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Saturday / March 25.

How politics played a bigger role than economics in demonetisation

Poor Man

By Siddharth Mitra

On 8 November 2016, 86% of the cash in circulation in the Indian economy, in the form of Rs. 1,000 and 500 notes, was declared invalid without prior intimation, through a live Prime Ministerial announcement. The officially-stated objectives of demonetisation are a war on black money and terror financing; neutralisation of high-denomination counterfeit notes; and a big push to cashless transactions in an economy characterised by one of the highest cash-to-GDP (gross domestic product) ratios in the world, and therefore a high propensity for the generation of black incomes.  

No right-minded social scientist or economist would disagree with these objectives; the key question is whether demonetisation is the right means for their attainment.

In this article, I argue that this is certainly not the case as the costs till date have been significant and promise to be more so in the long-run, while the benefits have been miniscule. Moreover, most of these objectives could have been achieved gradually through exclusive reliance on relatively painless moves, such as a gradual lowering of the ceiling on cash withdrawals from bank accounts, facilitation of cashless transactions through mobile telephones and Aadhaar1 cards, and tax discounts on cashless transactions (post demonetisation, we have seen the implementation of some of these measures). But merely asserting that demonetisation has been ill-advised amounts to scratching the surface. I will go on to argue that such measures, deemed inappropriate on the basis of standard economic cost-benefit analysis, often make for sound political arithmetic with political gains overwhelming losses.

Impact on the rich, middle class and the poor

In regard to costs, demonetisation has inflicted rare misery on the Indian population over the last month. The impact has been regressive despite claims to the contrary: the rich (defined here as the top 10% of the income distribution) have suffered the least; the middle and lower middle class (the population lying between the 40th and 90th percentile) significantly more; and the poor (those below the poverty line or slightly above it with a danger of falling below it in bad times) the most. The explanation of this conclusion runs as follows. 

A significant proportion of the rich are salaried professionals earning perfectly legitimate incomes, who have been transacting mostly with plastic money even before demonetisation.Demonetisation has had a very limited effect on this class: costs incurred in terms of queuing time, especially as many in this category have access to privilege banking services, have been low.

Demonetisation has had a very limited effect on this class: costs incurred in terms of queuing time, especially as many in this category have access to privilege banking services, have been low.
Contrast this with the middle and lower-middle classes who use cash more frequently, not because they lack access to plastic money but because of mindsets. According to Visa’s Global Payment Tracking Survey, 2011, the debit card penetration rate in India was 53%; by now it could well be 60%, thus covering almost every non-poor household. However, the surveyors find that the rate of usage is low with consumers preferring cash payments. This finding is attributed to two major misperceptions: the fear that an additional fee is incurred on each debit/credit card transaction and that the regular use of cards leads to overspending. The first perception, though, might not be false – shops even in the formal sector have often historically offered discounts on cash purchases (this is poorly documented, but I speak from personal experience). These small discounts are valued more by the middle classes than by the rich and result in greater propensity for cash transactions. Second, very often the same products are available in the formal sector as well as in the informal sector; while the rich meet their requirements almost entirely through purchases from supermarkets and branded outlets, those below them in the income distribution are more cautious in their purchases from the formal sector, often settling for cash purchases of lower-priced substitutes from the informal sector. 

Compared to those rich households which pay all their taxes, demonetisation has impacted the middle and lower-middle class households to a greater extent
Therefore, compared to those rich households which pay all their taxes, demonetisation has impacted the middle and lower-middle class households to a greater extent on two counts. First, their greater propensity for making cash purchases implies a more significant impact of demonetisation on spending habits in the form of a forced switch to cashless purchases of higher-priced products from the formal sector, thereby leading to a discernible decline in purchasing power. Second, this greater propensity combined with the association of lower incomes with a tendency to make smaller withdrawals may result in more time spent in queues.

But if the middle classes have been significantly inconvenienced, the impact on the poor has been catastrophic. Most poor people either work as wage workers or peddle varied merchandise. Lakhs of wage workers in the non-agricultural sector have already been rendered unemployed because of paucity of cash constraining wage payments. There is no reason why the story should be different in the agricultural sector, especially as cash-strapped large and medium farmers go in for large doses of mechanisation to displace human labour with their need for regular cash payments. In regard to the self-employed, the main reason for their woes is the deluge of Rs. 2,000 notes accompanied by a trickle of Rs. 500 notes and a scarcity of Rs. 100 notes, which has fed on itself due to hoarding. Thus, a fraction of even the vastly diminished desired purchases from the informal sector actually go through in these troubled times. The resulting contraction of consumer spending might sound the death knell for most small informal-sector operations. 

Shop in a village

The poor are the ones who have the least access to digital money|Image courtesy: Unsplash

What’s the good coming out?

But what about the rich who earn/hold significant amounts of black income/wealth? The government has declared its intentions to punish those holding black wealth and announced a slew of measures (for example, income disclosure schemes associated with higher than normal tax rates on disclosed incomes and very high penalties once the schemes close; possible interrogation by the Income Tax Department if deposits of more than Rs. 250,000 are made etc. – for a review see this). 

The cold facts that have emerged till now about the efficacy of these policy measures are not very encouraging. By 29 November, just 21 days after the launch of demonetisation, deposits made in banned currency notes, according to media sources, may have reached close to Rs. 11 trillion. According to RBI (Reserve Bank of India) data, as much as Rs. 14.18 trillion were in circulation in the form of now invalidated currency notes at the end of March 2016. This means that if we consider the period between 8 November and 31 December as the period earmarked for demonetisation (since hassle-free deposit of invalidated currency is allowed only within this period), about 77% of the total value of invalidated currency has already been deposited before the half-way mark has been reached. Simple projections demonstrate that the possibility of large amounts of black money stashed away by the rich becoming valueless after 31 December is indeed very remote. 

Media reports offer an explanation for the above statistical findings – commission earning intermediaries exchanging the old currency notes belonging to the rich for new currency or depositing these in their bank accounts (several such intermediaries linked to a significant hoarder of cash can get around the mentioned Rs. 250,000 ceiling for hassle-free deposit and facilitate laundering of black wealth).

To give a significant example, in just the first two weeks of demonetisation, the total balance in bank accounts under the 27-month old Pradhan Mantri Jan Dhan Yojana (PMJDY), launched to bring about financial inclusion of millions of poor households, has increased by about 60%. A large government campaign mounted through national television warning such account holders against collusion with hoarders of black money could only have been prompted by strong evidence of misuse of these accounts. 

Concluding remarks

Thus, the costs of demonetisation have been significant. Evidence, statistical and anecdotal, seems to indicate large-scale incidence of money laundering, thus rendering ineffective the war on black money. Further, the surmise that demonetisation is a lasting solution to the linked problems of fake currency and terror financing is based on the false presumption that the machinery engaged in manufacturing fake currency is unsophisticated and incapable of recalibration. Thus, it can be safely concluded that the realised benefits of demonetisation are small in magnitude compared to the costs. 

To conclude that this policy measure was a monumental mistake might, however, be a wrong inference, based on an incorrect notion that policies associated with an unfavourable benefit-cost ratio invariably lead to adverse political outcomes. In the case of demonetisation, making the realistic assumption that the satisfaction levels of individuals are influenced not only by their own material and physical states but also by those of others, is one way of realising that such an inference might be wrong. Thus, the very announcement of intentions to punish rich people with significant amounts of black wealth, through demonetisation and associated measures, could possibly have led to a surge in satisfaction levels among the middle classes and even among the poor, despite significant suffering for these very economic classes. In short, the very concept of utility, a standard tool used by economists, can be used to demonstrate that adverse economic outcomes might still result in favourable political outcomes for the incumbent. 

Note:

  1. Aadhaar or Unique Identification number (UID) is a 12-digit individual identification number issued by the Unique Identification Authority of India (UIDAI) on behalf of the Government of India. It captures the biometric identity – 10 fingerprints, iris and photograph – of every resident, and serves as a proof of identity and address anywhere in India.

Siddharth Mitra is a professor of economics at Jadavpur University.
Featured Image Courtesy: pexels.com
This article was originally published in Ideas for India.
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