India’s demonetisation policy: have the risks been averted?

India’s demonetisation policy: have the risks been averted?
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India’s demonetisation policy has caused disruption and reawakened concerns for the country’s growth prospects. Despite a resilient economy and the recent electoral victories of the ruling BJP party, financial and political risks still remain.

On 8 November last year, Indian Prime Minister Narendra Modi initiated a deep financial reform by banning the country’s largest currency bills in circulation. The government announced the ban on 500 and 1,000 rupee notes on national television, thereby wiping out over 80 per cent of India’s cash supplies, in a bid to crack down on corruption and untaxed money.

The reform has proved disruptive as a result of the country’s reliance on cash transactions. Cash shortages are particularly affecting small businesses and the middle classes, who form the bulk of Modi’s voting base. Despite the short-term financial cost of demonetisation, the government is maintaining its popularity, as evidenced by the BJP’s (Bharatiya Janata Party) landslide electoral victory in Uttar Pradesh, India’s largest state, on Saturday.

Background

The government presented the decision to withdraw the majority of India’s circulating cash as an attempt to crack down on corruption and crime. Government statistics ahead of the implementation of the program last year suggested that India had around $74 billion worth of untaxed or “black” money – a significant loss of revenue for the government.

Motivations for the rupee ban are also political. Narendra Modi ran his anti-corruption platform and defeated the Indian National Congress Party in 2014, with the promise to clamp down on the informal economy and generate new jobs, a message which resonated with the country’s expanding middle class. With the approach of several key municipal elections, the BJP needed a boost after the difficult first half of Modi’s tenure.

Short-term impact of India’s demonetisation

Demonetisation has had a significant impact on the economy so far. Since the program was announced, India’s cash shortage crisis has slowed down businesses and hit small traders and businessmen the hardest. Indians use cash for over 95% of transactions, making the country’s economy one of the most heavily cash-based on the continent. Images of queues at ATMs have come to symbolise the short-term chaos generated by the reform.

Politically, Modi’s government is faring well despite the disruptions caused by the sudden rupee ban, as evidenced by the recent victories of the BJP in a string of municipal elections in states like Maharashtra, Rajasthan and Gujarat. The BJP’s latest victory in Uttar Pradesh reflects Modi’s enduring popularity and the political appetite in the country for more transparency.

Economic perspectives

India’s population has already felt the impact of demonetisation but the long term economic benefits are yet to be tested. The government emphasizes that demonetisation will help reduce corruption and criminality. While banning high denomination bank notes is likely to reduce “black money”, the phenomenon is likely to disappear entirely, and corruption is likely to remain a central issue for the government to address. Demonetisation has also reawakened fears of an economic slowdown. Figures show that economic growth was only marginally affected in the last quarter of 2016; however, in a largely cash-based economy, the impact of the rupee ban is more difficult to measure and the latest figures could fail to capture the full picture.

Despite short-term challenges, demonetisation could have a positive impact on India’s economy in the long-run and pave the way for the country’s transition to a digital economy – a move that would benefit India’s booming digital and financial services sectors. The reduction in unaccounted money could also send a powerful message to international investors about India’s commitment to transparency and better tax management. Overall, financial institutions are viewing Modi’s reforms positively, with Goldman Sachs predicting long-term benefits.

Modi’s political perspectives

The BJP’s electoral gains in several states, including Uttar Pradesh on March 11, have bolstered Modi’s political position. Uttar Pradesh was seen as a referendum on the Prime Minister’s economic reforms and an assessment of his first years in government. The BJP’s victory is putting Modi on a course to be re-elected in 2019.

Criticism of demonetisation remains nonetheless strong among opposition parties in India and is unlikely to diminish in the next few months. Despite reinforcing the BJP’s grip on national politics, Modi could see popular support erode if the economic benefits promised by demonetisation fail to materialise. The months ahead will be a crucial test for India’s demonetisation gamble.

 

Categories: Asia Pacific, Economics

About Author

Cecile Guerin

Cécile Guerin is a London-based analyst. She has worked as a Counterterrorism Research Fellow at the Asia-Pacific Foundation, a policy assessment think tank monitoring emerging geopolitical threats. She holds an MSc in History of International Relations from the London School of Economics.


  • bmniac

    It is interesting to see economists making predictions which make astrology look respectable. Economists think in a linear fashion and that will not work. Moreover common assumptions made by them have been made irrelevant. With GST and much reduced cash payments and increased cheque and card payment as well as other digital modes. There will be much positive change i the economy. Having worked with Dr Sing Mr Narasimham and others I feel that they just cannot comprehend the moves made by Mr Modi.

    Seriously there is no precedent for this sort of disruption and the follow up by the taxmen. The next target will be verification of property ownership Gradually there will be much transparency in transactions and tax collection is bound to go up.

  • one potential positive externality that come out of this whole fiasco is the accelerated shift to non-cash payment methods in India. While it would take time for the likes of credit cards to be expanded in circulation, mobile payment platforms like Paytm stands to benefit greatly from the sudden jolts in cash circulation.

    On another note, it would be interesting to see if the continued risks as mentioned in the article may translate to devaluation of the Rupee in the coming months, as the Indian public start to hold more assets in foreign currency or precious gold in order to hedge against any future volatility in Rupee due to lack of confidence in all underlying issues of the fiasco being underresolved.