India's Coming Stagflation Shock

The Background

On November 8, 2016, Indian prime minster Narendra Modi announced a shock decision that he claimed would strike a blow against "black money" in the economy. He announced at 8 PM that 500 and 1000 rupee notes would cease to be valid by midnight, and that the only way to preserve one's cash would be to have these notes converted at a bank. This move promised to flush out all the unaccounted wealth held by people.

There were a few potential problems with Modi's approach, however:

• "Black money", or money that has been unaccounted for for taxation purposes, is estimated to be around 20% of the Indian economy, although that percentage has been reducing over the years. Many economists have been of the view that as the country's economy improves, black money will form a smaller and smaller fraction of it, and therefore should not be a source of worry in the future in any case. Modi's move may not have been necessary at all.

• Most of the unaccounted wealth in India is not held in cash. It is held in real estate, gold or as foreign currency, a lot of it in overseas tax havens. Striking at cash would only hit a small fraction of all unaccounted wealth.

• Poorer Indians deal only in cash, and the bulk of the cash in the economy is used by the poor. Indeed, the bulk of the Indian economy runs on cash. The 500 and 1000 rupee notes that were declared invalid overnight accounted for 86% of the total value of cash in the country, most of it in the hands of the poor, not the rich. It was the poor, and small businesses, who found themselves suddenly insolvent after Nov 8.

• Most Indians have no bank accounts. They would have to open bank accounts and deposit their cash, before they could withdraw part of it in 100 rupee notes. This again hit the poor hardest.

The turmoil was further compounded by poor execution.

• A cash economy needs denominations spaced at regular intervals - 1, 2, 5, 10, 20, 50, 100, 200, 500, 1000, 2000, 5000, etc. Before Modi's announcement, there was a gap in the Indian currency line-up. There was no 200 rupee note, and the jump from 100 to 500 was quite steep. The demonetisation exercise, far from plugging this convenience gap, worsened it by removing the 500 and 1000 rupee notes and introducing a 2000 rupee note!

• If higher denomination notes (like 500 and 1000) were suspects in the black economy (because they're easier to store and transact in shady deals), then the introduction of an even higher denomination note (2000) as part of a strike against black money was mystifying.

• There simply weren't enough 100 rupee notes to replace the withdrawn 500 and 1000 rupee notes. It could be argued that printing these in large numbers beforehand would have destroyed the element of surprise that was necessary. However, there were other logistical problems that compounded this problem.

• ATMs had not been recalibrated to dispense enough 100 rupee notes, nor to dispense the new 2000 rupee notes. In any case, banks soon stopped stocking ATMs so as to conserve the precious supply of notes for their own customers.

• The rules kept changing on an almost daily basis. To some, this indicated a lack of foresight and planning. To others, it indicated agility and an ability to adapt to changing circumstances. In any case, these frequent changes reduced people's faith in the system and the wisdom of those in authority. The Reserve Bank in particular lost a certain amount of credibility.

Along the way, as the government saw that most of the 500 and 1000 rupee notes were re-entering the system through bank deposits that appeared legitimate, it realised that its objective of exposing black money had failed. Either most of the cash in the economy was actually legitimate, or those with black money had succeeded in laundering it by using poor people as fronts.

About a month after the initial announcement, the government changed its tune to claim that the objective of the demonetisation exercise was actually to push India into becoming a "cashless" economy. In subsequent days, this claim too was toned down in the face of obvious logistical challenges, such as poor penetration of electronic payment systems, mobile networks and sometimes even electric supply. The currently stated objective is a "less cash" economy, which is a rather tame and uninspiring one when compared to the sound and fury that accompanied the initial announcement.

Where We Are Now

At any rate, what matters is that the Indian economy has been hit hard, and that brings us to the topic of this post. There are those (mainly upper class, city-dwelling folk) who believe that the situation will ease in the next couple of months as more cash in the form of 100 rupee notes is printed and released into the economy. Some have even argued that the economy is healthy because prices have stayed stable. But they are missing what has actually happened to the economy in the meantime.

Prices are stable today only because demand has been suddenly choked by a lack of cash. This is technically a period of recession, and it has been brought about by one executive decision. But supply has also been hit, and the full shock will be felt as the pipeline dries up. The economic hinterland has essentially locked up. Factories have closed due to lack of demand as well as the inability to pay workers in cash. Workers have returned to their villages to a lifestyle of subsistence while they weather the storm. Farmers have had no cash to buy seeds, and that has drastically reduced planting of the Rabi (winter) crop. There may not be an actual famine when the crop is due for harvest in February-March, but food prices will rise sharply because of the agricultural shortfall.

In short, the Indian economy is heading for a period of stagflation - the worst of all possible worlds. There will be high unemployment and prices will rise steeply. Many of the small business shutdowns today will end up being permanent because of creditors forcing asset selloffs. The shock will probably hit the country with full force after April 2017, once agricultural shortages from the inadequate Rabi harvest begin to be felt.

At that point, everyone (whether a supporter of Mr Modi or otherwise) will see what destruction he has wrought.

When a strong leader with little understanding of economics and a baseless faith in his own abilities takes such drastic decisions, an entire nation pays the price. In the past, we have only seen such tragedies play out in communist dictatorships (under Stalin, Mao and Pol Pot).

India is about to give the world an example from the ranks of the democracies.

As a postscript, it will be interesting to see who within Modi's BJP party fires the first arrow of revolt. I predict it will be the old patriarch, LK Advani, who will then be joined by several others who will snipe at Modi while taking cover behind Advani. If he survives the revolt, Modi will spend the last two years of his term as a lame duck prime minister, and it is very likely that he will have to return to his home state of Gujarat in disgrace after the 2019 election.