The RBI's Silence Means Modi's Demonetisation Was An Even Bigger Miscalculation Than Anyone Realises

On July 12, 2017, almost 8 months after the announcement of demonetisation, RBI Governor Urjit Patel told a Parliamentary Standing Committee that the RBI was still counting the money that had been received by the banking system, and hence he could not state how much money had actually come in.

This was doubtless an extraordinary admission. It speaks pretty poorly of India's banking system that there cannot even be a rough estimation of this amount, since all exchanges were stopped on December 25, 2016, giving the banks more than 6 months to count the cash.

I'm going to make a bold guess here and say that the RBI Governor is lying. Yes, you read that right. The RBI Governor is lying. He knows exactly how much money has come back into the system, but is unable to reveal it. Why?

Urjit Patel - Stuck between a rock and a very hard place

At the time of the demonetisation announcement last year, the amount of money in circulation in 500 and 1000 rupee notes was estimated to be 15.5 lakh crores. There was talk that the government was expecting about 13 lakh crores to come back into the banks as a result of the forced exchange, and that the remaining 2.5 lakh crores was "black" and could not be returned in the full glare of publicity. It was thought that black money holders would throw these worthless notes into the river (some of that did happen). This was how black money was going to be "hit".

Further, since 2.5 lakh crores of (in essence) promissory notes ("I promise to pay the bearer") were never going to be presented, it meant that the RBI would be absolved of 2.5 lakh crores worth of debt to the general public! This extinguished debt was going to be a one-time windfall that the RBI could transfer to the government as a huge budget surplus that could then be used to fund so many initiatives.

Now here's my theory.

I believe that the expected shortfall in currency returns did not materialise. On the contrary, I believe more money than the expected 15.5 lakh crores has come back into the system. It implies that far from demonetisation having struck a blow against black money holders and counterfeiters, the system has been cheated, and it has been cheated in more than one way.

1. Black money has been effectively turned white using demonetisation, since virtually all the deposits made have been under the no-questions-asked limit of 2.5 lakhs per bank account. A lot of private deals between black money holders and ordinary account holders must have been struck to enable this laundering, and the government is none the wiser. Minus a commission to the account holders, the original owners will eventually get back all their money. The whitewashed money will therefore largely return to the black economy, and the taxman will remain empty-handed.

2. Counterfeit currency in 500 and 1000 rupee denominations has been successfully exchanged for genuine currency in smaller denominations. Think about it. If the money that returned is more than what the RBI had put into circulation, it only means a large number of counterfeit notes have also been submitted and exchanged for genuine notes in smaller denominations. Demonetisation has unwittingly devalued the currency. By how much is anyone's guess. The RBI surely knows but is not telling.

3. Not only has the government not got its bonanza from the RBI in the form of the expected extinguished debt of 2.5 lakh crores (and hence no funds to spend on its pet initiatives), it is now in greater debt because of the demonetisation exercise. The increased deficit, as any economist will tell you, will add to inflationary pressures.

4. It means poor people have suffered for nothing. It was remarked during the months of November and December 2016 that the Indian people were demonstrating exemplary patience. Poor and lower middle class people underwent great hardship during these months, standing for hours in bank and ATM queues, and managing their lives with a chronic shortage of cash. Yet the thought that it was all in a good cause, and that holders of black money were suffering even more, kept them in relative good humour. But now, if it turns out that black money holders have managed to have the last laugh, and that common people have suffered for nothing, won't the voting public be outraged?

5. Paradoxically for a move that caused such widespread suffering, demonetisation boosted Modi's personal popularity. He was seen to have struck a blow for the common man against corruption, and the people were willing to suffer to see his efforts successful. The word "masterstroke" was often used, along with the phrase "He has delivered!" Modi seemed like a clever and decisive leader who had outwitted the enemies of the country and placed India on a path to growth and prosperity. Now everything has been turned upside-down. Modi no longer looks clever. He looks like a fool. The crooks have taken him for a ride.

Outwitted - an uncharacteristic look for a perpetually smug politician

This is politically explosive stuff. If it becomes common knowledge, Modi will be politically weakened, perhaps so badly that he may lose the 2019 election.

And that is why I believe RBI Governor Urjit Patel is trying to dissemble, obfuscate and delay his way out of the mess he has been forced into. His political masters have forced him into this sorry situation.

What Are The Second And Third Order Effects Of Demonetisation?

A nuclear explosion releases energy in four pulses - (1) Blast, (2) Thermal radiation, (3) Ionising radiation, and (4) Residual radiation

There are reports from major Indian cities that the queues at banks and ATMs have greatly reduced, and that one can walk up to an ATM and withdraw the new 500 rupee note without any delay. With this, many observers feel, the worst of the demonetisation pain is over, and the country will shortly return to normal.

Nothing could be further from the truth. In fact, the worst is yet to come. The optimism is a delusion of those living in a metropolitan bubble.

What has eased is the "first order" effect of demonetisation - the shortage of cash. If the government had prepared adequately for the demonetisation exercise by having sufficient stocks of 100 rupee notes and new 500 rupee notes to exchange, and had been able to effect the exchange within two weeks, the ill-effects could have been contained fairly easily. However, the significant duration that it has taken for this problem to abate (two months) has created second order problems, which in turn will create third order problems.

What are these second order and third order problems?

Second order problems are supply-chain disruptions. Third-order problems relate to reduced credit.

These are the two second order problems.

1. Agricultural shortfall and food price inflation

The demonetisation shock hit just when farmers were in the middle of buying seeds to plant the Rabi crop. Part of the planting had happened, but the latter half was disrupted. The Rabi harvest is due in Feb-March, so the shortfall is going to be seen when the crop reaches the market. Food price inflation will start in April 2017.

2. Massive unemployment in the small-scale and unorganised sectors

At least 35% unemployment has already been reported. Migrant labourers have left for their villages to better ride out the storm through subsistence farming. Factories and shops have closed.

Many of the closures will be permanent because creditors will have to be paid, forcing asset sell-offs. Therefore, unemployment will not ease significantly in the short term.

These two conditions together are known as stagflation, which is what India is heading towards.

But this is not all. When farmers and small enterprises suffer sustained operating losses, they lose their ability to repay their loans. This then translates into the following third order effects.

1. Increased NPAs at banks and reduced credit capacity

As loans to small businesses and farmers turn bad, banks will suffer increasing proportions of Non-Performing Assets (NPAs). This will curtail their ability to offer credit, ensuring a prolonged recession.

2. Reduced foreign investment

As the banking sector weakens, the country's sovereign rating could also be downgraded. This will make it harder to attract foreign investment, further dampening growth prospects and prolonging the recession.

Summary

In short, India is likely to see the second order impact around April 2017 in the form of rising prices and widespread unemployment in the small-scale and unorganised sectors. The second half of 2017 will see the start of a prolonged recession, which is the third order effect.

Two people deserve to be marched from their desks in disgrace - Prime Minister Narendra Modi and RBI Governor Urjit Patel. Modi's feat will have been as a turnaround manager. He will have turned a boom into a full-blown recession in about 6 months. Urjit Patel will be remembered as the man who could not say no.

Update 14/01/2017: I have created a cartoon mashup to illustrate what I think will happen.