The End of a Cash Society in India?

The End of a Cash Society in India?

Financial Lockdown

On November 8th Narendra Modi administered a shock to India’s financial system. Calling for the withdrawal of all 500 and 1000 Rupee notes from circulation, Modi claims demonetization will bring billions of units of currency, currently unaccounted for, into the formal banking system. This will, in theory, clean India’s economy of “black money,” a term used in the country to refer to undocumented and untaxed wealth.

The move rests on dubious rationale given that India is an overwhelmingly paper currency-based country: around 90% of the transactions are done with cash. India’s cash-to-GDP ratio is 12% and more than half of Indians don’t have a bank account. The two scrapped denominations – 500 and 1,000 rupees – account for more than 86% of the value of cash in circulation. By this mandate, the government effectively neutralized 86% of the currency in India.

Given that a staggering 94% of the labor force is employed in the informal sector of the economy, the implications for most people were disastrous. Daily-wage earners, farmers and small businessmen were hit the hardest, waiting for hours in serpentine queues that formed at banks and ATM’s to withdraw smaller denominations and exchange bills.

Not only did the abrupt implementation of the scheme harm the economy, as several foreign investors decided to pull out huge amounts of capital from the country, but the human impact was also dire. A number of senior citizens actually died from exhaustion while waiting and many sick people were not accepted to hospitals if they could only pay in old notes.

(Photo: Indianexpress.com)

Modi’s administration has faced sharp criticism over the slow pace of introducing the new notes, with banks running out of cash and ATMs having to be recalibrated to cope with the different sized bills – a process that is still incomplete.

Black money in cash represents roughly 6% of total black money belonging to citizens of the country, as most people choose tax free havens in Switzerland or Panama to store their gross amounts of wealth.

The world-renowned economist Lawrence Summers remarks on Modi’s policy are therefore very fitting: “Most free societies would rather let several criminals go free than convict an innocent man.  In the same way, for the government to expropriate from even a few innocent victims who, for one reason or another, do not manage to convert their money is highly problematic….”

 

Lessons From Other Countries

The Myanmarese kyat was demonetized three times in 1987 by its military government, all to curb black marketeering and smuggling. However there was no provision for exchange of the old denominations. A severe burst of inflation was caused by consumers frantically purchasing goods as they did not want to hold on to the old currency.

The rise in prices severely affected real wages, which remained fixed. Moreover, the high commodity demand led to goods being smuggled from China, which could produce goods at cheaper prices. Consequently Myanmar underwent economic stagnation, with food prices rising and the domestic industry suffering from competition with China.

The resentment that followed this period of protracted economic hardship towards the military administration was a key reason behind the riots and uprisings that occurred in 1988.

Narendra Modi’s demonetization move also echoes that of Mikhail Gorbachev’s in the Soviet Union. In 1991 he declared 50 and 100 ruble notes invalid as of midnight that very day. Old notes could be exchanged for new ones during a mere three-day window, after which one would have to appear before a special commission to exchange his or her worthless currency. The aim was explicitly stated to combat the black money-based parallel economy.

Economic activity took a major hit and several soviet republics were severely affected, causing them to leave the ruble zone. It’s contended that demonetization and its consequent effects led to the break-up of the Soviet Union. Trust in the monetary and financial architecture constitutes the foundation of a modern economy, so when you jeopardize that trust, pillars begin to shake.

Image result for mikhail gorbachev 1980s

Mikhail Gorbachev demonetized the Soviet Union in 1991. (Photo: biography.com)

 

Drawing it Back

Modi has urged for a movement to turn India into a cashless society, imploring young people to spread their knowledge of mobile banking and e-commerce technology.

While this may seem promising as over this year India crossed the milestone of one billion mobile subscribers and 220 million smartphone users, the internet penetration figure remains low at 15% of the total population.

Similarly to India’s previous demonetizing spells, the Reserve Bank of India rolled out a capped amount of 2000 rupee notes. Although it seems counterproductive, making it easier for people to store larger sums of black money, it is only temporary as the notes were only introduced to fill the void in the system created by the withdrawal of smaller currencies. This implies that yet another round of demonetization will take place in the future once there are enough 500 rupee notes in the system and the economy is stabilized.

The idea is to force people into using digital payment means, but is India really primed for such a transition? Modi’s desire to end the use of paper currency in India is ambitious, but it may tamper with society’s trust in the country’s financial institution which could have grave consequences.

The fact that this is the 3rd time India has resorted to demonetization speaks to the efficacy of the measure, but whether Myanmar and the former Soviet Union’s affairs with demonetization are portents for upcoming events, is yet to be seen.


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