A noted historian once observed that history is nothing but the unfolding of miscalculation. If this is true, then the Indian Prime Minister Narendra Modi made history on November 8th when he ordered two large denomination banknotes to be withdrawn from circulation and replaced.

No one doubts that criminals, corrupt officials, dodgy businesses, and tax evaders, purveyors of the so-called the shadow or “parallel” economy, prefer to deal in cash. Cash payments cannot be tracked or traced. Cash is also counterfeited. Electronic or digital payments, on the other hand, provide an effective way to weed out these evils and bring greater transparency to the workings of the economy, reduce corruption, fight crime, and ensure everyone pays their fair share of taxes.

If cash could be taken out of circulation, would it help? The answer is yes. Provided the reduction in cash is permanent and if there are electronic alternatives easily accessible to everyone for migration to digital means. Developed markets have done this before. The European Central Bank (ECB) acknowledged that large value currency is convenient for criminals and has decided to withdraw the €500 note by 2018. Because of high availability of digital infrastructure, high incidence of electronic payments, high penetration of bank accounts and credit cards, high percentage of tax payers, and (relatively) honest tax payment collection, developed markets can afford to gradually phase out large denomination notes.

In a developing economy such as India where digital infrastructure is rapidly developing but still in early stages of development and where a majority of citizens do not have access to financial services, taking cash out of circulation, has created untold havoc on ordinary people especially the poorest and most vulnerable who are heavily dependent on cash for wages and earnings.

Bold assumptions

In India, 98% of payments are made in cash. The government decided to withdraw 500 and 1,000 rupee notes which make up 85% of cash in circulation, announcing a 50-day period for people to deposit or exchange the banknotes. The premise is that most illegal transactions and illicit wealth are represented by large denomination banknotes. Banning the notes, so the argument goes, will make it very difficult for corruption to thrive in the economy as it does so today.

The move was designed as shock-therapy but its intended targets seems to have largely escaped the consequences. Instead it has delivered some unintended consequences by hitting the country’s most vulnerable the hardest who had to queue up for hours and even days to exchange their money losing wages which are already at subsistence levels. According to Bloomberg, “[Prime Minister] Modi’s cash decision has forced many families to spend as many as four days a week lining up to withdraw money or exchange old bank notes, costing them an estimated 615 billion rupees in lost business.”

Badly planned

A surprise attack, by definition, is privy to only to a select few. But this secrecy can result in inadequate preparation which is exactly what happened in India. Reports indicate that a “group of 5-10 people – a young team of researchers working in two rooms at Modi’s New Delhi residence”, developed the monetary medicine and the method for administering it.

To make matters worse, the Prime Minister also famously takes advice from a widely popular multi-millionaire yoga guru with interest in politics and loads of home-grown ideas to improve the country’s economic health. He had previously threatened the government by his intention to fast indefinitely to force the government to take action against corruption. He now believes that the move was not been implemented properly and has gone one to assert that corrupt bankers are somehow hampering the drive to weed out corruption.  

Badly done

What is obvious to most, but not perhaps to the demonetisation apologists, is that in any country, especially one with significant inflationary conditions, a majority of the black” or illicit wealth is stored away in tangible assets which appreciate over time such as jewellery or real estate, and not in paper currency. Estimates place only 5 - 6% of black money in India to be represented in currency notes. In other words, the demonetisation plan was built on a false premise.

Badly anticipated

A central motive behind the whole thing was that if a substantial amount of cash representing black money was not deposited before the deadline and, therefore, voided – the central bank of the country, the Reserve Bank of India (RBI), would be able to reduce its currency liability and pass the gains on to the government. That too, did not happen. In-fact more than expected cash has circled back into the banking system. Over 80% of the withdrawn currency notes have been deposited or exchanged.

In another bewildering move, the government has announced it will introduce a 2,000-rupee banknote – of significantly larger denomination than those voided. If the idea was to void large value banknotes because they are more convenient for criminals, why replace it with an even bigger banknote? Sceptics think the 2,000 rupee banknote is a bait which will be cancelled a few years from today in a similar demonetisation move.

Tax amnesty

Economists have explained the net effect of the demonetisation drive as a “de facto” tax amnesty. The government amended the law relating to taxation to include a clause which says that unaccounted-for cash deposited before Dec 30 will attract a tax rate of 50% (along with other restrictions regarding funds withdrawal timeframes). It is now believed that the tax on such funds realised by the government in the short term is likely to be relatively small. There is also likely to be litigation relating to unpaid taxes on such deposits which will take a very long time to resolve.

More opportunities (for money laundering)

Ironically, the economic misadventure has resulted in new opportunities for money laundering which a whole gaggle of unscrupulous entrepreneurs has capitalised upon. Bloomberg reports that these include flying plane loads of cash to the north-eastern states of India which are exempt from restrictions; brokering the services of high-turnover businesses who will “absorb” the ill-gotten currency charging premiums ranging from 10 to 50% “depending on the difficulty”; or offering jewellery or real estate in desirable locations around the capital at considerable premiums. In other words, the move designed to curb money laundering and tax-evasion has created more of the same.

Even religion is seeking ways to profit from the debacle. A television channel filmed a local priest offering to whiten money in exchange for donations which are exempt from the currency ban.

Trying to plug the widening leak, the government is taking further measures to stop these practices which include, believe it or not, asking for police approval for flights “taking off from airfields not controlled by the government,” requiring pilot and passenger “screening”.  

Its catching

No serious government, after seeing India’s demonetisation adventure, is likely to repeat the measure. The government of Venezuela, a country perennially on the brink of economic collapse, however, decided to do something similar.

In December, it withdrew the 100 Bolivar bank note causing riots and chaos. Those who managed to deposit the notes were puzzled when the same banknotes were dispensed by ATM’s. The new banknote has failed to make an appearance. Civil disorder has forced the president to postpone the move.

Doing it the right way

The good news is that away from the initial idea of catching criminals, counterfeiters, and thwarting corruption, the government is changing its tune to moving towards a cashless economy which is more credible and welcome. New bank accounts have been opened and even alternative payment platforms such as the paytm wallet linked to a major e-commerce website has seen significant new accounts on-boarded. The government is taking active measures to provide discounts and other incentives to bolster digital payments.

As a result of this, there are many consumers who will switch to digital payments. But for many more, the whole episode will be a painful memory that achieved nothing. They will continue to use banknotes - smaller denomination banknotes or new ones – not as a mark of protest against but simply because that have always used cash. Cash is embedded in people’s daily lives and the government has not provided them with compelling reasons to go digital nor a wide enough digital payment acceptance footprint.

For criminals and the corrupt the move may be a temporary set-back but they are not likely to change their behaviour and become honest simply because now there are new notes in circulation.

The process to bring greater transparency to the system in order to erode the parallel economy and introduce the fruits of digitisation - is a gradual one, it takes time. It requires making it worthwhile for consumers and offering very clear reasons and benefits for people to switch to electronic payments wherever possible.

Only 17% of Indians own a smart phone. Compare this to other BRIC countries – Brazil 41%; Russia 46%; China 58%. Another indicator: Adult % with access to the internet – India 22% (only 13% in rural areas);  Brazil 60%; Russia 72%; China 65%. Compare credit cards: 2.1% Indians have credit cards – in developed markets the figure is around 52%. When it comes to payment acceptance – measuring the penetration of electronic payment acceptance – “Brazil – with a population 84% lower than India – had nearly 29 times as many POS terminals”.

The government’s efforts and money should have been better spent to bolster these numbers. Also, money should have been spent to bring more people within the tax-paying segment and root out corruption in tax collection. Only 5% of Indians declare their incomes and 1 % pay income tax.

Shock-tactics offer the lure of a magical end to endemic problems. Putting penalties on the use of cash or applying shock measures may inconvenience criminals temporarily or provide a welcome short-term impetus to digitisation, but its side effects on a developing economy as a whole are too damaging. Even the uptick in digital accounts may prove temporary as people revert back to using cash for precisely the same reasons as before.

An empathy deficit

Political bribes are rife in India. The law requires political parties to declare only high value donations. Donations to Mr Modi’s party doubled in the year of his election made by those hoping to profit by his success. Of these, more than two-thirds came from undeclared sources. Calling for transparency from everyone while keeping one’s own funding sources private warrants some serious self-correction.

Listening to economic quacks and not possessing the experience to foresee the economic misery inflicted upon the poor and the vulnerable, leads a New Delhi based prominent Indian author and journalist to describe Mr Modi’s problem as an “empathy deficit”. Effective modernisation and rehabilitation should be based on better planning and a concern for all segments of society, not just on the fruits of hurried research or the ill-advised recommendations from quick-fix gurus especially where one of the most important economies of the future is concerned.

Undeterred and unrepentant, Mr Modi spoke about his early life experiences of being a tea vendor and that he continues to brew a strong cup of tea even where larger matters of the economy are concerned. But he has also developed the practice of breaking down during speeches to emphasise the sincerity of his plans and his good intentions. This brings to mind an ancient saying which is relevant: Any man can make mistakes, but only an idiot persists in error.