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.

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.