May 19, 2019

Thoughts on Demonetisation

Short term pain, long term gain

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It has been a very interesting fortnight or so. The election of Donald Trump to the highest office in the USA has come as a surprise to the mainstream (left liberal?) media. However, there were several similarities in how the media treated him and how they treated Narendra Modi in 2014…and with the same result. While there are several fears about Trump as President, I think he will pleasantly surprise.

In India, the buzz of the new President-elect was smothered by reports of a surprise move by PM Narendra Modi to demonetise currency notes of denominations higher than INR500. These constitute about 87% of the total currency in circulation. With currency in circulation estimated at nearly 12% of the GDP (~US$250bn), India has remained a ‘cash economy’ despite its growth.

The Bookkeeper will discuss the economic issues in just a bit, but it is worth pointing out that demonetization has seen an emotional response from many people in India. The Bookkeeper does not remember witnessing this level of ‘rallying behind the national leader’ even in the times of Atal Behari Vajpayee (NDA1). Remember, a cynical population is a corrupt politicians’ paradise and the despondency of helplessness that appeared to have seeped into the Indian psyche during the UPA decade is on the wane. A ‘trailer’ of this new renewed confidence evidenced in the “boycott Chinese goods” social movement during Diwali. One can debate its success (or otherwise) but The Confederation of All India Traders reported that there was a 60% dip in sales of Chinese goods during Diwali. This is significant given the “price conscious” nature of Indian shoppers. The support for demonetization seems to be a continuation of this participation of the Indian people in how the country is run. Reduction in cynicism will provide the ‘X factor’ for continuing growth in the economy.

While the focus remains on the black money aspect of demonetization, I feel the bigger benefit (and perhaps the real intent) is the dismantling of the counterfeit currency funded terror mechanism in India. Scrapping of Rs500 and Rs1000 notes has reportedly disrupted the Hawala trade, which supposedly fuels engineered protests and rallies in various parts of India. A good barometer can be instances of ‘stone pelting’ against the armed forces in Kashmir, which has come to an immediate, complete stop after the demonetization announcement, as per a statement given by the Indian defence minister. ANI had also quoted MHA (Union home ministry) sources as saying that there has been a decline in separatist-instigated violence in the Valley after the surprise demonetisation move

Interestingly, though The Bookkeeper sees queues in front of various ATMs and banks in Mumbai and Pune, the people in them are not complaining, and recognise that tough measures were required to target the menace of illicit, and counterfeit currency. In fact most are appreciative of the structured manner that PM Modi went about his move, i.e. first getting the poor to open a zero balance banking account*, then announcing a tax amnesty scheme (ended on September 30, 2016) and finally announcing the demonetisation.

* PM found a practical use for the 1.08 billion national identity cards issued over the years.

There is also an element of schadenfreude among the regular people. For the first time in my memory it is the ‘cosy club’ that is having sleepless nights due to a government regulation rather than the average citizen. Needless to say, several fortunes have been reduced to rubble by this move. In fact, as per some strategists, it is expected that 10-20% (US$25-50 billion) of the currency stock may never be deposited into the banking system as the owners would be hard pressed to explain the source.

This ‘vanishing currency’ can actually be a windfall for the Reserve Bank of India (RBI) that carries currency in issue as a liability on its balance sheet. While admittedly this can be considered aggressive accounting, the Government can then request RBI to issue a special dividend that can plug the fiscal deficit, or perhaps RBI can use the gain to re-capitalise PSU Banks.

The Bookkeeper would prefer the second option, as ‘banks’ are the “heart that pumps blood into the Economy”. Indian Banks’ stressed assets are expected to reach 12% of the total by FY17 and while the Government has committed to inject US$11 billion in PSU Banks by FY19, their capital requirements are estimated by independent analysts to be between US$32 billion (CLSA), to US$45 billion (S&P), and to US$90 billion (Fitch). Even if one assumes an average number of US$55bn, the ‘windfall’ for RBI, would suffice to avert the severest banking stress in India in recent memory.

The move also has political implications with unscrupulous political parties which allegedly used black money to bribe voters losing their stash all of a sudden. There are about five state elections slated for 1H2017 (These states send a cumulative 102 seats to the lower house of Parliament and 43 seats to the upper house). If BJP manages to pull off victories in Uttar Pradesh and Punjab, it would further strengthen PM Modi’s position allowing him to push through even more radical reforms.

The Bookkeeper feels that PM Modi is trying to build a war chest that will allow him to present a blockbuster budget in February 2018 with significant tax exemptions for the middle class. The Bookkeeper would not be surprised to see tax exempt income level extended to Rs1 million in 2018, with any excess charged a flat 30%. This will not only boost consumption, but (perhaps) also seal Modi’s position in the May 2019 elections for another term. On the whole, I have been watching PM Modi’s recent speeches and they have been increasingly assertive on the issue of terrorism and the parallel economy. It suggests that strong reforms will continue.

On another note, Pakistan remains an issue, but after India’s surgical strikes there is a renewed sense of unity and confidence in India. Pakistan’s nuclear bluff appears to have been called and the general chatter is that soldiers at the border have been asked to retaliate in full measure on any provocation by the enemy. I believe the strikes and the continuing tactics are part of a considered strategy by PM Modi to discredit the Pakistani army thus strengthening the position of Pakistan’s civilian administration led by PM Nawaz Sharif. This is important especially now when the Pak army chief (Raheel Sharif) is slated for retirement in a month. No Pakistani general goes quietly and the continuous pressure built by the Indian army just makes it untenable for him to continue. This will allow PM Nawaz Sharif to appoint ‘his man’ as a successor and protect the democracy in Pakistan, such as it is. Truly, PM Narendra Modi is no ordinary politician.

About The Bookkeeper 14 Articles
An intrepid accountant, investment analyst, ex fund manager, jyotish student, traveler and observer. Zinda hoon zindagi ka talabgar nahin hoon, Bazaar se guzra hoon, khareedar nahi hoon.