India’s Disruptive Gamble

by Ravi Srinivasan

(Ravi discussed this post at the BreakingBank$ podcast. His segment starts at 20:10.)

Modi’s demonetization was the other November 8th global earthquake.

A thorough historical record will show that not one but two man-made events shook the world on 8 November 2016. One was of course the election of Donald Trump to the US Presidency against the predictions of nearly all polls and pundits. The other was the Indian government’s shock and awe decision to withdraw from circulation all ₹500 ($7.3) and ₹1,000 ($14.6) rupee bank notes, equivalent to 85% of the country’s paper money. Although the first event dominated the headlines, the second will have a greater impact on over a billion people in India and elsewhere.

indiabanknote

500 rupee banknote, an endangered species since 8 November 2016.

This process known as demonetization is the latest in a series of initiatives by the Modi government to modernize Indian society and to increase financial inclusion and digitalization. Along the same lines in the past two years, other government efforts have included the ambitious and unprecedented Aadhaar national identification system started in 2012, the Aadhaar-based remittance system offered by the National Payments Corporation of India in 2013, and the Jan Dhan Yojana drive to bring financial services to lower-income segments of society. Some private players such as Paytm, Citrus Pay, Mobikwik and Freecharge have also moved in lockstep with public initiatives.

More recently in June 2016, the Income Declaration Scheme was set up by the central government as an amnesty to allow black money to be declared and taxed. This scheme came into effect as a one-time measure for non-compliant people to disclose and pay tax on hidden income. It lasted until the end of September and set the stage for demonetization a few weeks later.

The decision announced on November 8th was targeting three deeply rooted problems that have plagued India for decades:

  1. Counterfeit currency: India’s currency is the ninth most counterfeited in the world in terms of value. As explained here, regional tensions in South Asia contribute significantly to this situation.
  2. Cash-funded terrorist activities: Local extortionists, terrorists and other similar entities typically use cash, real or counterfeit, for their activities. It is very likely that they will adjust their tactics, but demonetization is most certainly going to have a short-term impact.
  3. Rampant tax evasion estimated at $400 billion annually: Along with the Income Declaration Scheme and potentially other future steps, demonetization will slow or could even roll back the accumulation of black money.

Near-term Impact

Before November 8th, the sum of measures intended to increase financial inclusion had not succeeded in overturning Indians’ deeply-seated preference for cash transactions. India had remained a largely cash-based economy, with over $220 billion in cash circulating in the just cancelled denominations.

Therefore, the near-term impact of the sudden decision has been severe in many quarters and includes the following:

  • A so-far unmeasured short-term impact to national economic activity as citizens, ranging from daily wage laborers to factory workers to white collar professionals, stand in multi-hour lines at banks across the country to exchange their banknotes.
  • Stunted business exchanges due to a multi-generational trust in cash. All forms of transactions and events are on hold as suppliers have been unwilling to accept payment in either the old cancelled bills or in digital form.
  • Small businesses engaged in more tax evasion through for example back dating of receipts and invoices.
  • Cash-rich and potentially tax-evading wealthier citizens pressuring their personal staff (drivers, cooks, etc.) to deposit cash on their behalf to circumvent the deposit limit of ₹250,000 imposed on each individual.
  • Good Samaritans who are depositing large amounts of cash in smaller denominations (₹100) to assist banks in their conversion efforts.
  • Multiple reports of deaths and suicides, as some people were unable to adjust their financial conditions.
  • Innovative approaches as, for example, with the introduction of coupons and debit cards in local vegetable markets in the state of Telangana.

The scale and size of India’s long-standing cash economy are now being tested as never before. The entrenched preference of many Indians is to trust cash and to distrust non-cash ‘financial inclusion’ measures. There are, however, encouraging developments towards non-cash solutions. Paytm, for instance, is a privately-run firm that is now India’s largest mobile commerce platform. Its digital wallets can be used for paying for everything from mobile minutes to movie tickets to electricity bills. Despite the historical aversion to non-cash transactions, demonetization has proved a boon for Paytm, rapidly boosting its user base from 100 to 150 million users.

Overall however, the two weeks since November 8th have proved to be stressful and somewhat disorderly. To many, the near-term dislocation in normal economic activity suggests that the government bungled demonetization by failing to communicate its purpose and by missing an opportunity to earlier educate the population on the availability of cashless alternatives like credit cards and e-payment systems. Even ATMs were not adequately supplied to handle the massive queues that quickly formed after the announcement. A case could be made then that other entities such as major corporates should have been enrolled to blunt the severity of the impact.

Longer-term Impact

Impact on behavior: At this stage, the longer term impact is harder to gauge. Depending on the extent of short-term damage and resulting political reaction, there is likely to be a fundamental realignment of trust systems that will ultimately drive changes in behavior.

The trust in cash and in the Reserve Bank of India is being tested and can lead to one of two outcomes: either a deeper distrust of government and government systems, or a move to digital payments and cashless transactions as hoped by the government.

Will people start using more digital payments sytems, bank accounts and payment wallets? Or will they revert to using other physical stores of value such as gold, jewelry and real estate? The answer could be one or the other depending on regional or local considerations.

Impact on Corruption: Opinions in the Indian media since November 8th have diverged markedly regarding the impact on corruption, with some expecting a sharp reduction and others seeing no change.

Some anecdotal evidence supports the idea that cash corruption, estimated around $20b, will decline from here on. But as noted in this Wharton article, other forms of corruption will be less impacted by the November decision and will be more difficult to uproot.

One positive development that is not getting sufficient coverage is the fact that there is far greater financial transparency and sophistication today than in the past. If this governance system and transaction tracking technology remain in place, a greater percentage of corrupt and fraudulent transactions will be tracked and captured. As platforms such as blockchain-based digital identities, next-gen behavioural biometrics and digital currencies take hold, the corrupt methods of the past will ultimately not work. True, the perpetrators will also evolve and upgrade their practices, but there is an opportunity now for the government to keep up or stay one step ahead.

Impact on banking system and economy: According to some estimates, $20 of the $220 billion in cancelled banknotes will in the end remain in the banking sector, an unintended factor that would help repair balance sheets at some Indian banks that are now burdened by toxic loans.

Political Impact: The political question significantly revolves around the severity of the current short-term impact on different voting blocs and on the longer-term impact perceived on the eve of the next elections. Although there will likely be increased bank lending and some decline in corruption, it is not certain that these tonic factors will kick in in time for the next major set of elections.

Global Impact: Though initially more preoccupied by that other November 8th event, policy makers and central bankers in other countries will be watching how demonetization plays out in India. It will be a useful case study for many governments struggling to uproot corruption and fight terrorism. Lack of transparency can be a destructive scourge even in developed countries and this new effort to improve transparency will be studied by many around the world.

Like any big disruptive move, demonetization was a calculated gamble for the Modi government. If there is a realignment of trust where there is greater use of cashless transactions, it will ultimately have a massive positive social and economic impact. If, on the other hand, there is some social unrest as a result of fundamental mistrust in government and related systems, it could open the door to more political uncertainty and instability. This risk is exacerbated by the so-far inadequate communication to those most impacted by the new policy, the daily wage labourers and workers.

The story continues to unfold. Any efforts by the government and other leaders across the Indian economy (be it banks, merchants, corporates) to show empathy and come up with localized, scalable solutions to those genuinely impacted by the short-term chaos will help ensure that the long-term benefits will arrive sooner and endure longer.

As with any reform, adversaries will mutate and adjust. But ongoing efforts like the bank information sharing scheme announced with Switzerland and perhaps in the future improved tax collection as in Sweden are bound to fundamentally alter the historically pervasive culture of corruption.

Meanwhile, the Modi government is keen to get some feedback, as evidenced by this invitation to “meet PM Modi” by downloading the Narendra Modi App.

Ravi Srinivasan works in information technology and sits on the board of several startups in business process outsourcing and in cybersecurity. He holds an MS in engineering from Stanford University and a BSE from Princeton University. He is based in New York City.

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This entry was posted in Corruption, Economy, Emerging Markets, Guest Post, India, Innovation, Podcast, Society, Taxation, Technology. Bookmark the permalink.

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