India’s current Prime Minister Narendra Modi was elected on the poll promise of fighting corruption and cleaning up the “black” economy (undeclared transactions outside the tax net), which by some estimates is worth over 20% of the official GDP. After a series of measures over the last couple of years, which have had varying degrees of success, the Government introduced its most drastic reform to date on November 8th 2016 by withdrawing the two highest denomination banknotes (500 Rupee and 1,000 Rupee) from circulation. The policy move created ripples throughout the country and caused large scale disruptions to businesses in the near term. For those of us in India at the time, the magnitude of Modi’s move was demonstrated by the fact that Donald Trump’s victory in the US Presidential Election on the same day became “second page news”!
“A Policy Shock”
India has a large unorganised sector and cash is used for 98% of all consumer transactions by volume. The two bank notes removed from circulation comprised 86% of all currency in circulation in India and their sudden withdrawal had a profound impact on the incomes of the poorest and on business activity across categories. The rural economy, particularly the agrarian part, which includes payments made by the government to farmers for acquiring produce, wholesale trading and transport of agricultural produce and purchase of farming inputs, is almost entirely cash driven, The biggest impact was seen across discretionary categories such as consumer durables in which demand declined by 50% in the days following demonetization. Unorganised labour in the country, which is largely paid in cash, saw a large drop in incomes and significant layoffs. The initial popularity of the plan was based on the belief that the greedy and corrupt, who had stored their black money in bank notes, had been caught off guard and would face heavy fines and tax scrutiny if they exchanged the old notes for new currency. In reality, however, many of these people had the flexibility to find alternative uses for their unused currency and most probably were not holding the bulk of their undeclared wealth in cash but instead in a combination of property and gold.
The Government has remained steadfast in its view that it was worthwhile to go through some short term pain for the longer term benefits of higher transparency and flushing out black money from the system. However, in its quest to maintain absolute secrecy around the timing of the move, the Government seemingly failed to plan the implementation phase properly and the ill-conceived operation to replace old currency notes with new ones created an immediate liquidity crunch and led to an almost daily ritual of short term policy flip flops. Public support for the move, which was overwhelmingly positive in the early days, also receded somewhat due to the inconvenience caused to a large section of the population.
The Government also suffered a setback as demonetization was expected to ensure that a part of black money stored in cash would not get exchanged, being unaccounted wealth (or black money). These unreturned monies would result in reduction of currency liabilities for the Central Bank and create some fiscal headroom for the Government in the form of additional spending power. Estimates for the amount of unreturned black money varied from 15-25% of the total demonetized currency of US$220bn, which would have provided US$35-45bn of additional spending power to the Government. However, the entire stock of demonetized currency was exchanged over the last two months, partially diluting one of the core target outcomes of the policy.
“Limping back to normality”
The Government had predicted that the liquidity situation would take about 60 days to normalize as the old banknotes were being replaced with new ones of 2,000 Rupee and 500 Rupee denomination. Those calculations proved overly optimistic with cash outages at Bank ATMs being the norm over the last two months. As of December 2016, new currency equivalent to 40% of the value of cancelled notes has been printed and distributed, and this is expected to increase to 60% by mid-February
However, post an initial period of uncertainty and extreme forecasts about the negative impact on the economy, recent data from corporate earnings seems to suggest that the negative impact on certain sectors of the economy may have been over-estimated. Sectors that were expected to have the highest negative impact included Autos, especially two wheelers, Construction and Real Estate, Building Materials, Financial Services, Consumer Durables and Apparel. Payments businesses were expected to receive a boost due to increase in electronic payments.
Data from corporate earnings suggests that two wheeler manufactures have indeed seen sales declines of 20-30%, while property sales have also declined by up to 20%, leading to a correction in property prices and decline in prices of cement and other building materials. However the impact on Financial Services businesses has been mixed, with some Banks and Specialty Finance companies seeing an uptick in collections as old notes were used to repay outstanding loans resulting in an improvement in asset quality. Loan growth was expected to slow down for most Banks, but the impact has been lower than expected so far and will be more pronounced in the January – March quarter. Our portfolio companies have reported similar on-the-ground impact with consumption being impacted by 15-20%, while our ATM outsourcing business, AGS, which was expected to see an increase in transaction volumes, actually saw a decline due to a severe shortage of the new banknotes, which led to almost half of ATMs being idle in the first few days post demonetization.
“What happens next?”
As events have stabilized over the course of the last few weeks, debate has shifted from the often shrill commentary about poor execution to whether the policy objectives have been met or not. Even though it is difficult to argue unequivocally that the government succeeded in achieving what it set out to do, there has certainly been a benefit from accelerating the role of digital payments in the economy; electronic payments have grown by >30% in the weeks following the demonetization. The Government has also announced a series of subsequent measures and incentives to promote the digital economy including lowering transaction charges on low value transactions. Overall, in the medium term, various steps to increase digital payments will structurally reduce currency in circulation, and lead to higher growth in financial savings/higher digital transactions.
Despite the short term impact of a slowdown in GDP growth, if demonetization achieves the longer term benefits of greater transparency, higher tax collections, and higher financial inclusion, the adage of short term pain for long term gain may hold true and India will have turned a new chapter in its economic history.