India cash crunch update: Still chaotic

Meanwhile in India…


That was taken on a lunchtime survey of the ATMs roughly 1km around FTAV Towers in South Mumbai. There were many ATMs and they were all shuttered. More so, there were queues of 50-100 people outside of every open bank branch we passed, similar in size to the queues we passed on the way into work this morning.


The simple fact here is that short-term pain is both rising and proving an inadequate description for those bearing an unfair weight in India’s fight against corruption, black money and the informal economy*.

It’s a fight that was kicked into high gear on November 8 and saw 86 per cent of currency in circulation — by value — rendered worthless outside of a bank branch. It’s a fight that featured justifiably high on prime minister Modi’s list of election promises. And it’s a fight which has suddenly, we have to imagine, gotten way more disruptive than Modi intended.

The simple questions at this stage are:

  • Will the ongoing pain be worth it or will the costs outweigh the benefits?
  • Will the government get what is an increasingly botched job under control? Today’s announcement that banks are to use indelible ink to deter people from converting old cash more than once isn’t comforting.
  • And how long will India’s people put up with this if not?

Without trying to be be tedious, the short answer is that we don’t really know. There have been previous demonitisations in India before, in 1946 and 1978, but they were on a much smaller scale, even if they did betray some clear trends. Here’s Nomura’s Sonal Varma’s guess as to the macro-effects based in part on those previous episodes. It’s from a note out last Friday, with our emphasis and more in the usual place:

The government’s decision to demonetise the 500 and 1,000 rupee notes (~86% of the total value of notes in circulation) is a radical step, which will have short-term costs but long-term benefits. Along with the goods and services tax (GST), this move will accelerate the shift of the shadow economy (20-25% of GDP) towards the formal economy.

• The demonetisation carried out in 1978 saw ~70% of cash tendered back initially, but this subsequently rose to 86%. It led to higher deposits, less currency in circulation and increased investment in government bonds. However, since only a fraction (~1.7%) of the notes were demonetised then, we believe the impact this time will be larger.

• We see a risk that GDP growth could slow to 6.5% y-o-y in Q4 against our current estimate of 7.3% and to ~7.5% in Q1 (vs. 7.9% currently) due to a cash shortage in the first few months (India’s cash-to-GDP ratio is high at 12% compared to an EM average of ~4%). However, this will be a transitory shock and should normalise by Q2 2017.

• We expect wealth destruction of ~1.9% of GDP, as fake currency and part of the illegal cash will not return, hurting conspicuous consumption demand and typical hoarding vehicles for black money (land, real estate, gold & jewelry). However, the rest of the economy will benefit over time and we expect GDP growth of 7.7% in 2017.

• This should be neutral for inflation in the short run as it hurts sectors that do not have a high weight in the CPI basket. The broader move towards formalisation, agriculture reforms and public capex push are disinflationary in the medium term.

• We are not changing our rate call. We expect maintenance of the status quo in December and a 25bp rate cut in February 2017. Even without a rate cut, we expect the transmission to be significantly enhanced.

• The banking system will be the biggest beneficiary, in our view. As cash demand falls, we expect banks to garner INR4.5trn (~4.5%) in incremental deposits, with some deployed in government securities (~INR2trn). Higher levels of liquidity should mean lower deposit and lending rates.

• Given the steep penalty, we expect disclosures to be limited initially, but tax compliance should increase over time. We expect tax revenue gains of 0.6% of GDP, the majority of which to accrue next fiscal (FY18). In our view, the reduction in the Reserve Bank of India’s (RBI) currency liability will be recognised as an unrealised gain on its balance sheet, but will not have any fiscal implication unless those gains are realised by selling corresponding assets.

Which is all fine and good. Short term pain for longer term growth seems fair enough.

But there are problems, one of which is that “short term pain” is, as already mentioned, not entirely adequate to describe what’s going on. People are reportedly dying, after all, and if your correspondent — with all of his bank cards, Mumbai ATMs and general resources — is finding this irritating in the extreme, then do spare a thought for those who exist in a cash-heavy but cash-poor world, often outside of cities.

Another problem is that since much of India’s black money is parked in assets like property and gold it’s hard to know if there will be a serious impact on such hoarding in the future. As Varma says:

Black money is usually parked as investment in land, property, stocks, gold, diamonds, or abroad, with only a small component held as cash in hand. Interestingly, a 2012 report by the government on ways to tackle black money argued against demonetisation (of high denomination notes) as a solution because it “is largely held in the form of benami [unnamed] properties, bullion and jewellery, etc.”

The issue is also a bit strange since India is introducing a new Rs2000 note. We’re still confused as to how a larger denomination note won’t end up in mattresses over time too. Fine, if you advertise this as simply a massive tax on wealth not declared during a recently closed amnesty but otherwise… well… confusion, as said.

At root it’s the creation of black money that needs to be stopped anyway and surely there were less disruptive ways to do that?

A larger problem, however, concerns confidence. Confidence in the currency and confidence in the government. On the former we are keeping a weather eye out for any large-scale moves towards private money solutions and any moves towards foreign currency (USD), gold (moar gold, anyway) or bitcoin. We don’t personally expect that on a systemic scale any time soon but it’s something the government really should be wary of. Credibility is a coin best not spent.

On the same note, we have to think that the Modi government is stretching the patience of the population. We are only working with a small sample in Mumbai — and a very middle-class sample even by Mumbai standards — but those we talk to are increasingly frustrated even as they voice support for the move in general. “We’re behind Mr Modi/ Modi-ji in this fight” being a not-unfamiliar refrain.

We’re curious how long that support lasts amidst this ongoing cash crunch and apparent administrative failure… Another week before the scale tips and Modi starts get blamed? Another two weeks? We don’t know but there has to be a point when it happens.

To close (and to avoid getting too dramatic in our own words before this hopefully settles down over the next week or so) we’d like to highlight the below by Suyash Rai.

Rai’s post is a good accounting of the cost-benefit framework at play, and the planning and execution of the move. It’s worth a read in full:

Black money creation is a problem, although perhaps not as big as it is believed to be. A bigger problem is how India can deliver high GDP growth for at least two decades, before we get into a demographic nightmare scenario. Solving both these problems – black money and sustained high growth – will require considerable improvement in the capacity of the state to perform its basic functions, which includes asserting itself on residents to take its due. If our government thinks that the black money issue is a major justification for doing difficult things, it should use it to take tough decisions that enhance administrative and regulatory capacity. It could be used to justify reforms of tax administration, government expenditure, investigation agencies, regulatory agencies, and even courts (under supervision of Supreme Court). Getting these basics right would serve us better than a large scale disruption that comes at a potentially big economic cost.

The biggest problem in India is the lack of State capacity. State capacity lies in systematic, professional thinking. This article shows the kind of policy thinking that would have been useful in analysing the question of de-notifying the 500/1000 rupee notes. These decisions have far reaching consequences, and it would behoove us to subject them to thorough intellectual analysis, ahead of time.

*Conspiracy theories abound but we’re going to stick to the main narrative.

Related links:
Brief notes from a cash hunt in Mumbai – FT Alphaville
Digging through India demonetization history — 12 Jan 1946 (Saturday) and 16 Jan 1978 (Monday) – Mostly Economics
The demonetisation and central bank balance sheet – Urbanomics

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