Withdrawing 86%
by value of the cash in circulation in India was a bad idea, badly executed
SUPPOSE that one day the government of a large and fast-growing economy
became convinced that its highest priority was to purge the country of
black-economy millionaires hoarding piles of illicit cash. Seeking popular
approval, it sent the printing presses into overdrive, hoping to inflate away
the value of these secret piles of wealth. It worked: rising prices struck a
blow against the undeserving rich, and by egging on others to deposit their
money in banks (where it could at least earn interest), the shadow economy
shrank. The government could plough the newly created money into tax breaks and
public-works schemes.
Critics, rightly, would stand aghast. Inflation would affect
everyone who held cash, law-abiding or not. Much of the wealth of those
enriched by the black economy would be insulated, because lots of their lucre
is held not in cash but in property, gold or jewellery. Such heavy-handed
measures could undermine the credibility of important government institutions.
Fear that they might be used again in future could weaken confidence in the
currency as a store of value—paving the way for some broader institutional
failure, like hyperinflation. Long-run trust in the judgment of the state might
be threatened.
On November 8th India’s prime minister, Narendra Modi, announced a
course of action just as radical as that described above, if the converse of
it. He declared that all 500- and 1,000-rupee notes—making up 86% of the cash
in circulation in India—could no longer be used in shops. More financially
mature economies than India would struggle to cope with such a scheme, but this
one floundered at once. Though Indians have until the end of the year to swap
their defunct bills, the roll-out of new ones has been bungled. A broad cash
crunch and broken supply chains threaten a sharp economic slowdown—albeit one
that will abate, at least in part, as the cash squeeze is alleviated. India’s
“demonetisation” is a cautionary tale of the reckless misuse of one of the most
potent of policy tools: control over an economy’s money.
Unlike most currency reforms, designed to boost confidence in the
currency, Mr Modi’s motivation is different. The primary aim of demonetisation
is reasonable enough: the government hopes to improve the functioning of the
economy and boost its tax take by cracking down on the shadow economy. The vast
majority of transactions in India take place in cash; many escape book-keepers’
notice. Economists reckon that India’s black economy accounts for at least 20%
of GDP. Such off-the-books activity shields fortunes from taxation and allows
corruption to flourish. Past efforts to attract black money into the
light—using tax amnesties, for example—have had little effect.
Demonetisation forces the issue. Indians can swap their hoards of
useless bills for useful ones, but those that cannot present paperwork
accounting for their cash piles will receive unwanted attention, and tax bills,
from the government. Demonetisation also increases use of electronic and
bank-based payment systems, which will make record-keeping easier and more
common, allowing government better to track and tax the proceeds.
Yet the government also reckons it can profit from bills that are
not turned in. In economic textbooks, money is considered a liability of the
central bank—a debt. In most modern economies that debt sits on its
balance-sheet, and is offset, on the asset side, by holdings of securities like
government bonds. The old and unreturned notes, if they are recognised as
cancelled liabilities, would therefore create a huge positive asset position on
the central bank’s balance-sheet. The Reserve Bank of India could, if it chose,
create new currency liabilities (that is, print money) and transfer that money
to the government to spend. Some economists hope the money will be recycled
back into the economy through a fiscal stimulus, which might help soothe some
of the pain caused by demonetisation.
The status of this would-be windfall is uncertain. If the
government allows Indians to redeem dead notes for live ones indefinitely, it
is not clear when or if the RBI might recognise cancelled liabilities on its
balance-sheet. So far, Indians are depositing their money in the banking system
with impressive haste. Of the 14trn rupees ($207bn) invalidated by
demonetisation, an estimated 8.5trn has already been deposited. Still, as much
as 3trn rupees could remain in the wild as a potential government windfall,
reckons a recent analysis by Credit Suisse, a bank.
The other rupee drops
However clever the plan looked on paper, it is both
extraordinarily blunt and risky. Demonetisation will probably make only limited
strides in shrinking the black economy while affecting all of India’s 1.3bn
citizens, the poorest most of all.
In much of the Indian economy, and especially outside big cities,
where cash transactions are most common and financial infrastructure least
developed, the sudden invalidation of a vast amount of outstanding currency
represents a significant monetary shock. Not all of India’s shadow
economy—which provides real employment and income, if not real tax revenues—can
migrate quickly and easily above board. Whatever cannot easily be shifted
represents a potential loss of economic activity, and a drag on broader Indian
economic growth. Similarly, if a cash crunch forces small firms without access
to credit to shut down, the eventual alleviation of the cash shortage might not
lead to an immediate and complete revival of economic activity.
Managing an economy’s money is among the most important tasks of
the government. Clumsy use of monetary instruments comes with high risk. John
Maynard Keynes, an economist, was echoing Lenin when he wrote in 1919: “There
is no subtler, no surer means of overturning the existing basis of society than
to debauch the currency.” Trust is fragile, and precious.
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