EUROMONEY, India - Fri February 10, 2017

Modi’s demonetization catches India on the hop

Scrapping large-tender notes sparks panic; ‘black economy’ crackdown prompts cash squeeze.

Chaos and confusion, panic and pandemonium. It’s hard to overstate the impact that India’s shock decision on November 8 to withdraw all high-denomination banknotes from circulation has had on this ultra cash-dependent economy. 

Overnight, on the orders of premier Narendra Modi, all R500 and R1,000 notes (respectively worth $7.3 and $14.7) were declared obsolete. Queues quickly formed outside banks and post offices as people sought to redeem cash stuffed in wallets and under mattresses for smaller tender, or for new, purple-tinted R500 and R2,000 notes.

Modi’s decision seemed to catch everyone on the hop. The prime minister skipped out of town after the announcement, first to Bangkok on a working visit, then to Tokyo to enjoy a lavish state reception, leaving his cabinet with a lot of explaining to do as the problems mounted. 

Snags

Unforeseen snags and hitches emerged, as they so often do. Printers had not been given enough time to roll out bundles of the new banknotes, leaving large parts of the cash-based rural economy ­– notably wheat-growing states such as Punjab, Haryana and Uttar Pradesh – all but frozen. Another hitch was the physical size of the notes, which were too large to fit ATM drawers. New Delhi also imposed strict limits on how much money could be withdrawn from bank branches. 

For all this, there is some logic underpinning Modi’s move to demonitize (and then remonetize) so much of the economy. Since rising to power in 2014, the premier has been set on transforming India’s archaic economy: boosting exports, transforming creaky infrastructure, and bringing hundreds of millions of workers’ wages and savings into the formal economy. 

Achieving this last part was never going to be easy. A recent report by US consultancy AT Kearney found that 90% of all consumer transactions were conducted in cash, while the two highest-denominated notes accounted for 86% of all the cash in circulation. Much of this horde bypasses India’s tax authorities completely. The same report found that the ‘black economy’ – a broad financial universe that ranges from under-the-table wage payments to corruption to terror funding – accounts for about a quarter of total economic output. (Compare that with estimates that as little as 1% of the population pays income tax). 

This undermines the economy and makes it hard for the government to budget. Tax revenue as a share of GDP was 17.7% in 2015, against 22% in China and 34.4% in Brazil, according to OECD data. It also further undermines India’s lenders, already struggling with low earnings and revenues growth and high rates of non-performing loans. 

Kunal Kumar Kundu, India economist at Société Générale, says: “One of the main reasons for the demonitization push is to convince more people to open bank accounts. Currently, just 30% of the working-age populace has a formal account. Undoing centuries-old habits, with people used to storing cash at home, may take years and even decades to unwind. But it’s a good start.”

Suvodeep Rakshit, an economist at Kotak Institutional Equities, adds: “Despite the short-term pain, demonetization will strengthen the financial system, give savings a boost, and channel more deposits into the banking system. It will be a much-needed boon for India’s lenders.”

Modi and his ministers want more citizens to take their money out of gold and put it to work in active and economy-enriching investments, such as infrastructure stocks and bonds. 

A fillip

“Unaccounted income is generally invested in avenues such as gold, precious stones, real estate, apart from being held in form of cash,” says Rana Kapoor, founder and CEO of Yes Bank, India’s fifth largest private lender. “As unaccounted cash makes way to the formal economy, incremental household savings will be invested into financial assets, giving a fillip to the future financialization of the economy, while boosting the national savings ratio.”

Demonetization has also been a boon for fintech firms, with a new generation of banking customers taking the opportunity to open and fill a virtual wallet. Noida-based Paytm, whose parent is part-owned by Chinese e-commerce firm Alibaba and the former head and current interim chairman of Tata Group, Ratan Tata, saw $2 million added to its accounts in the first hour of trading on November 9, against a usual daily average of $200,000. 

But all the talk of long-term benefits will count for little unless the short-term pain can be mitigated. Modi has asked people to be patient “for 50 days”, which would take the country up to December 30, after which the old, large-numbered notes can no longer be deposited at banks or converted into new tender.

Yet anger on the streets and in executive boardrooms is rising. The IMF projects India’s economy, one of the world’s few bright spots, to grow by 7.5% in the financial year to end-March 2017. Most economists now expect the cash squeeze to shave around a percentage point off full-year growth. Mumbai-based Ambit Capital has gone a step further: on November 18, it tipped the economy to expand by just 0.5% year-on-year in the second half, slashing full-year growth to a little under 4%.

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