Are the demons of demonetisation starting to haunt the government?

We are now well into the third week of yet another “surgical strike” (as it was described by Amit Shah) from Prime Minister Narendra Modi’s magic wand – that on the India’s “black money” economy. But the government’s attempt to cleanse the Indian economy of unaccounted-for cash by demonetising Rs 500 and Rs 1,000 notes sucked out about 87% of the currency in circulation.

When the prime minister announced its shock move aimed at ridding the country of black money – which is really income and financial transactions that the state did not get its rightful share of taxes from – the entire nation welcomed it. The other reasons the government gave for the move was that it wanted to purge the system of counterfeit notes and break up the terror finance network.

Counterfeiting is indeed a serious problem. In 2014-‘15, counterfeit notes seized rose by 22%, to almost 6 lakh pieces, according to the Reserve Bank of India’s annual report. In 2015-‘16, more than 6.3 lakh counterfeit notes were detected, of which 41% were in Rs 500 notes, 35% in hundreds and the rest in thousands.

These are the notes in circulation and let us assume that an equal number are sitting dormant. Consider this against the fact that in April, there were 1,646 crore Rs 500 notes and 1,642 crores Rs 100 notes in circulation. Counterfeit notes therefore are still a small proportion of the notes in circulation, not distorting the system by much and a better way could have been found to filter them out, through an orderly exchange of high-value notes.

With the benefit of cold hindsight and the comfort of not having to go against the now-waning popular sentiment on demonetisation, it is very evident that the government was clearly unprepared to embark upon such a major reform.

Complete breakdown

The nation has experienced a breakdown of the financial system and the severe pain it has inflicted on the hundreds of millions of daily wage earners, small retailers of perishable goods and farmers who have to invest in sowing fresh crops and reap harvests. Consequently the nation has belaboured the prime minister severely and Modi, proud of his broad chest, has been reduced to tears twice in the past fortnight – once while addressing the nation from Goa last week, upon his return from Japan, and the second at a meeting with National Democratic Alliance’s Members of Parliament on Tuesday.

So, what went wrong? The first aspect of this is fairly obvious. The government should have had enough new currency in circulation to replace the withdrawn lifeblood. The government should have also built up meaningful stocks of the existing Rs 100 notes and smaller denominations for everyday transactions to happen without much disruption. That was not the case. The RBI will most certainly take several months just to replace the high-value notes. Till then, the low circulation of currency – the anaemia – will persist.

This prolonged anaemia is bound to have an economic cost. In his widely reported speech in the Rajya Sabha on Thursday, former Prime Minister Manmohan Singh, less of a politician and more of an economist, estimated the consequential contraction of Gross Domestic Product as a result of the demonetisation to be about 2%.

In discussions with several senior and serious economists, the most conservative estimate that emerged was a 2.2% drop. This kind of sudden contraction, about halfway through the financial year, implies a painful situation in the near future.

Consider this: the informal sector, which deals almost entirely in cash, accounts for about 45% of the GDP and at least 165 million Indians are estimated to be unbanked.

The government’s financial inclusion scheme, Jan Dhan Yojana, has added substantially to the number of bank accounts. But nearly half of the additional bank accounts were “zero balance” accounts, as on August this year. Creative optical solutions being this government’s forte, many of these accounts were mysteriously credited with Re 1 each, ostensibly to reduce the number of zero-balance accounts, an Indian Express investigation revealed. However, no probe has been ordered into this, the government said in the Rajya Sabha earlier this week.

Creative solutions?

With a looming contraction in the immediate future, one would not be surprised if creative optical solutions are relied upon again to improve national income accounting, by assigning new values to unrecorded production and services – for instance, by re-estimating the value of chappals made by village cobblers or the value addition of panwallahs. The last such tweak – where the method of calculation was changed – gave this regime a 2.2% GDP boost, but was misused by it to suggest that the economic engine was moving faster.

Now look at the scale of damage caused. India has a workforce of close to 450 million. Of these, only about 7%, or 31 million, are in the organised sector. Of that, about 24 million are employed by the state or state-owned enterprises, the rest being in the private sector. Of the vast reservoir of more 415 million employed in the unorganised sector, about half are engaged in agriculture and another 10% each in construction, small-scale manufacturing and retail. These are mostly daily wage workers, who for the most part earn less than the officially decreed minimum wages. Thus, a good part of this so-called black money held in Rs 500 and Rs 1,000 notes that the government has choked is actually money in circulation.

What the government is seeking to unearth is a smaller part of the money in stock, which is held by businesspeople, politicians and bureaucrats. But in its professed anxiety to unearth this, the government has effectively thrown out the baby with the bathwater. The economy may not have ground to a complete halt, but in hundreds of million homes, cooking fires are not being lit. This is because most daily wage earners are not getting paid in full or even in part. Some are being paid in the now-devalued notes, and assuming they get the time to go to a bank (which could cost them an entire day’s worth of pay) to exchange the money, there aren’t enough small-denomination notes or even no notes in circulation.

So far, previous income tax raids have found that only 5%-6% of tax-evaded income in the country is in the form of cash. The rest of the black money is stowed away abroad, or used to buy land and jewellery.

So, after failing to anticipate the scope of the economic devastation on the nation, the prime minister has taken a new tack. He is now claiming that he is fighting for the vast mass of the poor who have been looted all these decades by the upper classes. He has thus demonised the upper classes and has fired the starter gun for class warfare that would have made even Lenin and Mao proud.

He has also started saying things like “Meri jaan ko khatra hai,” – my life is under threat – because of this newly donned mantle of class warrior. His claim of death threats has generated much consequential mirth in the social media with a play on the word “jaan.”

This is new for Modi. So far, he has enjoyed huge support, even without the bot armies and professional social media manipulators, while he has also been hugely vilified. But of late, he has become a cause of mirth. With that, he has entered politically dangerous waters.

Will the Prime Minister now retrace his steps somewhat? Will he order massive build up of Rs 100 and smaller notes to relieve the cash crunch? This will no doubt involve some loss of face. But better that than his post.