Comrade Modi has not learnt much from 1991 – when Licence Raj ended (as did the Soviet Union)

The Soviet Union specialised in underground black humour. In one story, the Commissar arrives at the collective farm and speaks to the chief farmer.

Commissar: “Comrade Farmer, how is the farm doing?”
Comrade Farmer: “Excellent. By the grace of God, we have had record production of grain.”
Horrified Commissar: “ But there is no God, Comrade Farmer!”
Comrade Farmer: “There is also no grain.”

In late January 1991, the joke changed. The Commissar met the Chief Engineer of Lada car factory.

Commissar: “ Comrade Engineer, how is the factory doing?”
Comrade Engineer: “ Excellent! By the grace of God, our assembly lines are running at full capacity. I’m having to pay overtime to all comrade workers.”
Horrified Commissar: “ But there is no God!”
Comrade Engineer: “There are no cars either. Nor is there any cash.”

The Union of Soviet Socialist Republics demonetised on January 22, 1991. All 50 rouble and 100 rouble notes were removed from circulation, and bank withdrawals were restricted to 500 roubles per account per month. The reasons cited were much the same as in India’s demonetisation. The high value notes were being used as stores of black money, and for criminal activities, blah-blah.

The currency withdrawn amounted to about 10%-11% of all currency in circulation. The exchange window for private citizens was only three days and each person could exchange a total of only 1,000 roubles. The old notes could not be deposited, only exchanged.

Millions of ordinary citizens lost their cash hoardings. New 50,100, 200, 500, and 1,000 rouble notes were issued over the next few months. Food, transport and utility prices went insane, first dropping as the cash crunch hit, and then rising over 700% in the next four months. The rouble dropped below 100/US$ in hawala and it officially depreciated to 31/ US$.

Soviet per capita income declined by 20% in 1991. There was an abortive coup in August (where Boris Yeltsin came to the fore) as the economy went South, The Soviet Union broke up in December 1991. Both coup and break up were, at least partially, triggered by economic crisis. Most successor states remained in recession for several years.

Obviously, political turmoil contributed to this terrible experience. The USSR and the successor states were also transiting to capitalism (though most of those nations remain undemocratic) and some of the pain came from that transition.

Nevertheless, this is what happened when just 10% to 11% of currency was withdrawn. The Indian demonetisation is withdrawing 86% of currency and imposing controls on withdrawal (although the old cash can be deposited and exchanged for much longer). The USSR was, despite all problems, at a far higher standard of living in 1991, compared to India in 2016. Everybody was literate, everybody had bank accounts and every household had at least one member employed as a government servant.

There was another consequence. The Soviet bureaucracy had always been extremely corrupt and it wielded immense powers. Corruption went off the scale.

First, withdrawn notes were exchanged in complicated ways as government-owned institutions discovered unexpected stores of cash.

Second, people were allowed to queue up multiple times to exchange currency. The new 1,000 rouble notes came in handy as they were exchanged for $10 notes. (Russia has since introduced a 5,000 rouble note.)

Lessons from 1991

There are a few lessons which we can draw from this, and other examples of demonetisation.

1. The pain is usually much more than people bargain for, and it can last much longer than the first glib predictions suggest.
2. There is a flight to other stores of value such as hard currency, or bullion.
3. There are often peculiar swings in terms of price deflation/inflation.
4. Bureaucracies turn into kleptocracies during such transitions.

Much of this is likely to play out in India. Currency controls setting limits on cash withdrawals for example, are very likely to stay in place for months, or indeed, “until further notice”. Anybody who wishes to take her own cash out of the bank will have to plead special circumstances. The notifications for this are already madly complex, in terms of wedding allowances, etc.

The “denotified” rupee has gone to triple-digits in hawala where there are now two parallel rates. The withdrawn Rs 500/Rs 1,000 notes are being traded at Rs 110/US$ and that rate will rise as the December 30 deadline for turning them in draws closer. The Rs 100 notes are trading at Rs 75/US$ which is also a substantial premium to official US$ rates. Gold smuggling increased after import duties were imposed in April and anecdotally, people have found ways to get around the Rs 2 lakh upper limit for a non-Permanent Account Number transaction in gold. In Assam and Bengal, Bhutanese and Bangladeshi currency are being used in some areas. Manipur has shut down, while Mizoram is operating on note of hand – IOUs – since there is no cash.

As of now, food prices are down because farmers are desperate to sell produce before it rots and customers don’t have cash. This could change dramatically if there’s a food shortage. That is not unlikely given that the rabi crop has been hit by the cash crunch and that truckers are finding it hard to operate.

Two weeks into the great experiment, the banks have received Rs 5.5 trillion so far in deposits (out of approximately Rs 16 trillion outstanding in withdrawn notes). People have withdrawn Rs 1 trillion, meaning a net inflow of Rs 4.5 trillion. If currency controls are removed, much money will flow out immediately.

Best guesses about replenishment of cash in circulation are hard to make,. About one-third of ATMs have been reconfigured so far. It will take about 4 more months to print enough cash to replenish. It will take longer perhaps to deliver that cash into unbanked areas.

Discretionary powers

Coming to the bureaucracy, the Income Tax department has raided many locations, including homes of professionals such as doctors and lawyers. Cash seizures have been proudly tom-tommed. Presumably discretionary authority is already being extended about such seizures since people can supposedly deposit unlimited amounts in banks until Dec 30? They may eventually have to pay penalties and taxes on the cash deposited but right now, they can deposit unlimited amounts.

Why can’t somebody who has been raided simply claim, “I was going to deposit this cash by Dec 30 and declare it as income for the current fiscal?” At best, the IT authorities should escort that person to the bank, rather than seize the currency.

If bureaucrats have the authority to mandate upper limits of cash withdrawals, and the discretion to raid and seize, they will have a field day making up regulations as they go along. The IT department will certainly enjoy a vast expansion of discretionary powers as it queries large cash deposits next year.

This will also lead to another bout of suffering for ordinary households as entire household incomes will be clubbed together in many cases. One of the much-touted statistics of this demonetisation is that Jan Dhan Yojana covers “almost every household”. It doesn’t. Some households have multiple Jan Dhan Yojana accounts, some have none.

Some households have one account and several earning members. Let’s say a household has one account and three earning members, who each make around Rs 2.2 lakhs. The first income tax bracket starts at Rs 2.5 lakhs – hence all three are below the tax limit. (India’s per capita is Rs 96,000 and per capita for Delhi is over Rs 2.5 lakh ).

The three earnings members will willy-nilly, deposit cash savings in that Jan Dhan Yojana account. Now the IT Dept will demand that the person in whose name that account was opened pays tax . The family may find it difficult if not impossible to prove that this is the clubbed income of three members. Similar situations will arise in many households next year and discretionary authority will be that of the IT Department.

Net-net, India will remain a cash economy. It lacks physical infrastructure required to go cashless at the “first mile” of the primary sector. Four out of five villages (which house roughly 550 million people) don’t have physical banks. Rural internet infrastructure is not good enough for point of sale use of cards, or even for reliable ATM operations since banks often can’t connect to central servers. There are very few smartphones in rural India, to enable options like Unified Payment Interface or PayTM, even if the local mobile internet is up to the mark.

Rural people will pull much of their cash out of banks the instant they are allowed to do so. Cash is much more convenient than trekking for miles to deposit cheques. But they might not find too much to do with that cash, since many small informal businesses will go bust in the next few months.