Demonetization: An unmitigated politically motivated disaster

The Prime Minister Modi's announcement of the withdrawal of Rs.1000 and Rs.500 notes, an audacious move giving wild hopes of a decisive blow to the black economy and counterfeit currency and converting India into a cashless economy. The disruptive impact of this decision is only now becoming clearer and dampening the celebratory mood that followed the announcement.  While many are still hopeful that this landmark initiative will reap dividends eventually, deeper analysis concludes it is not only poor politics but also an unmitigated disaster.

1.   Cash is an insignificant component of black assets less than 6%
Illegitimate cash is just the tip of the iceberg and dealing with it does not mean taking down the mammoth black economy.

2.   Counterfeit currency is more molehill than mountain
At any given point of time Rs.400 crore worth of fake notes were in circulation in the economy. This is merely 0.025% of the total budget outlay of Rs.19.7 lakh crore. Just the printing cost of new notes being taken out of circulation is approximately ₹12,000 crore.
Is it sensible public policy to flush ₹12,000 crore down the drain to purportedly remove about ₹400 crore of fake currency?

3.   Information may have leaked—rise in bank deposits
Firstly, people withdrew cash in large amounts in smaller denominations due to rumours of demonetization of Rs.1000 and Rs.500 notes.
Secondly, in the past few weeks, local dailies in Gujarat had also reported that such a move might be in the offing.
Thirdly, the BJP's West Bengal unit deposited an unusually large cash amount of Rs 1 crore just before the move's announcement.
All the above indicates information leakage. Those who don't have black money might have ignored these rumours, those having black cash took action right away.
In the absence of any upturn in economic parameters, the sudden rise in deposits just before demonetization decision, is definitely fishy.

4.   Whitewashing of whatever little black cash there is
Even the insignificant black assets in cash that remain with people are likely being whitewashed through various loopholes viz. buying of gold and exchanging through the new black market for exchange of notes are prominent ways in which those with black cash are getting it laundered or changed to smaller notes.

5.   The root problem of black money generation is untouched
Black economy is conservatively over 20% of our GDP i.e. over Rs.30 lakh crore which is greater than total cash in circulation i.e. Rs.17.77 lakh crores (86% of this cash is in the form of withdrawn Rs.500 and Rs.1000 notes). It's clear from this that demonetization cannot do any long-lasting damage to the black economy since the roots of it remain untouched.

6.  The government's politically motivated sensationalism has spread panic
In a bid to derive maximum political mileage out of the move, BJP sensationalized the move and announced with great drama for maximum impact. Many myths were spun around it, which made people panic. This panic is leading to untold miseries with ATMs reporting long lines and various establishments refusing to offer change; some hospitals are even denying treatment. Had the BJP been more sombre and pragmatic in its narrative and execution, rumour mongers would not have had such a field day and the move's implementation would have been less painful for the people.

7.   In poll-dictated hurry, government was woefully underprepared
The government is visibly unprepared for the move.
Firstly, the RBI didn't have enough supply of smaller denomination notes and is supplying soiled 100 notes to meet the demand.
Secondly, the new Rs.2000 notes being released are smaller in size than the old notes and ATMs have not been modified to dispense them. Thus, ATMs are storing less cash and thus running out faster as they can only dispense Rs.100 notes.
Thirdly, the new Rs.2000 notes are released without any security features as the hurried decision by the government didn't allow for the provision of such features. The government pushed through the action in six months, although over three years or so are usually needed to introduce new notes. As a result of such haste, many errors are being reported in these notes. Because of the absence of additional security features (and presence of mistakes), the task of counterfeiting will become easier. Thus despite spending so much of public wealth, the hasty manner of the move will deprive us of any benefit in reducing counterfeit currency.
The forth coming Uttar Pradesh elections and the model code of conduct are round the corner, the government decided to implement the move so as to milk the issue before the polls.

8.   Reintroducing higher denominations facilitates future hoarding of black cash
Government is left with no option to reintroduce higher denominations as today India doesn't have the infrastructure for a primarily cashless economy. It would have made more sense to first focus on transitioning to a cashless economy and then completely withdrawing these larger denominations? By introducing Rs.2000 notes, the government has made it easier for  black money hoarders as they will now need only half the space giving boost to black economy.

9.   Where is the infrastructure for a cashless economy?
The argument that the move will spur a cashless economy is flawed .
Firstly, how does replacing Rs.1000 notes with Rs.2000 ones help make the economy cashless?
Secondly, merely depriving people of cash doesn't make an economy cashless.
With only 46% banking penetration, only 22% internet connectivity, 19% of population without electricity connection and only 1.2 million of 14 million merchants having point of sale devices, India simply doesn't have the infrastructure for a cashless economy. Another problem is the low level of digital literacy in India. Unless these real challenges are addressed, withdrawing the bulk of cash only creates chaos as we can now see.

10.  Economic activity is taking a beating
The gross under-preparedness of the government, the sensationalism of the move and it being inherently economically imprudent, have all lead to the move creating extreme chaos.
Firstly, the people are desperate for cash, so much of the workforce that should be productively working is wasting long hours in unending queues at the banks and ATMs .
Secondly, the abrupt call-back of 86% of cash, has brought the informal economy to a standstill—this sector is the worst affected, with the most marginalized suffering the most.
Thirdly, the wide speculation on property and gold pricing will also undermine economic stability and reduce investors' confidence in India.

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Thus for the variety of reason discussed above, the move is an unmitigated disaster. It's simply a case of headline management trumping sound economics. The government in its attempt to win brownie points on the black money issue has rushed into a decision that is poor economics and may ultimately prove to be poor politics too.

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