The Prime Minister of India, Modi, instituted a ban on the 1,000 and 500 rupee notes in November. He wanted to modernize the Indian economy and crack down on the money earned in the underground economy. This action was the wrong way to achieve those goals. The Indian economy can’t be modernized and become cashless when it has 287 million people who are illiterate. This policy skips many steps. If almost all Indians were literate and had access to the internet, the economy would be ripe for modernization. Other developed countries like the U.S. never had to institute a cash ban because progress naturally happens in a free economy. Maybe Modi doesn’t care about the bottom level of the economy since it doesn’t contribute much to GDP. Also, the caste system didn’t value the lower rungs highly, so he may have similar thoughts even though that system has been phasing out of society.
The Indian economy has experienced a sharp downturn after the demonetization as uncertainty always leads to business contraction. Modi could have pre-announced his plan beforehand to prevent this mass scramble of uncertainty, but it may have been part of the plan. This ‘shock and awe method’ may have had the goal to increase momentum towards getting rid of cash. It did achieve its goal as people acted in a self-preservation mode by returning their cash to banks promptly. Also, if the plan was announced, it may not have been executed because the people may have expressed their displeasure with it. This method of implementation was a poor choice, but it may have been the only option. My solution to this would be to not do the cash ban at all. We know the economy felt a negative impact from the cash ban because even the politicians are admitting it. Their spin is to say the issues are temporary. The spin would be that everything is great if there was no short-term impact.
The chart below shows the decline in manufacturing after the demonetization. According to the PMI report, output and new orders fell for the first time in a year. Firms reduced buying and payrolls. Inflation costs also accelerated which is especially bad news for India because of its reliance on raw material imports. India imports 80% of its energy. Oil prices had a great year in 2016 and the OPEC production cuts could accelerate its rise. The World Bank projects energy prices to rise 25% in 2017. The PMI report showed raw materials prices increasing for the 15th straight month and accelerating in November.
As you can see from the PMI, it fell to 49.6 in December from 52.3 in November. The demonetization directly led to the decline in new orders. Cash flow declines hurt purchasing activity and employment. The key to determining if the politicians are right about the economic issues being temporary will be the metrics reported in January and February. The window for exchanging rupees ended in December, so that’s where the acute economic effects will end. The politicians want economists to ignore these issues which isn’t a surprise because it’s in their best interest to always be positive. Even if the metrics rebound, I still think it was a mistake as economic liberty is what drives progress, not government bans.
According to the PMI, business from external markets fell after having a 6-month streak of growth. Global trade growth is expected to be tough to find in 2017 as the amount of protectionism increases. The catalyst of this populist approach is the people are angry about the growing inequality gap. It isn’t being caused by free trade; it is being caused by central bank policies which blow asset bubbles. Increasing asset prices help the people who own the most assets disproportionately. If you are living pay check to pay check, then you are hurt by these bubbles because rent expenses are increasing along with the price of real estate. Low interest rates also hurt savers. Nonetheless, there is a right wing populist approach growing in the western world which will hurt India’s ability to export.
Because of this anti-trade policy trend, the World Trade Organization lowered its trade growth estimate from 3.6% to a range between 1.8% and 3.1%. I expect it to hit the low end of the range if it even reaches 1.8%. President-Elect Trump is the biggest risk to Indian trade growth in 2017. America is India’s biggest nation it exports to as America represents 15% of the goods exported and about 60% of software exports. I don’t expect any major changes, but the level of uncertainty can freeze business growth until Trump presents a clear vision on trade with India. Trump may want to forge a new bilateral agreement. We’ll get a good picture on Trump’s vision at his inaugural address on January 20th.
As I said, Modi’s cash ban isn’t the correct way to improve India’s economy. He should be focusing on creating a better government that serves the people honestly. He needs to cut insane regulations to let the economy grow. By focusing on executing the cash ban, it limits his ability to get needed reforms done that will actually be beneficial to the short and long term economy.
Instead of forcing people to pay taxes and having a decline of liberty be collateral damage, the government needs to be improved. In 2012 India was rated as having the worst bureaucracy in Asia. The rating was on a scale of 1-10 with 10 being the worst. India got a 9.21which was worse than Vietnam, the Philippines, China, and Indonesia. Bureaucrats are rarely held responsible for their actions. India’s legal system is in disarray as the courts have a backlog of 31.5 million cases. The cases take decades to be resolved. This makes people less likely to see justice as they don’t bother with bringing about cases. Therefore, the 31.5 million number could be even larger if you take these potential cases into account.
A big reason the black market is so large in India is because regulations are ridiculous. Indian companies with over 100 workers need government clearance to fire workers. This prevents companies from growing this large; the other option is hiring temporary workers. 90% of Indians are in this informal economy. Instead of forcing them into the formal economy, Modi should be making it advantageous to do so.
Conclusion
While India’s economy had been growing quickly in 2016, the demonetization is throwing a wrench into growth estimates, as you can see in the chart below. The key will be determining if this issue will be temporary or more lasting. We will get clarification on that when data on January and February are released.
1 Comment
Rajiv Mehta
January 4, 2017I was just there, in Mumbai while this ws going on. With my US passport, I was able to withdraw Rupees 24,000 per week from my bank in Mumbai. That's about USD 350.00. not enough for that city without a credit card. In Don's words "that's neither here nor there".
The underlying reasons, however, seem to outweigh the short term downside effects. Corruption. Rampant everywhere. Billions of USDs in Rupee currency were converted from the black market system to the legit system. More were found and confiscated. People were jailed. Aside from the black market money ammased by business people, politicians were caught with Billions from bribery. I also heard rumors that the neighboring terrorist regimes weere dumping counterfit curreny in denominations of Rupees 500 and 1000.
Hopefully, all this will result in a better and more stable currency. At which point India will be in a better position to compete against China with its under valued currency.
In short, time will tell, but this was not all bad. Any early announcement of his intentions would have been fair only to the inside politicians not to the rest of the masses.