More Money, More Problems: India's Fiscal Use Of Monetary Policy

Prime Minister Narendra Damodardas Modi’s name rolls off the tongue almost poetically. His rise to power in India in the spring of 2014 discombobulated international pundits. The Economist for instance trumpeted that “India deserves better”. These fears and faint whiffs of an autocrat appeared to remain unfounded until very recently.

On the 8th of November in a televised address, Prime Minister Modi announced that all existing 500 Rupee and 1000 Rupee notes would be invalid effective midnight (of the same day). These banknotes would be replaced by a new 500 Rupee note and the issuance of a 2000 Rupee note. Panic ensued.

A little context to the Indian Rupee (INR) and to understand why the Indian population began raiding its ATMs. 1 USD is equal to about 70 Rupees (Rs.). To say that the Rs. 500 and Rs. 1000 notes are common would be a gross understatement. These notes are staple currency, comprising 86% of currency in physical circulation in a country where 90% of transactions are cash based.

People are paid in these denominations, spend in these denominations, and stuff their mattresses in these denominations. It is destabilising to wake up and realise that that your monetary assets have lost their values overnight.

The government did however give its citizens a grace period, until the end of the year, to replace their old notes with the new ones. This seemingly short deadline coupled with limitations on ATMs dispensing only a limited amount of money per day per account has a bottle neck brewing in the Indian peninsula. In the short-run at least, economists are expecting India’s GDP growth to fall between 1% and 2%.

Black Money, that’s allegedly why.

The official stance is that this surgical strike will flush out “illegal money” also labelled “black money” by rendering it useless. The scenario being played out is the following – Rich racketeers and illicit dealers are unable to trade their millions in paper cash denominations because they would be unable to explain wherefrom their monies came.

The “shadow economy” in India is almost 20% of GDP; the optimistic condoners of Modi’s move are expecting this 20% to return to the light, making it therefore taxable. There are three contentions against this line of argument.

  • The illegal economy is not 20% of Indian GDP. It is smaller.

The term “shadow economy” is used to refer to “illegal economy”. This misnomer creates a staggeringly false impression that 20% of the Indian economy is illegal. The shadow economy includes both illegal and legal transactions, from smuggling and racketeering to purchasing food off of street hawkers.

Small manufacturers in India are in fact incentivised by not being taxed and regulated. Are you a manufacturer with less than 20 persons employed and have no electricity? Congratulations, you won’t be registered, regulated, or taxed.

  • Illegal money is not majorly held as currency.

Professor at the Booth School of Business and former governor of the Indian central bank Raghuram Rajan was asked earlier this year if demonetisation was viable in combating illegal hoards of cash. His response was that “the clever find ways around it”, as those dealing in felonious money are often likely to split their plunder into smaller droves as to make it easier to launder.

By the same token, in a country where housewives own more gold than the central banks of the U.S.A., Germany, and Switzerland combined, illicit money is often stored as gold. And when not, it’s tied into real estate. It’s unlikely that the majority of black money is stored in currency.

  • Reducing denominations help, increasing them do not.

High currency denominations facilitate crime. 1 million euros in 500 euro bills weigh about 2 kg and can be carried in a briefcase. The same amount in 20 euro denominations would be more than 10 times as heavy, not to mention painstaking to lug about. In May 2016 the European Central Bank discontinued the production of the 500 euro note citing this as a reason for doing so.

But this isn’t the case in India. While demonetising the 1000 Rupee note, the Indian government will be introducing a new 2000 Rupee note, going against the sage logic of fighting crime by reducing denomination value. 2000 Rupees or roughly 30 USD, is far from higher international denominations. It is more likely a means of keeping up with inflation in a rapidly growing developing country, which may in fact be a sound move. But to wrap it in the context of obstructing illegitimate activity is puzzling at the least.

Elections, that’s probably why.

The state of Uttar Pradesh does little to capture limelight on the world stage. In fact, its demeanour in India at present is itself rather placid. With a Human Development Index of 0.380 (maximum 1.0), it ranks far below the national average of 0.5, and almost half of the world average of 0.65. Situated in the north of India, this mammoth of a state lays dormant on world affairs. But when it comes to domestic politics, Uttar Pradesh is Excalibur, and he who wields it is crowned King.

The state of Uttar Pradesh highlighted in red.
The state of Uttar Pradesh highlighted in red.

The reason U.P. is a political powerhouse is the size of its population. With 215 million constituents, it is the largest subdivision of a country in the world (i.e. largest state). It sends 80 elected officials to the Lok Sabha (Lower-house of parliament) and 31 elected officials to the Rajya Sabha (Upper-house of parliament). This total of 111 representatives is almost twice any other state, the second highest being Maharashtra with a total of 67 officials (Parliament has 790 total).

To underlie the influence this state has had on Indian politics, 8 of the 14 Prime Ministers in India have come from Uttar Pradesh.

At the crux of it all, U.P. is not ruled by the incumbent party in parliament, nor by the national opposition. The Bharatiya Janata Party (incumbent party) and the Indian National Congress (key opposition) are bereft of these 111 representatives from U.P. The Samajwadi party is currently in power and since its formation in 1992, neither the BJP nor the INC have managed electoral victory in Uttar Pradesh.

This excursus boils down to the following thesis. Uttar Pradesh is having its state elections coming up in 2017. The BJP won 71 of the 80 Lower House seats in U.P. in the 2014 elections, however it has only 3 of the 31 Upper House seats. By winning a majority in the upcoming state elections in U.P., the BJP can gain more control of the Rajya Sabha.

The move to demonetise may help the BJP in the following ways in the upcoming elections:

  1. Contending parties for the 2017 elections in U.P. would have gathered cash funds to spend on campaigns by this time. With the stroke of his pen, Prime Minister Modi has deemed all these hoards of cash null and void, thereby hindering and delaying campaign financing for his opposition. However, this argument is speculative.
  1. With this move, the BJP positions itself more strongly as an “anti-corruption” government, perhaps laying the foundation for more such measures to come. Corruption was decisive in the 2014 national elections in India, vanquishing black money was a key promise from the Modi campaign. Moditics, not Modinomics, is laying the foundation for his 2019 national election run.

To be fair, we don’t really know why.

At the time of writing this article, a family in Mumbai declared Two lakh crore Rupees of income stored as cash. That’s Rs. 2,000,000,000,000 (two trillion) in cash. This $29 billion cash declaration (more than NASA’s budget) currently being investigated by the authorities, lends credibility to the government’s move.

Secondly, if this really were political power play, it appears to be going very badly. The dearth of new notes in supply has halted innumerable transactions in India. Farmers are unable to purchase seeds to plant for the next crop cycle, the real estate market is beginning to tank, and weddings, a $40 billion industry, are being postponed. The economic costs and damage to the government’s reputation appear to be rather high, to the potential gain of winning U.P. state elections.

Lastly, Hanlon’s Razor: Do not attribute to malice, what you can to ineptitude. Too often do we assume an ulterior motive or malintent, when in fact it is incapability. In this instance, it is the Indian government’s inability to implement and enforce regulation. Speaking with economics researcher at the University of Tilburg, Vatsalya Srivastava, he offers the following,

“Fiat currency works on trust. I accept a Rs. 500 note because I am certain that when I give it to someone else, she too would accept and value it at Rs. 500. This trust exists because the central bank will always honour the value of a Rs. 500 note.
When the state revokes this guarantee, as it recently has, the trust underpinning the value of currency breaks down. Demonetisation does not need the government to “enforce” it. Simply by broadcasting that demonetisation has occurred, the government has an effective self-enforcing policy measure. As to whether this (demonetisation) is an effective measure at combatting black money, that is an empirical question.”

Along with the rest of India, we’ll simply have to stand in line and see how this plays out.

Acknowledgements: I’d like to thank Rohit Ticku visiting research scholar at Cambridge, Shrey Kapoor researcher at Cornell, and Aishwarya Nair consultant at Dolder Associates, for their contribution and editorial efforts.