The Great Gamble

by V Anantha Nageswaran - Dec 2, 2016 04:24 PM +05:30 IST
The Great GambleNarendra Modi
  • With demonetisation, the Prime Minister has taken a huge risk — both economic and political. He must succeed, because this move could transform both our economy and our society.

As I write this, it is two weeks since America learnt that its next President would be Donald Trump. Large sections of America are yet to come to terms with it. It is also two weeks since Prime Minister Narendra Modi went on television and announced that currency notes with the existing denominations of Rs 500 and Rs 1,000 would not be legal tender with immediate effect. India is yet to come to terms with it on the ground, on the air and in print.

In our recently published report “Can India grow?”, Gulzar Natarajan and I wrote the following about the kind of leadership that India needed:

“Leaders can break down resistance with appeasement or with empowerment, combined with accountability. Appeasement buys peace and cooperation in the short term but at the cost of potential long-term damage. At the same time, enforcing accountability is not costless. In the short term, adverse economic consequences are possible, resulting in personal unpopularity. But visionary leaders trade off short-term popularity for long-term national interest. When decisions — choices and trade-offs — are made with the consistent application of values and ethical norms, the credibility of the decisions and that of the leadership will be enhanced. The public will understand and accept decisions better. This takes time, often longer than an electoral cycle. Hence, risks need to be taken. But conviction and communication could make such risk taking electorally rewarding, too.”

The government’s decision on demonetisation of the existing currency notes ticks most of the requirements of leadership that we had identified in that paragraph. Despite two weeks of chaos and difficulties, the decision still has high levels of approval among the public because the decision carries credibility. It carries credibility because the decision maker knew that it could hurt his own interests. Many sections of society that support the BJP have been hurt. They are angry and they are complaining. Yet, Modi has gone ahead and taken the decision. Therefore, the decision could not have been made for selfish reasons.

In a television interview, Arun Shourie said that even suicides would be radical. In other words, the sheer radical nature of the decision could not be a reason for its vindication. Even though his remarks implied criticism of the decision, unwittingly, he has zeroed in on the reason for the sustained and widespread appeal of the Prime Minister’s decision. He has shown that he is prepared to commit suicide in the nation’s interest, to purge India of a scourge that many have talked about but very few, if any, have attempted to tackle. That imparts this decision with tremendous credibility. To a considerable extent, this explains the enduring popularity of the decision despite several anecdotal evidences of botched execution leading to considerable inconvenience and even loss of income for low-income and poorer households. Of course, since this decision has hurt his core constituency, the Prime Minister can suffer political setbacks because of this. That risk is real and I will return to that theme later.


Columnist Manas Chakravarty, in a thoughtful analysis of the decision in economic daily Mint, argues that the Prime Minister is trying to mould India into a hard state that cannot be trifled with, both internally and externally:

“The most significant thing about the announcement is that Modi has not shied away from hurting his own vote banks…. It shows that Modi is able to detach himself from his immediate backers and make policies that hurt their interests. That ability arises from his status as a Bonapartist leader, his power to force his will not only in his party but also against sections of his own supporters…. Nobody can now say that India is, in Gunnar Myrdal’s words, ‘a soft state’…. a state that can take the drastic step of demonetising 86 per cent of its currency, that can make the masses stand in queues for hours to exchange their own money, that can finally bring tax evaders to heel, is not a soft state. And it’s very likely that Modi will follow up the demonetisation exercise with other measures to clean up the system.”

Economic commentator Anil Padmanabhan, in his piece published in the same newspaper on November 21, has zoomed in on an important observation that the Prime Minister made in a recent speech in Goa:

“Analysts (and critics) have failed to recalibrate (after I assumed power) the metrics they used to assess previous governments and old-generation politicians. This is exactly why they have failed to grasp the import of what happened on 8 November.”

That is a very insightful observation on the part of the Prime Minister. In fact, his remarks could be applied to the election of the new American president too! That also happened on November 8. Analysts missed that too. Most were unprepared for this decision and hence, they have been reduced to making up criticism in response to unfolding events. Therefore, there can be a legitimate criticism of the criticisms as being reactive and opportunistic rather than principled.


An all-too-common refrain is that there are other ways to tackle corruption and black money. This drastic decision of banning high denomination notes is the equivalent of cutting the nose to spite the face. The government has taken several steps already. The Prime Minister listed them in his speech. There is no need to recount them here.

This decision has come as a logical step in a sequence of measures. Some have been done prior to this and some will follow.

Take benami transactions, for example. According to a speech that Dr Y.V. Reddy, former governor of the Reserve Bank of India, delivered in Bhopal on October 5, “Benami Transaction (Prohibition) Act was enacted in 1988. For some reason or the other, no regulations were issued under the Act. In other words, it remained unimplemented for more than 25 years. The President seemed unconcerned about implementation. The Parliament was indifferent. The Executive had no compulsion to explain. The Judiciary did not consider it a matter of public interest to dwell on that. However, an Amendment Bill was introduced in Lok Sabha in May 2015. It has been passed in August 2016.” It received the Presidential signature in August and the Income Tax Department had notified it to take effect from November 1. Prior to this, the Black Money Act was passed in May 2015 and became effective from July 2015.

Another criticism is that cash is only a small portion of the illegal and ill-begotten wealth and hence, going after cash would not make a dent on the problem. It is correct that cash is only one form of black money just as burglary is one of the many offences that are committed. However, it would be incorrect to criticise law enforcement for going after burglars because, say, frauds are not targeted. As the Chinese idiom goes, killing the chicken to scare the monkey is an effective strategy and may even obviate the need to kill the monkey. Moreover, most of the official bribes are kept in the form of cash as gold and real estate have to be declared to the government in annual returns.

It is no one’s case that a surgical strike on the stock of black money would end the scourge of corruption in India. Attacking a camp of terrorists would not end terrorism but it would raise the cost for terrorists and would deter many potential attacks. As a perceptive commentator told the author, the costs of dishonesty had never gone up in this fashion ever before in India. But, risks avoided would never be visible and hence would not be counted. In other words, by its very nature, the black money that would be dissuaded from being created in the future would not be visible. That exactly is the problem with the government’s decision to rob the “legal tender” status of the existing high-denomination notes.

Interestingly enough, Peter Sands, former CEO of Standard Chartered Bank, made similar observations in his recommendation to ban high-denomination notes in Western economies in a paper he published in February this year. He conceded that cash was but a small part of the problem of illegal and criminal activity. But he underscored the signalling effect of a ban on high-denomination notes and the increase in transaction costs that it would entail for criminal activity. The paper itself was titled “Making it Harder for the Bad Guys: The Case for Eliminating High-Denomination Notes”.

His report anticipates and addresses a poorly argued piece by Ruchir Sharma that “revenge” was not a development strategy. Regardless of who chose the headline (I read it on, and the headline was “Revenge No Development Strategy: Populist Nationalism Cannot Paper Over Economic Chaos Unleashed By Demonetisation Drive”), it is a poor one. The Prime Minister is not taking revenge on anyone. Second, if development would address corruption, there would not have been a need for the report by Peter Sands. Deterrence is as important as incentives in enforcing good conduct. Hong Kong set the example on addressing corruption in the 1970s and 1980s, as I mention later briefly.


However, the short-term costs of inconvenience and hardship are visible and there could be costs in terms of economic growth for the next few quarters. But the benefits to the economy would be several and would accrue over several years and even decades. It might even be infeasible to identify the benefits to this particular decision. For example, the government’s shock therapy on high-denomination notes might not just nudge but shove many self-employed professionals to earn their incomes officially through bank payments and declare them, rather than run the risk of them being confiscated or declared illegal. Such changes and turnarounds in behaviour would be hard to track and the magnitudes of the sums involved would be virtually impossible to estimate. Therefore, it is relatively easy to calculate the net present value of the decision as being overwhelmingly negative. Costs are being incurred by the poor here and now, and benefits would remain invisible for quite some time. So, it is all too easy to come up with a negative scorecard.

Concerns over the travails that the poor face due to the government action must reckon with the fact that black money generation deprives the economy and the government of resources that could contribute to eradication of poverty. Further, it is easy to allow visible suffering to agitate minds but is it possible to account for the damage that the poor suffered on account of the double-digit inflation that India endured from May 2009 to May 2014? That is real but not easily measurable. In any case, in an elegant opinion piece, Krishnamaurthy Subramanian and Prasanna Tantri, two academics associated with the Indian School of Business, have debunked the notion that the poor are the ones standing in the queue for hours, suffering hardship and losing wages. They show that, based on average incomes of the poor, the poor would not have to visit the bank more than once or at most twice. Most of the long lines must be attributed to those who are trying to help the dishonest launder their illegal wealth.

The farm loan waiver of December 2007 done with the 2009 elections in mind provided temporary relief to farmers but caused lasting damage to savings, payment discipline and the culture of healthy borrowing and repayment. It is generational. The government’s decision on the high-denomination notes could actually be the mirror image of the farm loan waiver of December 2007 in terms of consequences.

Finally, the government’s reference to the tackling of fake currency notes and its links with financing of anti-India activities by terrorists and others has attracted criticism. The critics note that the share of fake currency notes in circulation does not appear excessive in an international comparison. The government’s press release at the time of the announcement on November 8 noted:

“High-denomination notes are known to facilitate generation of black money. In this connection, it may be noted that while the total number of bank notes in circulation rose by 40% between 2011 and 2016, the increase in number of notes of Rs.500/- denomination was 76% and for Rs.1,000/- denomination was 109% during this period.”

The government’s information suggests that the growth rate of fake currency notes has accelerated in recent years. A working paper from The Institute for Business in the Global Context at Tufts University published about two years ago (October 2014) has a table on the growth of soiled and fake currency notes in India (See Table 1). Over the seven years from end of March 2006 until March 2016, the compounded annual growth rate of fake currency notes in India was 21 per cent and that of soiled currency notes was 5.6 per cent. The government was right to be concerned with the growth (flow) rather than the stock of fake currency notes.

When Zhou Enlai, the late Premier of China, was asked in 1971 about the consequences of the French revolution, he is supposed to have said that it was too soon to tell. That has become an internet legend. Later, it has been clarified that he was remarking on the student riots and protests of 1968. That is about right for this move. It might take three years for a proper assessment of the currency exchange decision of the government.


It is well known that cash in circulation is a high proportion of the Indian Gross Domestic Product (GDP) compared to other countries. A BloombergView article presents a chart (Chart 1) from Harvard Professor Ken Rogoff in his book The Curse Of Cash. India’s cash-to-GDP ratio is little over 12 per cent and is exceeded by only Hong Kong and Japan. Japan is easier to understand. Demographics might be playing a role here. Older people might prefer to keep more cash with them (that also raises a question of whether the Indian government’s decision factored in the inconvenience caused to older people in the country). Hong Kong is somewhat puzzling. Perhaps, it must have something to do with the traffic from mainland China who come to Hong Kong for shopping. For various reasons, they might prefer to do it in cash.

Separately, in consumer transactions, the share of cash is 98 per cent in India, bested only by Indonesia where it is 100 per cent (Chart 2). In the long run, the potential for these to move to online, credit and debit card payment methods is considerable. That would be both efficient and potentially a source of tax revenue to the government. Currently, these transactions might be flying under the tax scanner. In the short run, they would be disrupted and quite considerably too. That would be a significant drag on economic growth. Pronab Sen, former Chief Statistician of India, pointed out that the informal lending sector operated wholly on cash and that the government decision had completely choked it. A private equity-venture capital investor in microfinance institutions (MFI) said that, in the first week after the government’s announcement, repayments to MFI plunged to 20 per cent. But, in the second week, it had improved to 80 per cent. Perhaps, the fears are overblown, but the risk is real and it needs to be watched.

In the short run, it seems reasonable to expect that economic growth would suffer. Estimates vary and there is no point in striving for false precision here. That might last up to three to four quarters. India’s economic growth in recent years, though it has picked up from the lows of 2012-13, has been somewhat mediocre and unbalanced. The private corporate sector has not been investing. Growth in real investments —productive capacity — has been low and slowing. Consequently, the share of capital formation in GDP has been declining. Economic growth has been left in the hands of private consumption and government spending. Private consumption and government spending are now 70 per cent of GDP. That is unhealthy for a developing economy. That said, in the short run, consumption spending would likely decline since 98 per cent of retail transactions are carried out in cash.

Banks are witnessing a huge inflow of cash as people come to deposit their cash holdings. Some are withdrawn. These are early days and hence, it would be premature to guess how much of the inflows to banks would remain with them and not be withdrawn. Based on that, banks can lower their deposit rates and lending rates and still boost their lending margins. The resulting improvement in their financial positions should spur them to commence lending for commercial and industrial purposes. In this context, anecdotal reports suggest that banks have taken to cutting their deposit rates aggressively but lending rates only tepidly. That would be a double whammy on the economy.

It risks a political backlash for the ruling party too.

Lower deposit rates spell negative real rates for savers. India’s official inflation rate might be closer to 4 per cent but core inflation rate is above 5 per cent and the public’s perception of inflation rate is closer to 10 per cent than 4 per cent. Negative real rates are a big disincentive for savings and, if they remain persistent, they work against the objective of “less cash” in the economy. Households would have less incentive to keep their money with banks. India’s savings rate is barely above 30 per cent and well below its investment needs. That is why India’s current account is perpetually in deficit.

Hence, aggressively low deposit rates would be against what the doctor ordered for the Indian economy. Talk of the law of unintended consequences.

Before this announcement was made, the government had made considerable progress with a nationwide Goods and Services Tax. It has to be implemented with effect from October 2017. This is what former Finance Secretary Vijay Kelkar and others wrote in October:

“The finance minister has successfully thrown away the steering wheel by notifying all the sections of the Constitution (101st Amendment) Act on 16 September 2016. As per Section 19 of the Act, the GST has to be implemented within one year of the notification, since after this period the laws relating to the levy of excise, service tax and VAT (value-added tax), as we know it now, will no longer be in force. He has thus won the game, since GST cannot be delayed beyond September 2017.”


There are two potential economic risks. One is the combined effect of the withdrawal of cash and the uncertainties it has given rise to and the implementation of a new nationwide indirect tax. Both businesses and households face an environment that features two big unknowns. Learning will take time. In the interim, human tendency is to pull back to the trenches and undertake as little activity as possible. Needless to add, the effect of such a cautious attitude on economic growth could be big.

The second risk is whether the state has the capability to help the economy through the transition to the new era of “less cash” and a new indirect tax regime. Has the government miscalculated or underestimated the logistical challenges?

Encountering the chaos of exchanging old notes for new and seeing the hardship faced by the poor, some have suggested that the government could have gone for a package of measures. They include phased implementation or giving more time to the public to exchange notes combined with a tax amnesty (a low rate of 35 per cent on the amount of black money declared) and enhancement of direct tax slabs.

Of course, it is hard to say if extra time and amnesty would cause a behavioural shift towards the formal economy. The purpose of the “shock and awe” approach that the government has resorted to is not just to shrink the stock of black money but to discourage its creation in future by instilling fear and uncertainty about the soundness of generating and storing unaccounted wealth. More time and tax amnesty might be interpreted as “more of the same” and behavioural shifts might not happen. Dr Y.V. Reddy, in his speech, has come out clearly against tax amnesty, chiefly because it has moral hazard written all over it. India has resorted to it on several occasions with unimpressive results. The tax amnesty announced in the Budget (45 per cent tax rate) netted 0.45 per cent of GDP. Interestingly, a tax amnesty scheme that P. Chidambaram, the Finance Minister in 1997 announced, without any stick attached to it, netted only 0.6 per cent of GDP. In contrast, the tax amnesty scheme administered by Indonesia this year has seen repatriation of huge sums of money stashed overseas. The tax rate was 4 per cent. But, those who point to Indonesia’s success and India’s failure are in no position to guarantee that Indonesians would not accumulate money overseas all over again, especially if they can get away so lightly. If economic pragmatism prevailed over moral principles and rule of law always, both society and the economy would decline irreversibly.

Hence, the more legitimate criticism with respect to the demonetisation decision is with respect to its implementation. As I was writing this on November 23, a friend sent me a message from Delhi airport. Upon landing there in the morning, he found out that there was no cash in the ATM there. It is two weeks since the announcement. The number of pieces of currency in circulation in India is staggeringly higher than it is elsewhere. Although dated, Table 2 gives an idea of the scale of the problem in India compared to other countries.

The number of pieces in circulation had increased since then to 90.27 billion pieces by end of March 2016. Of course, the share of high-denomination pieces in this is less than 10 per cent, but even then, they easily dwarf other countries except the Eurozone. Doing some arithmetic on the amount of currency notes that need to be printed, Latha Venkatesh of CNBC anticipates that the problem of currency shortages and long queues might linger long after the end of the year.


The experience has a cautionary tale for policymaking in India. Is the Indian state capable of ushering in revolutionary change as opposed to evolutionary change? If it opts for the former as it has in this case, will it end up biting off more than what it can chew? The government has to consult widely to ensure that all angles are considered. Some, who appear to or claim to have the ears of the Prime Minister, are bragging about their next set of recommendations. The Prime Minister would do well to make haste slowly. Ideas that have no international precedent and lacking in conceptual validity are better off being left on the drawing boards.

Even more importantly, governance is a big part of the problem of corruption. According to Dr Reddy, black money could be a “manifestation of a broader problem of lack of mechanisms for enforcement of contracts between private parties and between government and private parties or even between agencies within public sector. More generally, it is possible that generation, perpetuation and multiplication of black money is merely a reflection of inappropriate laws, and undermining of such laws by public institutions themselves. How far are the three wings of governance—legislative, executive and judiciary—responsible for the large presence of black money?”

The ban on the stock of cash held in the form of high-denomination notes must be followed up with strict enforcement against all sources and facilitators of corruption. Hong Kong’s successful drive against corruption in the 1970s spared no one and many corrupt senior government officials, or “big tigers” as described by the local media, were netted, prosecuted and sent to jail. As a result, corruption rackets which existed in government departments were quickly crushed. Wealthy businessmen, chairmen and senior executives of listed companies, high-ranking officials, legislators and influential politicians have been brought to justice for committing corruption or related offences. In other words, action against corruption has to be targeted at specific actions and actors rather than be carried out as a carpet-bombing exercise. The collateral damage could be unacceptably high and could boomerang on the government politically and economically.

As I said earlier, the public support for the government’s action has remained consistently high in the first two weeks. That cannot be taken for granted. Implementation has to show a marked improvement. Otherwise, support would easily turn into disapproval. Many are geared to engage precisely in that conversion and then fan it further. More importantly, the government should not forget that the support reflects a “lynch mob” attitude and, as Dr Reddy points out in his speech, support for severe action by governments exists in countries where governance systems are generally weak. Adversarial attitude towards economic and other offences must be matched by policy actions that support economic aspirations. Otherwise, the net present value of these actions would be negative both for the society and for the economy. The next Budget, to be announced in February 2017, is of enormous significance in that respect. The opportunity needs to be grasped. If not, the risk of the Modi government being a one-term government would be real. He should not forget that the British voters defeated Churchill after he led the country to victory in World War II. If that happened, the Indian economic revival story would be dead before arrival. Modi’s failure would be the nation’s failure and the country would return to the economic dark ages.

As stated earlier, these are early days for declaration of victory or disaster. The future has many more pages to unfold. I would like to leave the last word to Monika Halan who, in Mint, wrote the following the day after the Prime Minister’s announcement:

“Modi has taken a calculated gamble and we’re all hoping that it pays off. No transition is painless. He is pressing the reset button on corruption. We, who had so desperately wanted to kill corruption, now need to support this bold move by the government.”

V. Anantha Nageswaran has jointly authored, ‘Can India grow?’ and ‘The Rise of Finance:Causes, Consequences and Cures’

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