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December 30, the deadline Prime Minister Modi set for completing his exercise in demonetisation has come and gone, and there is now no room to doubt that it was the single greatest blunder that any government has made in the 69 years that India has been free. On November 8, Mr Modi demonetised 20 billion bank notes, accounting for 86 per cent of the cash in circulation in the Indian economy. But only a fraction of the new currency notes needed to replace them had been printed. As if this was not inept enough ‘somebody’, that is to say everybody from the prime minister to the head of the Reserve Bank, ‘forgot’ that if the new notes were of a different size from the old, the ATMs would not work. The result was that, like a car engine run without lubricating oil, the economy simply seized up.
The impact on the economy has not only been catastrophic but highly unequal. Those with bank accounts and credit cards were merely inconvenienced. Those who earn and spend mostly, or entirely in cash, found themselves rendered penniless overnight. These were the poor of India. Banks still account for only a little over 30 percent of total credit extended in the country. The balance comes from moneylenders who deal in cash. That credit collapsed. In terms of value the proportion of transactions that has been digitized is also about the same. But this figure is deceptive because in numbers around 90 percent of transactions still take place in cash. This entire segment – the lion’s share—of the economy is now paralysed.
The fewer are the transactions in the economy, the lower is the income they generate. There is now a consensus among economists and bankers, therefore, that the GDP will shrink in the second half of this fiscal year. Shortly after the demonetisation Goldman Sachs slashed its growth estimate for the second half of the year by 1.6 percent and predicted that the GDP would grow by 6.8 percent. This was 0.8 per cent below its original estimate. Deutsche bank similarly estimated that the annual growth would be around 6.5 percent. But the most pessimistic estimate was that of Ambit Capital which forecast that the economy would actually shrink in the remainder of the year, and bring the annual growth rate down to only 3.5 percent for the year.
Anecdotal evidence suggests that Ambit’s estimate is likely to prove closest to the mark. 90 percent of India’s more than 300 million non-agricultural unorganized labour is paid daily or weekly in cash. To pay them their employers have to have that cash first. The government’s severe weekly withdrawal limits have made it virtually impossible to pay these workers in the new legal tender. So far employers were paying them in old notes and asking them to convert these into the new money. But this loophole has been shrinking and will shut on December 30.
As a result, Mazdoor Nakas—casual labour markets-- where many of these workers congregate every morning in the search for work, now receive a trickle of hopeful aspirants, as the news has spread that their employers, mostly in the construction, do not have the cash with which to pay them. There is a swelling reverse stream of migrant workers returning to their home villages, where the cash they have managed to save before the calamity will last longer than in the city. Sectoral information from organized industry for the month of November was bleak: a 20 percent fall in auto sales, 35 to 40 per cent in two wheelers, 63 per cent in tractors.
But the most severe crunch has taken place in the rural areas, where nearly all transactions are in cash and there are far fewer banks. The demonetisation occurred just as farmers in north India in particular were selling their Kharif crop and making their purchases for the Rabi. There is some preliminary which suggest that the area sown with Rabi crops has therefore shrunk but the full impact upon the Rabi will only be known as the crop ripens. What is certain is that farmers all over India have minimized their purchases of non-essential goods. This will killthe fillip that the bumper Kharif harvest would have given to the consumer goods industries.
Mr Modi has sought to reassure the people that this is only a short term, and necessary pain that the people have to suffer, to cleanse the black money of corruption and black money. Once it is over the economy will not only revive, but emerge stronger than ever. This is wishful thinking. For the sharp cut in spending that has taken place will last for the entire time, now estimated at up to six months more, that it will take for all the old notes to be replaced. During all this time spending will remain constrained so income growth will fall too. This means that the decline in consumer spending will persist.
This will force manufacturers to cut production in order to clear their unsold stocks. That will cause a second round of reduction of orders and retrenchment of employees, so another contraction in income and expenditure. The economy will therefore continue to glide downwards till it bottoms out. Left on its own the economy is likely to take another two years to recover. By hen 2019 will have come and gone, and so will the Modi government.
If Mr Modi wishes to revive the economy quickly enough to recoup his party’s political fortunes, he will have to give it a huge jolt, not unlike the electric shock given to patients suffering a cardiac arrest. The only way in which he can do that is through a huge cut in interest rates. By this I do not mean a cut of 50 or even 100 basis points in policy rates. I mean a slew of changes in various policy rates that will bring the lending rates of the commercial banks lend to investors of five to seven percent below the banks down to at most five per cent; that is six to seven percent below that rates that had prevailed before demonetisation.
A cut of this magnitude will enable India’s dying infrastructure and real estate companies to refinance their debt and thereby halve their interest costs. This alone will enable a large proportion of these companies to pull out of the red and take up many of the Rs 8,80,000 crore worth of ‘stalled’ projects that they abandoned when interest rates began to rise, and industrial growth to sink, six years ago.
A halving of bank lending rates will also revive the real estate sector as millions of home buyers will once more be able to meet their monthly installment payments, and give a huge fillip to the sale of consumer durables that account for more than a quarter of manufacturing output.
But how will Mr Modi bring interest rates down so sharply now , when neither he nor his predecessor were able to persuade the RBI to do so earlier, and when he has formally ceded the entire power to set them to the RBI and its newly created monetary policy committee? The latter contains economists who, one presumes , are more sensitive to economic growth issues than the bankers of the RBI, but even they will be bound by the now official diktat of ‘inflation targeting’.
Inflation targeting requires central banks to keep lending rates in the economy above the rate of inflation at all times. Its purpose is not economic growth but financial stability, because doing so reassures all Indian, and particularly foreign, holders of Indian money that the government will not allow the value of their savings and investment to depreciate. Advocates of inflation targeting claim that growth will automatically pick up when prices and exchange rates stabilize, but they are unable to describe the chain of cause and effect that will make this happen. There is also very little evidence in the experience of other countries that had adopted inflation targeting, to buttress this claim. On the contrary, South Korea’s two-decade long surge to prosperity took place in the midst of a 21percent annual rate of inflation and a continuous devaluation of the won to counteract its impact upon external competitiveness.
In India inflation targeting, which has been the informal mantra of the RBI since 2006, has bestowed the kiss of death on industry, infrastructure, construction, and therefore employment. This is because it does not distinguish between inflation caused by an excess of demand in the economy, which high rates can bring down, and one cause by shortages of supply, whether of food grains, industrial raw materials ( usually a reflection of rising global commodity prices) , or labour which, by curbing production, they can only intensify.
India’s cost of living index is sticky, and has diverged further and further from the wholesale price index of inflation that the government used earlier, because ever since 2007, its CPI inflation has reflected local and global shortages, and not the state of domestic demand. Judged by the latter, which is reflected both by the wholesale price index and the GDP deflator, the true rate of demand inflation in the country was zero or negative even before Mr Modi exploded his demonetisation bombshell.
In India inflation targeting will play a useful role if it keeps interest rates two to three percent above the rate of demand inflation. By that yardstick today even a five percent long term rate of interest would be on the high side. So bringing commercial bank lending rates down to this level is the minimum that Mr Modi should do.