The Economy of Trust

Blitzkrieg

The year 2016 had been full of surprises. After the Brexit, the U.S Presidential Election was taking a surprising turn. And then by surprise, when the Indians all along the world were on the edge of their seats waiting for the election results, PM Narendra Modi surprised with the magic trick of turning all the 500 and 1000 Rupee notes to worthless pieces of paper. This sudden move was the NDA government’s blitzkrieg on black money or ‘Surgical Strikes’ as Twitterattis called it. When I saw the post in one of the Whatsapp groups, I thought that it was a fake news, a late night joke! How can any government in the world phase out 86% of the currency notes in circulation overnight without consequences? I found the press release when I googled for it. And the joke was on me.

How can any government in the world phase out 86% of the currency notes in circulation overnight without consequences?

What just hit us?

The first thing that came to my mind is that only valid major denominations in circulation were 100 and the newly announced 2000 rupee notes. There will be a sudden upheaval in the demand for 100 rupee notes and smaller denominations. Do we have enough notes to remediate this sudden rise in demand? Usually when this question was asked around, the response was that “of course the government would have thought about that? This is a bold move towards corruption and black money”. Very questionable assumptions as last couple of weeks taught us.

Government and RBI quickly came up with more details on where the old notes can be exchanged and till when. The banks operated longer hours and over weekends exchanging the old notes. The ATMs were lined up with long queues. The ATM machines had to be quickly configured to vend the new notes. Army ensured quicker delivery of new printed notes. Exceptions were given to petrol, CNG and gas stations, government hospitals, railway and airline booking counters, state-government recognized dairies and ration stores. What we saw was different government and private agencies working together to contain any damage as soon as possible. The nation was indeed at war. But were we actually fighting the black money and corruption or is there more to it than meets the eye?

The nation was indeed at war. But were we actually fighting the black money and corruption or is there more to it than meets the eye?

General Perception

The move was indeed very bold in many dimensions. Making the 500 and 1000 notes obsolete overnight, after the banking hours, would have definitely made at least some people restless – especially the people who hide their undisclosed money under their beds and some prominent politicians who are already under the radar with corruption charges. Some of them quickly ran to the nearest Rolex showroom or jewelers and bought expensive ornaments! The counterfeit bills that were printed across the borders in the enemy territories became good for fire wood. It might take some time before they catchup with the latest design and notes. Meanwhile, as a country, we can do a lot to prevent it from flowing back in again.

The Income Tax Department of India, under the income disclosure scheme, had been very generous in extending the deadline to September 30th, to reveal any undisclosed income. The demonetization was a knockout blow to those who still haven’t heed to the last warning. This forced them either to deposit the money in banks, which would expose them to the Income Tax department through the KYC documents, or to abandon the money. But as per Central Board of Direct Taxes “demonetisation may not be a solution for tackling black money or economy, which is largely held in the form of benami properties, bullion and jewellery“. So why did the process still go forward?

The time was right – crude oil prices were still down, good monsoon this year, US elections and wedding season in the North India? The US elections created market turbulence all over the world. With the Trump’s victory, several billions of dollars of FDI in India were withdrawn, making the rupee weak against the dollar. Such occasions usually lead to a high volume of foreign exchange transactions and are often thought to be opportunities to bring or withdraw black money. Demonetization would have managed to slow down this a bit. Meanwhile, the spending of black money during the wedding season was also affected.

The Question of Secrecy

The secrecy of this operation has been questioned by many. If the information had been known to the ruling party members and supporting business leaders, that would definitely of advantage, especially if we consider the upcoming U.P elections in 2017. It would give the ruling party a head start with the election funds in the state, while the opposition parties struggle to get valid notes. The banking data indicates that there has been a surge in the deposits in banks before September 30th.  The gold prices had dipped to the lowest in the last quarter. The prior knowledge of demonetization can be attributed to sudden rise in demand for gold and could result in hoarding of gold when it was available at low prices.

The funds could be distributed to a larger number of people in small amounts, deposited in banks and then collected back in some other means. Consumer goods could be sold at lower prices than the norm and write off the rest as loss? For people who had always found ways around the law to evade taxes, they will find a way to bring the money back into the country as legitimate money. There is even a bizarre story floating around that Reliance Jio’s 4G plan was deliberately sold cheap to collect the Adhar cards (Indian version of social security number system in US) details from people, so that fake bank accounts could be opened with it to deposit the unaccounted money.

The Bigger Picture

As a move in improve financial inclusion in the country, the NDA government started Pradhan Mantri Jan Dhan Yojana scheme. The program was successful initially with a Guinness record of most number of bank accounts opened. However, most of the common people, who were used to manage and store their own wealth at their homes, especially farmers, were reluctant to hand over their hard-earned money to the relatively unfamiliar banks. The government had seen potential in this underutilized capital and wanted to leverage. The demonetization rule would push such people to quickly make accounts or make deposits in the nationalized banks. This would raise more deposits and help some of these banks to ease the bad debt situation. This would also provide more funds for governments to perform infrastructural development.

On the flip side, the government gets more control over the private wealth. Even though we make deposits in the bank, we do not have any control over what the bank does with the money we lend. The bank in turn loans it out to government or a private agency who has got the contract from the government to perform an infrastructural development. The private agency, using its political power and financial might can delay or deny the repayment or even declare bankruptcy. The bank goes into stress and consequently fails. In India, in case of such an event, the maximum amount that a depositor is eligible for repayment is 1 Lakh Indian rupees. Can you blame anyone for not trusting the bank or the government in a time when we still haven’t completely revived from the 2008 global recession? The field of cryptocurrency itself was born from the revolt against such irresponsible banking activities and ineffective government regulations. Complete financial inclusion could mean that the economy becomes more susceptible to global financial changes such as a recession.

Complete financial inclusion could mean that the economy becomes more susceptible to global financial changes such as a recession.

The next action in the agenda is said to be to implement a digital currency. Although that plan a long way to go, including ensuring digital network and banking access to every nook and corner in India, the path is overwhelming – difficult to say whether the future is bright or scary. Digitization of currency makes it easier for the nation’s wealth centralized under the control of central government or towards a state-sponsored capitalism model with the citizens having lesser say in what should be done with their wealth. And if that central government cabinet is controlled by a powerful prime minister and his party secretary with an almost absent opposition in parliament, the decisions became autocratic in nature. Sounds familiar?

Aftermath

This operation is said to have affected retail and real estate the most. I have a 2000 rupee note that no one is accepting as they do not have the change to give back. There are places where they perform barter exchanges or provide slips with the money due for payment. Such actions keep the liquidity at float and prevent deflation due to slow down in business. However, too much unregulated liquidity causes inflation to rise and adversely affects poor people. Also, as retailers have to show source and there for bills for tax inspection, the prices of commodities charged on customers would rise. Many of the people who are daily wage workers, are reluctant to spend half a day in queue, trying to exchange the notes or in front of the ATM.

This operation has also affected the Co-operative banks and its customers. The scope of operation of these banks are restricted to the state where they have been established and is overseen by the state government officials. Also, these banks do not have the deposits to become a bank under RBI regulations. The main reason for this is that the customers of these banks are low-income farmers, daily wage workers etc. These banks help fund their farms, build the infrastructure, houses etc. RBI believes that these banks does not have the expertise and the skill to disperse the new notes. These banks are thus in great liquidity crisis.  The farmers are helpless with the harvest season approaching. This has resulted in wide-spread protests all over the country, especially in Kerala. It could be also attributed to the political differences between the central government and the state government in Kerala.

Economy of Trust

As I had mentioned earlier, the move was bold in many dimensions. The move was constitutional as per section 26(2) of the Reserve Bank of India Act, 1934 which says that “on recommendation of the central board of the RBI, the central government may, by notification in the Gazette of India, declare that with effect from a date specified in the notification, any series of bank notes of any denomination shall cease to be legal tender.” This is one of the reasons why the RBI should be independent of the government. In this case, the secrecy means effectiveness of the operation. Tomorrow, it could be some other decision that concerns national interests. The over concentration of power could be dangerous. The law makers should review such predated acts and processes which central government could misuse and make it more tight with multiple approvals.

Now it seems though that the central government has actually lost the purpose of this exercise. At first it was about black money, then about cashless economy. The general public supported the central government as they trusted the intention behind it. Several economists suggest that the effect may not be evident in short-term, but in long-term. In long term we all are dead. According to RBI, 12.44 lakh crore rupees out of 14 lakh crore rupees have returned to banks after demonetization. This means that either the expected black money has already been converted as legitimate after demonetization.

Also, there is no mention of what actions will be taken to prevent the building up black money again. The tax exemption on agriculture should also be revisited and made similar to other industries. The government has not followed up with further steps as they had promised earlier. The Fed rate hiking has made the rupee even weaker. RBI is unable to take any action to absorb back the rupees in the market, to create a demand for it and stabilize its forex value as it would only worsen the liquidity crisis in the country. Even the 2000-rupee note is planned to be rolled back once the new 500 and 1000 rupee notes are in circulation.

All the growth India had made was based on the trust on its economy. The trust that the system is stable and it will not fail. When a promissory note does not full its promise, it fails the economy of trust. This mistrust might further discourage the investors to invest. The consumer spending could reduce and focus more on savings in the form of gold or land or even Bitcoin. Reduction in consumer spending and investments would bring down the country’s GDP from the forecasted level. The sad thing about this is that there was a similar incident in erstwhile Soviet Union in 1990’s with similar consequences. If such an incident and its consequences were already known (I found it just by googling), why didn’t we prepare for it? I hope the other countries who are getting ready to follow the suit learn from our mistakes.

The central bank may be able to print enough notes in a few months and economy might recover in a year or two. The many lives and livelihood lost in the struggle may recover. But rebuilding the trust we had in our system will take forever.

Footnote

The media and social media activists seems to be polarized and engaging in pointless arguments. What we are not understanding is the key is a proper debate, a proper discussion. Not attacking someone or branding them as anti-national when they do not agree with your political views. It is not that if your affiliation is towards right you are an extremist or if your affiliation is towards left you are anti-establishment. It is not about your religion or caste or creed or sex. It is about the interest of the nation and its people. It concerns all the people in the nation, equally.

References

Article by former Prime Minister of India and a renowned economist – Manmohan Singh

Comments from Amartya Sen, Nobel prize winning economist

On the announcement and secrecy

http://www.voanews.com/a/indian-pm-modi-says-demonetization-will-boost-economy/3655628.html

http://www.dnaindia.com/india/report-demonetization-noted-economists-criticize-pm-modi-s-decision-in-standing-committee-of-finance-2285468

http://www.forbes.com/sites/timworstall/2016/12/04/absolutely-true-demonetisation-will-boost-indias-gdp-but-how-true-is-it/#3bc1c8c03217

http://www.hindustantimes.com/india-news/htls-2016-demonetisation-gains-uncertain-says-noble-laureate-paul-krugman/story-dFszJMERsydirqemQXcZ7L.html

Featured image courtesy – http://www.euroscientist.com/trust/

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