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Demonetisation in India

On the 8th of November, apropos of seemingly nothing, Indian PM Narendra Modi went on television and gave a live address, announcing that 500 and 1000 rupee notes would no longer be legal tender in India. This decision, he said, would be effective as of less than four hours later.

Needless to say, this isn't how this kind of transition is usually made. The UK is currently phasing out the old five pound note, over a period of eight months. Old Australian notes get withdrawn from circulation, but are all still legal tender. So it's pretty remarkable in its own right that the rupee 'demonetisation' is happening so suddenly. But that actually underplays the significance of Modi's move, which would be much less disruptive in the UK than it is in India. I've been half-following this story for the two and a half weeks since it started, and found it very difficult to understand why this was happening or what its consequences were. Yesterday I went to this panel in an attempt to get a better grasp; it turned out (perhaps not that surprisingly) that the picture you can get of these events from Western media is extremely credulous and doesn't at all convey their magnitude. So here's a brief report on what was said and what's going on. (The event was held under Chatham House rules; what's written below is a mix of comments from the panellists and from audience members.)

The best place to start is with an understanding of why, whether it's good or bad, this matters so much. There's a lot of uncertainty and change in the rules governing the demonetisation - they have changed more than 30 times since the initial announcement - but the general principle is that it's not possible to directly swap your old invalid notes for new ones: the old notes are handed in and the funds credited to your bank account. Each person can make one direct cash exchange of a very limited value. (The precise limit has changed several times.) And weekly limits on cash withdrawals from bank accounts have also been imposed, so it's not possible to deposit old notes and then subsequently withdraw the funds again.

This matters because the informal sector of India's economy, which operates largely on a cash basis, accounts for 50% of the country's output and 93% of its labour force. (Given the nature of the informal economy, there's obviously a false precision in those estimates; but the rough magnitude is widely agreed on.) And the 500 and 1000 rupee banknotes make up something like 86% of the hard currency in circulation. Given the limits on how quickly new notes can be printed, it may take six to nine months for the withdrawn currency to be fully replaced. So it's a move that's causing huge disruption to swathes of economic activity in India. Having money in the bank, for hundreds of millions of Indians, is just not a practical alternative to having cash in the way it might be in the UK.

There's also a large number of people for whom having money in the bank isn't an alternative at all. The estimates of how many Indians have access to a financial institution like a bank or post office vary widely, but they're all low: the highest is about 50%, and the lowest 32%. (This is after two years of Modi's government working to expand bank access.) Women are much less likely to have personal bank accounts, and so are faced with either letting their personal savings become worthless or handing them over to their husbands. Hundreds of millions of people don't have any of the forms of official identification needed to redeem old notes. 

The upshot is that the Indian economy and the everyday lives of Indian people - especially the poorer and those in rural areas - has been severely shaken for the last two weeks. The agricultural sector has been thrown into confusion by the sudden unavailability of cash to pay for seeds, which for some crops are due to be planted imminently; activity there, and in structurally similar sectors like fishing, has collapsed. The price of cotton and soya has spiked; other crops have seen their prices stay relatively steady because both supply and demand are falling. Many banks aren't accepting loan repayments in old notes, pushing borrowers into arrears and themselves into a liquidity shortage. Some pensions are not being paid because the funds don't have access to enough new currency. Although public hospitals are (temporarily) required to keep accepting the old notes, private hospitals are refusing; the former Prime Minister Manmohan Singh has claimed that 65 people have been unable to access medical treatment and died as a result. Some employers are using the opportunity to take advantage of their labourers: paying maids a year's salary in advance, in old notes, or paying construction workers in old notes and then buying back those notes at a discount.

That's all to say that the impacts of this change are a lot more widespread than the long queues at banks you might have seen in Western newspapers. (Remember, almost 70% of Indian people don't even have access to a bank.) So what's the point? It's not breaking any rules to reveal that nobody at Friday's event, except one audience member, thought this policy was a good idea. In light of the costs, that's not so surprising; what's more striking is the widespread doubt that it had any benefits worth mentioning at all.

The most widely cited justification is a crackdown on illicit wealth: those with 'black money' stored in cash will be effectively expropriated, since it won't be possible to deposit or exchange large quantities of money without attracting attention from authorities. This is also the only apparent justification for withdrawing the notes with four hours' notice rather than gradually - it gives criminal wealthholders less opportunity to transform their notes into other forms of wealth. But as far as anyone can tell, only about 6% of black money is held in cash. So this is a far worse way of tackling black money and tax evasion than a variety of other members: 'presumptive taxation' of people who own certain kinds of high-value assets; increasing the pay and structural capacity of audit and tax collection agencies; reforming electoral laws which create massive demand for black transactions by limiting legal campaign spending to about 2% of what most candidates find themselves needing to spend. Nor is there any large-scale problem with counterfeiting (except, perhaps, in Jammu & Kashmir). Nor does demonetisation make sense - unlike, say, the EU's moves to withdraw the 500 euro note, or India's 1979 scrapping of large denominations - as a way of disrupting organised crime's high-value cash transactions, since these notes are widely used and anyway are to be replaced by a new note in a higher denomination.

What is going on, then? The panel identified two broad sets of motives, neither of which are as uncontroversially good as the desire to crackdown on illegal wealth. The first is a dramatic modernisation programme, emerging from the thought that India's economy can only flourish with a greatly reduced reliance on the cash economy. This would make sense of the various measures which make it very difficult to hand in old notes, withdraw new ones and return to cash-based economic activity: demonetisation is aimed at forcing Indians to integrate the banking system more tightly into their everyday economic activity. That might be a laudable goal, but even if it were a realistic prospect for more than a third of the population, the costs of pursuing it in such a sudden manner are extraordinary. The second aim is more starkly political. In his televised address, Modi was at pains to depict demonetisation as an attack on 'anti-national elements'. A few days later, he commented darkly that the move is opposed by forces who "may not let him live". The policy has been called a 'surgical strike' against corruption, echoing the military strikes India claims to have made against militants in Pakistan-administered Kashmir in September. If demonetisation is meant to make Indians feel like participants in a united national project to fight corruption and black money, the suffering it's causing may be a necessary part of creating that sense of shared sacrifice.

It's too early to be very confident, but the signs are that this political gambit might be paying off. Even among economists and commentators who think demonetisation is catastrophic, it's widely acknowledged that the people suffering most are for the most part keen supporters of the policy. Some of the BJP government's most implausible claims about the benefits of demonetisation - that it has crippled terrorist activity in Kashmir, for instance - seem to be gaining currency. If the costs of the transition can successfully be painted as necessary for a unified response to threats against the nation, then Prime Minister Modi's second surgical strike may prove even more politically rewarding than the first.