Demonetisation's enduring damage

Demonetisation is still hurting India's monetary stability, and govt/RBI have been unusually poor stewards of the macro-economy

Demonetisation refuses to go away. One and a half years after Prime Minister Narendra Modi went on television to declare that, in a few hours, Rs 500 and Rs 1,000 notes would cease to be legal tender, Indians still need to worry about what and how many notes are in their wallets. The most basic of questions for a modern market economy, a foundation so solid that few think about it, is the stability of the money supply. Yet Mr Modi and the Reserve Bank of India have managed to, somehow, undermine this.

Reports have come in from across India — particularly from Karnataka, Telangana, Bihar and Gujarat, but sporadically from elsewhere as well — that ATM machines have run dry, and that people are chronically short of cash. We cannot confirm this one way or another because there is no reasonable data issued by the RBI that can substantiate or deny this problem. The economic affairs secretary came up with some numbers for “excess” withdrawals, which do not at all gel with the RBI’s other numbers for regular ATM withdrawals. Even those with privileged information, such as SBI Research, have chosen instead to add to the confusion: They first claimed that there was a Rs 700-billion shortfall in the system, and then declared that there was a decline in ATM withdrawals in the March quarter — which again contradicts other publicly available data — and so the cash shortage was “superficial”.

In other words, we have been left in the dark — we have no idea what is going on other than the fact that there are multiplying complaints from various parts of the country about the availability of currency.

The response of the government and the RBI to this has been beyond unsatisfactory. On the one hand, we have been told that there was a spike in demand for cash, and that has caused a shortage; on the other hand, we have been told, usually in the same statement, that there is more than enough supply of cash. Both these statements cannot be true. One is forced to the conclusion that our senior economic policymakers are unfamiliar with the definitions of the words “demand”, “supply”, “shortage”, or “enough”.

Two things are clear. First, demonetisation did lasting damage to India’s monetary stability; we will return to this point shortly.

Second, this government and the RBI have shown themselves to be unusually poor stewards of the macro-economy. They declare themselves, for example, perplexed by this increase in demand.

What could underlie a spike in demand if indeed one was observed? First, there is the possibility of an unusual, one-time coincidence of factors — such as, for example, the combination of regional new year festivities, the Karnataka assembly elections, farmers’ requirements, and so on. Such a combination of factors might serve as a useful defence for the authorities against the charge of incompetence if they indeed had the virtue of being difficult to predict. Unfortunately, it is not generally considered an insurmountable task to predict the dates of assembly elections, festivals, and the sowing season.

Illustration by Ajay Mohanty

Second, one should consider the Opposition’s claim of a growing distrust in banks, fanned by concerns about widespread fraud and information about the government’s Fiscal Resolution and Deposit Insurance (FRDI) Bill, which failed to properly provide for the protection of depositors’ funds. Such concern is not, as far as I can see, visible in the numbers, although bank deposits grew in 2017-18 at the slowest pace not in the past few years, not in the past few decades, but in the past 54 years. However, perhaps I should not argue with the anonymous finance ministry officials who have told the Press Trust of India that the FRDI Bill is responsible; or with the All India Bank Officers’ Association, which thinks similarly. If these worthies are correct, then again the blame rests with the government; and an increase in cash hoarding should have been entirely predictable.

Third, one could examine the data provided by Credit Suisse’s Neelkanth Mishra, who has argued that at least since 2009, there has been a noticeable spike in currency demand in two fortnights of the year: The Diwali fortnight and the first fortnight of the new fiscal year (the beginning of April). If so, then the “excess” demand claimed by the government is simply seasonal — and, again, entirely predictable.

Fourth, one could perhaps look at the break-up of the currency in circulation at this precise moment. We have the Rs 2,000 note, which few want to hold as a medium of exchange but many might want as a store of value. In other words, it would have high demand, low velocity (the rate at which it is transacted). The Rs 200 note, which is rapidly being printed, might work in two ways: It might cause those holding on to Rs 2,000 notes to seek to break them and pick up a large number of Rs 200 notes in order to be more liquid; or it might cause an excess supply of notes, because people are hanging on to Rs 2,000 notes as a store of value. We don’t know the answer. Nor do we know what the ideal combination should be. But here’s the basic truth: The government and the RBI should have some sense of these dynamics. It does not appear they do; instead, it looks like they are pushing notes out almost at random, in response to technological and political demands.

And so we come to the last point: That demonetisation did lasting damage to India’s monetary stability. The likeliest explanation is simply that there is still too little cash out there, and that whatever cash is there is not in a stable demand-driven combination of high- and low-value bills. There may be more currency circulating than on the eve of demonetisation, but India’s nominal GDP is far higher. If consumer behaviour is the same as it was prior to demonetisation, then of course there is a general shortage of currency in the economy. (Vivek Kaul estimates this shortage at Rs 1,300 billion.) The government, in one of its final meretricious and implausible justifications for demonetisation, had declared India would move to digital payments, and need less cash. The authorities seem to have been operating on the basis of that assumption being true, and may thus have caused another crisis. Instead the truth appears to be that demonetisation changed nothing — except making individuals more concerned about the availability of cash, and aware of the dangers of a currency shortage, and are thus more likely to hoard and provoke self-fulfilling shortages.

Demonetisation was an absurd and dangerous policy. The RBI damaged its credibility as the guarantor of monetary stability by playing along with the government’s folly.

In refusing to accept its failure, the government has sowed the seeds of further damage: by keeping India short of cash; reducing the headroom for responses to seasonal spikes in cash demand; and increasing the chances that groups will panic at temporary cash shortages. Where is the accountability for this disastrous policy?

m.s.sharma@gmail.com

Twitter: @mihirssharma