Will Modi Reap Bad Karma? Lessons From A Half-Botched ‘Note Badli’

With just two-and-a-half weeks to go for the end of the note-badli scheme for demonetised Rs 500 and Rs 1,000 notes, it is possible to draw tentative conclusions about its success or failure.

Demonetisation has surely been a half-success, given the likely impact it has had on black money hoards. Most of it is coming back to the banking system, and a jolt has been given to a corrupt eco-system.

Since the national media is full of stories about how cash shortage is upending everyone’s livelihoods, from farmers to daily wage workers to small traders and businesses, let’s look at the negative side of the ledger first for lessons.

Lesson No 1: Sending a thief to catch a thief isn’t the best way to reform. The black money stash was not created by lone wolves going rogue and corrupt. It has been the product of an eco-system created by decades of socialism and a mai-baap state. Crony capitalism marched under the banner of socialism and welfare of the masses, peaking in the UPA years. The corruption has been systemic, which means almost everyone is involved – politicians, bureaucrat, the professional middle classes, the law enforcement agencies, the taxman – and bankers. Money ultimately has to touch a bank somewhere.

This is why when you ask banks to handle the whole note badli affair, we get to see umpteen cases of bankers in cahoots with black money holders, giving them access to new notes behind closed doors. This is why the taxman has been able to find tonnes of loot during raids across the country. It is why a few bankers are now cooling their heels behind bars. This is one small reason (but not the whole reason) why banks are unable to give the aam aadmi his sanctioned daily quota of cash withdrawals. When cash is disappearing from the vaults directly in favour of the corrupt, is it a surprise that the poor are left high and dry?

Cleaning the corrupt system needs extreme vigilance, especially when you are going to use the same machinery for the clean-up. This means long after the demonetisation saga is closed, clean-up of the banking system and the tax administration is vital.

Lesson No 2: Poor briefing on the challenges after demonetisation. The Prime Minister promised that after 50 days of pain, the worst would be over. Now, he is saying things will improve slowly even after 50 days. He said the other day in Gujarat: “For 50 days this difficulty has to be there. And this difficulty will even increase, but after 50 days…the situation will turn to gradually move towards normalcy. You will see after 50 days that situation will slowly start improving in front of your eyes.”

This statement could be true, but most people will wonder why he said that things will be fine in 50 days? Did he not know that the cash printing process was going to be slow? As of today, roughly Rs 5 lakh crore – or one-third – of the currency demonetised has been printed. Printing another third, which is when the shortage phase will abate, could take another three months. This change in the Prime Minister’s stance speaks poorly of the level of information he seems to have got even after the demonetisation was announced. He should have been briefed better by both the finance ministry and the Reserve Bank of India about how many months it would take to normalise. We were wrongly told that the problem was about ATMs not being programmed for the new notes; the real issue was shortage of note printing capacity.

Lesson No 3: Poor communication. When something is going to affect almost every Indian, the government must keep an open channel of communication with the people. In the initial days, it seemed as if Modi was indeed doing this; but as the queues outside banks grew longer and people were becoming restive, the Prime Minister did not talk much, and government spokespersons were busy trotting out the same line that the people are with the government; they also admitted to some inconvenience. But disrupting the lives and livelihoods of millions of people can’t be called an inconvenience. Granted, mistakes may have been made and the pain was going to be longer than earlier anticipated, but surely open communication is the best way to handle this mistake? Running away and parroting clichéd statements must have cost the government quite a bit of credibility. In a hyper-media world, governments must constantly communicate. Indians are a patient lot, but they will not take kindly to empty talk and promises. The least the government could have done was to prepare the people for a longer time of hardship – which is what Modi tried to do last week. A bit too late, that.

Lesson No 4: The lost art of apology. When people die standing in queues to collect money, it did not behove the government to keep quiet about this. At the very least, apologies and sympathies could have been proffered and cash compensations announced on the spot. Indians know that s**t happens, but surely they can be assuaged with some degree of contrition? Why do governments and politicians behave as if an apology somehow diminishes them?

Lesson No 5: Weak preparation and followup. If demonetisation was always in the works, why did the government not launch public education campaigns for digital payments? If 25 crore households had a bank account, how come there was no investment in ensuring financial literacy? If tomorrow people accepting digital cash and mobile banking find that their money has been swiped by cyber fraudsters, won’t it dent confidence in the whole system? It is not too late to begin this process now, but it would still be an after-thought.

However, these apparent failures are counterbalanced by several gains, some of them permanent

First, an expanding tax base. The return of the bulk of the Rs 15.4 lakh crore outstanding in demonetised notes will result in a permanent increase in the income tax base. While the surge in deposits will probably give revenues a small boost this fiscal year, whoever has made big deposits will find that it will not be easy to report lower incomes in future years. The big cash earners – whether professionals like doctors or lawyers, or traders or small businesses – will have to move to higher levels of earnings disclosure in future. This will yield larger tax revenues continuously.

Second, short-term bank nirvana. The huge deposit inflows into the banking system will bolster bank bottomlines like nothing else. The deposits will take time to be withdrawn as cash. The larger deposit base available to banks will help lower costs immediately, enabling them to lower lending rates. Lending rates no longer depend on the Reserve Bank of India lowering its repo rate; of the 175 basis points (ie, 1.75 per cent) cut in the repo rate since January last year, just about 100 basis points have been passed on to borrowers. With deposit rates set to fall, costs are coming down faster, giving banks elbow room to cut rates and restart lending. A virtuous cycle of lower rates fuelling higher borrowings and investment may begin from 2017-18.

Of course, banks will also have higher costs, including the recent costs incurred in recalibrating ATMs, speeding up cash movement logistics, higher employee deployment costs, and the possible surge in bad loans due to the demonetisation shock. But these costs will be easily covered by the biggest gains for banks: more profits and easy capital. With yields on bonds falling in line with the deposits surge, banks will make large treasury gains. Yields on 10-year benchmark government bonds have fallen 1.3 per cent since March to around 6.4-6.5 per cent now. If yields fall further, as the deposits deluge indicates, banks could be sitting on treasury gains of Rs 1,50,000 crore, according to KV Kamath, chairman of the New Development Bank, and former ICICI Bank chief.

The implications are huge: it means banks can write off their bad loans faster and recapitalise with internal resources. They will not need government support at least in the next one or two years. Once again, this signals a positive trend towards reviving the lending and investment cycle.

Third, low inflation. The drop in business due to demonetisation will bring down prices as businesses discount to revive demand. Even though the Reserve Bank kept its rates steady last week, the chances are the threat to inflation is over-rated. Businesses will be seeking to push sales any which way they can, and this does not mean a price spike. Food prices should also stay in check.

Fourth, going digital. The prolonged cash crunch has given digital payments the kind of rousing start that one can only dream of. While some of this may come down once the cash shortage ends, some of the shift to digital payments will be permanent. Like ATMs and internet banking in the last two decades, digital transactions will bring new efficiencies to the financial system, and also feed the taxpayer information loop.

To be sure, banks will have to up cyber security, an area they have been a bit casual about so far. But the costs incurred will be more than made up by digital efficiencies.

The ultimate question is whether these long-term gains will be enough to wipe off the short-term bad karma of causing so much hardship to so many millions. The jury will vote on that soon.