<b> Siddhartha Mitra</b>: When politics trumps economics

Demonetisation move is economically inept, the measure might be a political masterstroke

On November 8 this year, 86% of the cash in circulation in the Indian economy in the form of high-denomination notes was declared invalid without prior intimation through a live announcement by the prime minister. The officially stated objectives of demonetisation are a war on black money and terror financing; the neutralisation of high-denomination counterfeit notes; and a big push to cashless transactions in an economy characterised by a high cash-to-GDP (gross domestic product) ratio and, therefore, a high propensity for the generation of black incomes. 
 
While no expert would disagree with these objectives, the key question is whether the right instrument has been adopted, given that there are a dozen relatively painless alternatives for promoting a less-cash economy. I argue that this measure, though economically inept, might be a political masterstroke.
 
With regard to costs, over the last month demonetisation has inflicted misery. The impact, as explained below, has been regressive despite official claims to the contrary: The rich (say, the top 10% of the income distribution) have suffered the least; the middle classes (population between the 40th and 90th percentile) significantly more; and the poor (those below or slightly above the poverty line) the most.
 
A significant proportion of the rich are plastic-money-using salaried professionals earning perfectly legitimate incomes. Queuing costs induced by demonetisation have been low, especially because of access to privilege banking. Contrast this with the middle classes, who use cash more frequently. According to a Visa survey, debit card penetration rate in India was 53% in 2011; by now it may have covered almost every non-poor household. However, the surveyors find that cash payments are preferred and attribute it to two major inaccurate perceptions —fear of additional fees on debit/credit card transactions and regular use of cards leading to overspending. The first perception, though, may not be false: Many shops offer discounts on cash purchases which, though small, are valued more by the middle classes than by the rich and result in greater propensity for cash transactions. Moreover, often the same products are available in the formal as well as informal sectors; while the rich meet their requirements almost entirely from supermarkets and branded outlets, the middle classes often settle for cash purchases of lower-priced substitutes from the informal sector.
 
Therefore, compared to rich households that pay all their taxes, demonetisation has impacted the middle classes more: 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 adversely affecting purchasing power. This propensity combined with the association of lower incomes with smaller withdrawals may result in more time spent in queues.
 
The effect on the poor, employed as wage workers and peddlers, has been catastrophic. Many non-agricultural workers have been rendered unemployed as paucity of cash has constrained wage payments. The story in agriculture should be no different, especially as cash-strapped large farmers probably go in for mechanisation to displace human labour needing regular cash payments. With regard to the self-employed, the deluge of Rs 2,000 notes accompanied by a trickle of Rs 500 notes and a scarcity of Rs 100 notes have had a severe contractionary effect on the volume of transactions thus sounding the death knell for most small informal-sector operations.
 
What about the rich, who hold significant amounts of black wealth? Statistics point towards the ineffectiveness of demonetisation: Within 21 days of its onset, deposits made in banned currency notes reached close to Rs 11 billion — around 75% of the Reserve Bank of India estimate of the value circulating at the end of March 2016 of now invalidated currency notes. Simple projections demonstrate that the possibility of large amounts of black money stashed away by the rich becoming valueless after December 31 is indeed remote.
 
Media reports corroborate these findings: Commission-earning intermediaries exchanging 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 Rs 2.5 lakh ceiling for hassle-free deposit and facilitate laundering of black wealth). For example, in just the first two weeks of demonetisation, the total balance in accounts under the 27-month-old, ostensibly pro-poor Pradhan Mantri Jan-Dhan Yojana has increased by about 60%, prompting a large government campaign warning against collusion with hoarders of black money.
 
Demonetisation is also unlikely to be a lasting solution to the linked problems of fake currency and terror financing: A forensic report by the National Investigation Agency indicates that a sophisticated machinery exists for manufacturing fake currency capable of recalibration.
 
Demonetisation has been associated with significant costs and almost none of the touted benefits in the form of destruction of black wealth and a permanent solution to terror financing and counterfeiting. To conclude that this policy measure was a monumental mistake might, however, be a wrong inference. The very announcement of intentions to punish rich people with significant amounts of black wealth, through demonetisation and associated measures, has led to a surge in satisfaction levels among the middle classes and even among the poor despite their own suffering. Electorally, it might be a masterstroke, at least in the short run.

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The author is a professor of economics at Jadavpur University, Kolkata
Published with permission from Ideas For India (www.ideasforindia.in), an economics and policy portal