The demonetisation puzzle

Was the massive economic disruption worth it?

A year after Prime Minister Narendra Modi stunned the nation by announcing the demonetisation of high-denomination currency notes, the government and the Bharatiya Janata Party (BJP) have declared that the anniversary will be celebrated as “anti-corruption” day. A corruption-fighting narrative is sound and clever political positioning and the ruling party has earned hefty dividends from it so far. Almost immediately after this highly polarising decision, the BJP had a resounding success in state Assembly elections — crucially sweeping aside all opposition in Uttar Pradesh. 

Government spokespersons also have data to back their claim that demonetisation reduced the cash-to-gross domestic product ratio — it has come down to 9.7 per cent from 11.3 per cent that prevailed before the note ban announcement last year. Digital payments have received a boost; these are up 41 per cent, year on year. Taken together, this has pushed India towards a “less-cash” and more formal economic structure, which while facilitating greater financial inclusion, is more transparent and less prone to tax evasion. The government has said that the note ban has brought an additional 9 million people inside the tax net. Moreover, tax officials have sent out close to 2 million notices, asking people to explain their bank deposits in the wake of demonetisation. Similarly, many companies are facing inquiries and over 200,000 shell companies have been deregistered already. All these are expected to cleanse the system somewhat, backing government claims that the so-called short-term inconveniences will be more than made up by the long-term benefits to the economy as well as society. 

The problem is that many of these so-called gains have come at a huge cost, raising a question about the desirability of the decision, not to mention the botched execution that inflicted enormous hardship on millions, delayed remonetisation, regularly shifting goalposts and almost daily changes in rules. For instance, it is now evident that the Indian economy, especially the informal sector, which was mostly dependent on cash, received a massive jolt. As reporting from across the country has shown, the informal economy was grievously wounded by the sudden monetary vacuum. Even a year on, many small and medium businesses are struggling, and the additional disruption due to the introduction of the goods and services tax in July has made things worse. The fact is data on GDP growth, which plummeted to 6.1 and 5.7 per cent, respectively, in the first two quarters of 2017, barely capture the decline of economic activity in the informal economy. 

The question is whether the government could have achieved all its stated goals – from greater digitisation to less cash use to newer currency notes and attacking black money – without the massive disruption to the economy. The government also clearly underestimated the speed and flexibility of methods of money laundering, which is clear from revelations that suspected shell companies deposited and withdrew Rs 17,000 crore in the days after the note ban. One company, which had a negative balance before demonetisation, transacted Rs 2,484 crore within a few days after November 8, 2016. Finally, the decision to go ahead with demonetisation despite the Reserve Bank of India advising against it does not reflect well on the government’s ability to choose economic policy instruments.