Demonetisation Read from TOI Blog

Something all should read...

At a time when populist nationalism is confusing ideological battle lines across the world, no nation is more confused than India. Politics here divides into camps for and against Prime Minister Narendra Modi and this is once again evident in the reaction to the demonetisation plan. Ironically, Modi’s enemies on the left find no merit in this scheme to apparently soak the rich, and his supporters on the right see no reason to question this clumsy exercise of state power.
The Prime Minister has presented the demonetisation plan as his version of draining the swamp and has called on Indians to join this “decisive war” on corruption. Early on, many responded with patriotic fervor but now the dialectic seems more fractured than ever.

While Modi’s allies concede that removing nearly 90% of the cash in circulation is indeed leading to some chaos, they insist it will eventually promote larger goals: increasing tax collections, boosting bank deposits, thus fixing many of the institutional shortfalls that keep India poor.
The impassioned debate obscures a basic problem with the demonetisation scheme, which is that it presumes to know what comes first, development or growth. In general, institutions grow stronger as a nation grows richer. India cannot expect to leapfrog up the development ladder simply by purging black money from its system. Certainly no other nation has done it that way.

Drastic action might have still been appropriate if Indian institutions were especially dysfunctional, but as heretical as this may sound they are not for a country with such a low per capita income. Though commentators often compare India unfavourably to global averages the relevant comparison should be nations with similar average incomes, around $2,000. On most measures that matter in this debate, India mostly ranks better than its peers.
Like other low income countries India is cash dependent, but not outrageously so. Cash in circulation amounts to 12% of GDP, somewhat higher than the emerging world norm but not out of line with even countries like China and Thailand where the number is around 10% of GDP. The black economy is about a quarter the size of the formal economy. That is similar to low income peers like Indonesia, and in fact smaller than in higher per capita income nations like Mexico and Russia.
Indian banking and tax institutions are flawed, but not so flawed as to justify this kind of therapy. Tax collections amount to 16% of GDP, slightly higher than the norm for India’s peers. Bank deposits amount to 60% of GDP, strong for a poor country and about the same as in emerging countries known for institutional competence, such as Poland and the Czech Republic.

Modi also chose an odd moment to attack corruption, which appeared to be in retreat. On Transparency International’s ranking of the most and least corrupt nations, India was getting worse until 2011, when it bottomed out at 95th, and lately it has rebounded to 76th. India currently ranks as less corrupt than average in its income group, ahead of peers like Pakistan and Vietnam. The least corrupt countries tend to be richest countries from Norway to Singapore.
In the past, the Soviet Union, North Korea and Zimbabwe and other nations also took draconian steps to retire large bills, but most were responding to crises marked by hyperinflation, and were ruled by dictators. India may be the first democracy to attempt this kind of purge in stable economic times.

If India wanted to do something radical it should have taken on privatisation of a banking system in which government ownership is higher than in any other democratic nation. On that metric, India is truly out of line with its peers. Instead, the wide-ranging crackdown on the cash economy has further expanded the powers of India’s leviathan with government officials now emboldened to question any wealth or transaction deemed inappropriate.

There is also a better way to downsize the black economy, which Modi’s government tried but with underwhelming results. Earlier this year, it offered a tax amnesty and imposed a punitive tax of 45%. The result: Indians came forward to declare assets worth less than $10 billion. Contrast that to Indonesia’s recent amnesty, which imposed a tax of just 4%, and drew out $300 billion in hidden wealth – reportedly including $30 billion declared by a son of former dictator Suharto. Of course, such a move in India would not deliver an instant populist punch and would entail the hard work of marketing the benefits to the masses.

It might be more satisfying to punish shady fortunes, but revenge is not a development strategy. Scrapping large bills may destroy some hidden wealth today, but the black economy will start regenerating itself tomorrow in the absence of deeper changes in the culture and institutions that foster it, which in turn is a function of a country’s per capita income. Only as a nation gets less poor do corruption, black money and the role of cash decline. There is no shortcut.

India will have to climb the development ladder one rung at a time. But for now, as economic growth slumps here, the message to other populists in the world is: be careful when draining the swamp. more