What did we learn from demonetisation?

The nation got a four-hour notice.  The Prime Minister announced on national television that by midnight all the high value currency notes would cease to be legal. This was Mr. Modi’s Pokhran moment. The similarity with India’s nuclear blast of 1998 was in more ways than one. Firstly, the secrecy, which ensured only a narrow circle knew what was coming. In Mumbai, senior bankers had been summoned to the Reserve Bank of India, for an evening meeting, and were clueless until the last moment about what was coming. The surprise element was crucial.

Secondly, like the nuclear test, it was also the sheer audacity of the decision. It was unthinkable that the third largest economy in the world, would abruptly make 86 percent of its currency illegal. Just like Pokhran, the entire world sat up and took notice. Thirdly, just as Pokhran test led to nuclear sanctions, and drying up of foreign investment, so did demonetisation lead to large economic costs and hardship. But more about that later. Fourthly, the nuclear test led to a bitter debate on whether this was good for India or not. And whether India had lost its moral authority on nuclear disarmament (never mind that she never signed the nuclear non-proliferation treaty). The naysayers against the Pokhran blast were in a small minority. And indeed, within seven years of the nuclear test, the US signed a special civil nuclear deal with India, bringing it out of a three-decade old unfair nuclear apartheid.

 So looking back Prime Minister Vajpayee’s decision to conduct the nuclear test proved to be a net positive. Similarly demonetisation too led to a bitter debate. But in this case the naysayers were in a large majority. The comparison with Pokhran can only be stretched so far. Unlike the Pokhran test, demonetisation has affected each and every Indian. If it turns out to be a net positive, that is still in the distant and uncertain future.

The costs of demonetisation were all front loaded, are significant and quantifiable. The benefits will accrue in the medium to long run, are uncertain and some are even unquantifiable, so demonetisation fails the test of conventional cost benefit analysis.  The textbook definition of demonetisation calls for discontinuing high value notes, with a notice period of twelve to eighteen months. What was carried out in India instead, was a giant currency swap with zero notice period. The higher value new 2000-rupee note was introduced. So this is not the demonetisation that is talked about in the G20 circles or advocated by the likes of Kenneth Rogoff, former economics head of the IMF. Since this was a currency swap, and old notes were instantly abolished, while new notes were not quite ready, it caused a lot of hardship. People had to wait for hours in long lines, over several weeks to withdraw their allowable quota of new cash.  Since commercial banks were flush with old notes, most of that old cash was deposited with the Reserve Bank of India in the reverse repo facility. The RBI had to pay reverse repo interest (around 6 percent) to the banks. The RBI also had to incur the cost of printing close to 15 lakh crore of the new notes. Due to both these additional costs, the RBI annual dividend to the government of India dropped by more than Rs 35,000 crore. This amount too should be counted as a cost of demonetisation.

It is now well known that the agriculture and informal sector where cash plays a big role, suffered a loss of output and jobs. It is reflected in the slowing down of GDP growth to below six percent. A one percent lower nominal GDP growth rate, implies a loss of national income equal to Rs 1.5 lakh crore. That also meant a loss of millions of jobs. This is a huge cost to pay for removing black money, which was ostensibly one of the prime objectives of demonetisation. On that count, too success looks limited, although a lot of accounts with suspiciously high fresh deposits have been identified. Of course, it does not automatically imply that those accounts have black money.

On the positive side was the increase in digital transactions (due to forced shortage of cash), and an increase in the number of potential taxpayers. The government says that now every rupee has “an address” and is traceable, which was not possible before demonetisation. But given that black money has a tendency to be created all the time, and be converted to benami land and gold, it won’t be long before we have a new stock of black money.

The main lessons of demonetisation were as follows. Firstly, the PM’s word carries a lot of weight of credibility. For weeks and months, the people supported the PM, and despite their hardship, believed that this shock therapy was good for the nation. This was reflected in various surveys. Unlike India, in Venezuela a similar experiment to discontinue high value notes had to be aborted within 48 hours.  The second lesson is that eradication of black money is not possible with a one-off action, however drastic and unexpected. It calls for all round strengthening of institutions and mechanisms, and reducing incentives to create black money. Thirdly, the RBI level of preparedness was simply inadequate to meet the huge demand for new cash. Hence better homework is called for. Fourth lesson is that the goals of less cash, less informal economy, higher financial savings, and widening of the tax net, need constant, relentless, innovative and gradual policy and institutional pressure. It does not happen with a one-time jolt. Fifth lesson is that the Indian public has large reservoirs of patience, resilience and forgiveness. If they sense honest intent, they might forgive policy mistakes.

 India is willing to experiment, up to a point. Even at great short-term cost. But mid-course correction is necessary. The sixth lesson is that politics trumps economics, always. If economists had been asked, most of them would have advocated against the abrupt style demonetisation. They would have advised caution. It was ultimately a political decision, which did pay political dividends. The political narrative was powerful and compelling. Even though on all metrics, the economic benefits fell short of the costs, there was hope, that in the longer term the benefits would come. Whichever side of the optimist pessimist camp you belong, this unprecedented and unthinkable demonetisation has been a watershed event in modern India.

The author is an economist and Senior Fellow, Takshashila Institution