Was the risky gamble of demonetisation better than long-term reform?

Serpentine lines at banks continue. Nearly two weeks after Prime Minister declared the old Rs 500 and Rs 1,000 notes would cease to be legal tender from November 9, most of India is still reeling. Despair and desperation apart, the broad consensus is that these short term pains are worth it for long term gains. Experts everywhere are hailing this “demonetisation” as having a profound long-term impact on the economy by freezing black economy, bringing the informal sector under the taxation net, improving the tax/GDP ratio, and moving India to a cashless society.

This year is also the 25th year of another profound change that played out in the long term: the liberalisation measures of 1991. Most of what we see in India today can be traced back to the opening up of the economy in 1991.

The end of the licence-raj disrupted the old way of doing business. The Premier Padminis gave way to Honda and Hyundai and Maruti Suzuki only became stronger. Mobile telephony and private banks are things that we take for granted today. Neither would have been possible if the telecom and banking sector had continued to be in the grip of the government. Almost every global brand today has a presence in India.

This transformation took 25 years and changed every aspect of independent India. Manmohan Singh had factored this in his budget speech of July 24 1991:

“We are committed to adjustment with a human face. It will also be our endeavour that the adjustment process does not adversely affect the underlying growth impulses in our economy. We do not have time to postpone adjustment and stabilisation. We must act fast and act boldly. If we do not introduce the needed correctives, the existing situation can only retard growth, induce recession and fuel inflation, which would hurt the economy further and impose a far greater burden on the poor.”

Incremental reforms

Reforms didn’t end in 1991. On the contrary, that is when they began.

These reforms spurred gut-wrenching disruption and caused the closure of weaker and emergence of stronger players. But it took time for the benefits to be seen.

To put things in perspective: Average Gross Domestic Product growth before the reforms (Financial Year 1985-’92) was 4.9%, average GDP growth a decade after the 1991 reforms (FY 1993-2003) was merely one percentage point higher at 5.9%, but average GDP growth during FY 2004 to FY 2014 was much higher at 7.6%.

Change, indeed, takes time.

The opening up of the economy was not smooth at all.

Just one year later, the stock markets were shaken by the Harshad Mehta scam. In response, the Securities and Exchange Board of India was formed in 1992 and was instrumental in moving Indian stock markets to paperless trading and dematerialised accounts.

The telecom sector was ridden with mounting losses after players bid high fees to bag telecom licenses. This was resolved when the National Telecom Policy 1999 moved to a revenue share model. Seventeen years after those reforms, India has one billion mobile subscribers.

The power sector saw meaningful reforms in the late 1990s with the formation of the Central Electricity Regulatory Commission in 1998 and the Electricity Act in 2003.

The cable and satellite industry – notorious for under-reporting – saw a difficult transition. From cable outfits being run in basements to the multitude of dish antennas that you can spot on walls and building terraces – the transition has taken many years and has been a tough one.

In the late 2000s, the insurance and mutual fund industry was rife with malpractices of high commissions and mis-selling of products – regulators in both sectors have worked towards improving things.

Finally, India’s public finances have also seen major reforms.

Count among them the introduction of service tax in 1994, bringing services under the ambit of tax. Service tax has been so successful that in FY16, service tax revenues, at Rs 2,10,000 crore nudged past custom revenues (Rs 2,09,500 crore).

Similarly, the Direct Tax Code was aimed at simplifying India’s complicated direct tax system. The biggest, most ambitious public finance reform – the Goods and Services Tax – was passed in August 2016 and the rates finalised earlier this month.

A better alternative?

In view of the above incomplete list, would it be fair to ask if institutional reform was a better option than demonetisation? Reform that results in the overhaul of the machinery that supports corruption and bribes that breed the black economy? Reform of taxation to make paying taxes an easier and a better alternative than hiding them?

Going by our recent history, it would seem that there is encouraging evidence in favour of reforms. After all, we did get the huge services sector, which was once unorganised and informal, under service tax over the past two decades. We did manage to reform the stock market that was once susceptible to scams. We rescued the telecom sector from losses. We even finished the old model of crony capitalism and bribes when we finished off the licence raj.

Along the way, even the poor benefited with the rise in average incomes.

The Modi government itself has been committed to reform with measures such as the “JAM” trinity – Jan Dhan Yojana, Aadhaar, and Mobile phones – for better delivery of subsidies to the poor.

Demonetisation, however, has hurt the weakest and the poorest where it hurts the most – their income. The Modi government seems to believe this collateral damage is worth it in its fight against black money. It is possible that the government has some goodies on the way, including reform that will ameliorate the current situation. Is that hope, along with the “long-term benefit” enough to make people feel good about waiting for hours to access their own money? Only time will tell.

Anupam Gupta is a chartered accountant and has worked in equity research since 1999, first as an analyst and now as a consultant. His Twitter handle is @b50.