Thoughts on demonetization

It was few days after Diwali, India's festival of lights - celebrating the mythic victory of Rama over Ravana - the symbolic victory of good over the bad. Trump was kicking ass in our part of the world in the US of A. As one sixth of world population in the second most populous country were getting ready to hit the bed - something akin to the diwali pataka woke them up with shock and awe.

Modi declared in his characteristic, rustic charm on live TV that Rs. 500 and Rs. 1000 notes would no longer be legal tender. He did share that this exercise would address the topics of counterfeit currency, cross border terrorism, black money hording and corruption. The honest tax payers would be spared - Modi thundered.

In one sweep - over the next month - as common man was struck between - standing in the ATM queue to supporting the move, one way or the other every one was impacted. In one way or other - every Indian - resident or non resident got impacted (or do not yet know that he/she has been impacted).

Let's put things in perspective. I am not writing this article as an argument against or for demonetization. As far as possible I am trying to put a structure to my thoughts as I feel more comfortable with my thoughts after putting pen on paper; these thoughts are made more as an NRI - having seen the effects on my parents, friends and my personal investments.

This has impacted me as anyone else invested in the Indian stock market (this would bring in an element of bias in my analysis - knowingly or unknowingly).

First things first - what's the historical perspective for demonetization:

Germany after world war 1 was reeling under tremendous inflation. The Weimar republic was on the last gasps of breadth. The currency had totally lost its value. 100 million deutsche mark or even a billion deutsche mark was a common currency used to buy groceries, etc. Here's a pic of 100 million mark that you can buy for 25 euro cents in any flohmarkt in Germany.

Demonetization was the only way for the country to proceed. So was the case with Soviet Union when they broke up post socialism. These historical perspectives don't really chime / make a case for demonetization in India.

Mostly - demonetization was used as a tool to wipe a bad dream and start afresh. Only other large scale example of recent demonetization to curb black money proliferation was in Burma in 1988 (refer - book by Sean Turnell) which ended up as coup by the military. Only failed states can try to use this as a tool.

Why was this not thought of by Govt of India before? 

It is a rational question according to me. Why did other governments before not think of something so simple to curb black money proliferation and curb the parallel economy?

Actually I searched around on the web and found this is not true. In 2012 - the ministry of finance had made a detailed study and made recommendations on tackling black money in India and abroad. For those really interested in reading more can get a copy of the pdf here: Link to ministry of finance study.

Why was this study not taken seriously is a question one needs to ask. Did Modi and his men know about this study which was done as recently as 2012 that strongly advocated against demonetization? I am actually asking the same question. Its scary to think that Modi has come up with the biggest monetary policy shift (taking out 86% of legal tender out of the system) sitting in his bungalow with rookie political analysts who over simplified the problem at hand and came to the conclusion - "any action is better than no action". I, for one - as an investor would be scared by the thought. Various newspaper articles since have come up to support this theory.

It also brings to question what the new RBI governor Urjit Patel really doing? Again - an indication of a toothless governor of RBI - given the fact that an elected prime minister does not feel comfortable taking opinion from him on monetary policy. Is this why Raghuram Rajan was brushed aside and not given a second term? This makes me wonder if this move was already thought of when pushing aside Rajan from the scene as a road-block.

Will this help India?

That is - I think; the most important question. What's done is done. But - will this help India? Atleast - will this a) fight counterfeit currency, stop cross border terrorism b) put fear in minds of people c) bring a tax windfall (equal to the original estimates of 3-4 lakh crores).

Among India's middle class, Modi's surgical on corruption and black money appears to be very popular (atleast among the media and in the cities it seems popular). I think this is also the "bitter medicine" theory - if the medicine tastes terrible - it must be good for you. If something tastes good (let's say - Ice cream), it must be bad for you. And - again its the "common suffering" theory. If something affects your neighbor and not you - you feel its singling you out and you rebel. But - what it affects everyone alike? Then you rationalize this as something you do for the "greater good" of the nation.

For an example of how we (or our far cousins - monkey's) dislike discrimination, see this -

Since enough Indian's are now suffering, we would like to believe that its for a greater cause. It's a moral project, not just an economic project. Stand-in-line (literally at ATM stations), you would be told - you honor our brave soldiers at the border.

a) fighting counterfeit currency:

Here's something to quote from Prof Arun Kumar -

"Not at all. In fact, our macro-economic indicators were reasonably good. But the real point is, what does this move achieve? According to the prime minister, there are two objectives. One is (curbing) terrorist financing and counterfeit currency—and the second is that the black economy has become very large and it is the source of poverty and all the problems in India so we need to get rid of the black economy.

The question is—does demonetization overcome these two problems. As far as counterfeit notes are concerned, they are only 400 per million, which is very tiny. And according to RBI, there is only Rs 400 crore worth of counterfeit currency.

Total currency in circulation is Rs 17.5 lakh crore. It’s not even “oont ke muh me zeera”, as they say in Hindi. It’s negligible.

Terrorists need financing. So they print these fake notes and circulate it. But once they have given the money to another person, it’s circulating within the economy. So they have to print more and more money. That is what you have to stop. And how do you stop that? Not by demonetization, because there are state actors involved in counterfeiting. They can counterfeit the new currency notes also."

b) put fear in minds of people:

I think this move will definitely help in this regard. However, I think this can affect the honest people as much and in most cases even more than the dishonest.

It may affect the honest citizen more than the convoluted hoarder who's built up huge wealth (that is mainly in real estate and gold).

There is a story that Abraham Lincoln narrates when he was fighting to end slavery -

"If I saw a venomous snake crawling in the road, any man would say I may seize the nearest stick and kill it. But if I found that snake in bed with my children that would be another question. I might hurt the children more than the snake, and it might bite them."

c) bring a tax windfall (equal to the original estimates of 3-4 lakh crores)

This is highly debatable. Out of the 15 Lakh Crore Rs (500 Rs and 100 Rs) in circulation which amounts to 86% of the currency in India by value - 12 - 13 Lakh Crore Rs. are already back in the banking system.

This seems to be a miscalculation of the highest order. It makes this move look childish in retrospect if less than 1 Lakh Crore Rs is brought back as tax windfall. The cost of taking an entire nation through this exercise would be more than the benefits this ensues. Even basic government run corporations would like to get a decent return on tangible capital before moving on a new product introduction.

Where is the black money? Is this the first step in a series of steps?

As per the last study of the finance ministry - 3/4th (or more) of the black money is in bullion / jewelry and real estate.

I will not go into details here - but as an illustration, India holds over 18,000 tonnes of above ground gold (represents roughly over 11% of the known gold reserves worldwide). This is nearly 2/3rd of India's current GDP.

Further - it beats reason why a 2 BR house in Bangalore should be almost equal to price of a house in most tier 1 cities of the USA whereas income levels are much lower. The worldwide historical indicator of home prices is an interesting ratio called: "home price to income".

The price-to-income ratio looks at the total cost/price of a home relative to median annual incomes. Historically, the typical, median home in the US cost 2.6 times as much as the median annual income (so if the median income in an area was $100,000, the median price of a home would typically be about $260,000: $100,000 * 2.6).

In comparison, if it takes 20 - 30 years of annual income to buy a home in any tier 1 city of India, what it clearly means is that the real estate companies have priced themselves out of the market or alternatively there is so much black money in the market that home prices have been highly inflated (artificially that is).

This brings me to the point to ponder - "what next". Gold / real-estate seems to be the next logical step. Now - lets see if the same patriotic fervor remains when the price of the home you own goes down by 1/3rd or 1/4th or even more. Can it happen? Looking at figures worldwide, home prices in India are somewhat 3x or 4x more than what they should be.

Can Modi do anything to touch this - without losing support of people - irrespective of the color of money they hold - black or white? If there is no next step - why make this move at all in isolation?

"Its the trust", stupid!

When you hold cash - you trust that the value of the money you hold is really what is written on it. "I promise to pay the bearer of this note Rs 500" would mean just that. Not more, not less. In the current situation there is an *conditions apply. The rural poor who lack infrastructure to setup accounts / have to walk miles to the nearest ATM are being thought a lesson fast forward in digitization. 

It is difficult to estimate the second and third order effects of something as complex as this. Indian's are by lot - highly resilient and adaptable. We do believe in the maxim - "this too shall pass".

But, it does bring to the fore- certain questions on creating over simplified solutions to bigger economic problems a country faces. It begs the question - what next?

And until its clear what the strategy is, I am not convinced if this is the right first step in executing the strategy. The lack of transparency and poor execution is not giving me a lot of hope.

Ciao till next time...Harsha