Demonetization Economics

Black money & Demonetization

     Demonetization of 500 & 1000 notes was a risky move given that corporate sector has still not fully recovered, international headwinds remain strong and private investment remains below par. Demonetization of 86% of the total currency, compared to <2% in the previous such episode in India, can be viewed as an incredibly bold decision or a gamble, depending on your point of view. It must however be analyzed in the context of other actions against black money taken by the govt. 

1) Black money abroad: Black money bill, cooperation with US, EU who have introduced corruption & tax evasion laws, International co-operation on Tax havens.

 (2) Domestic Reforms: Transparent auction systems for natural resources (telecom spectrum, coal, minerals); Real Estate Regulation Bill, GST, CIT reform (25% by 2019), measure to ease payment of PIT, mobile wallets, Aadhar & bank acts for poor (Jan Dhan), Rupay credit/debit card.

(3) Policy Reforms Needed for sustained decrease in the share of black economy in GDP and national wealth: PIT simplification & rate reduction, end of tax terrorism, stamp duty reduction, lower circle rates, promotion of mobile wallet; State financing of elections, rigorous auditing of accounts, penalties for non-compliance including eventual de-registration, removing criminals from politics (all to be implemented/supervised by Election Commission), criminal justice system reform (law-police-judicial). 

Economy Impact

      Such a large demonetization has significant positive and negative effects on the economy. On the positive side, it's a blow to Cross border counterfeiters, corrupt politician-bureaucrat-police, and to operators of the 60-40 land-real estate system. The demonetization will make it impossible to use undeclared income, and thus put severe downward pressure on prices. It's conceivable that almost the entire black component of price is eliminated, bringing down prices by 30% to 50%. But this cannot happen if govt rules like high "circle rates" make it impossible. State Govts must quickly eliminate rules & procedures which can keep real estate prices from falling and reduce stamp duties, an outdated transaction tax that discourages transparent deceleration.

  The other channels for holding black wealth such as jewelry & foreign currency (hawala),  will also be reduced, but the effect will be mostly on volumes, not much on prices, as these are set by international markets. Conspicuous consumption in the form of extravagant wedding ceremonies is also likely to be moderated. However, the effect on these items will not last beyond 3-5 years, unless complementary measures are taken to reduce new generation of black money.

     On the negative side, retail trade in goods & services (including daily labor) will collapse in the first few weeks. To the extent the rural areas usage of cash is higher relative to cheques & cards, economic activity will be affected more than in urban areas. The speed/slowness of retail recovery is directly related to the speed/slowness with which the transaction demand for currency by users of retail services is met, in each geography (city, district, block, Panchayat). RBI must ensure supply of new lower denomination notes upto & including Rs.500 one, in every geography: In the absence of Rs. 500 and Rs. 1000 notes, the need/demand for Rs 100 notes increases manifold and must be met. New Rs. 500/- notes need to be introduced quickly as Rs. 2000 notes are not even a pale substitute for the de-monetised 500 & 1000 notes for the purpose of transactions/trade.
    Wholesale trade & manufactures are less effected by currency shortage as they can increase use of cheques (Demand deposits) more rapidly. Banks must facilitate their deposit of cash in bank accounts to expedite it, for instance by having separate lines for depositors having accounts in their bank branch.

    The reduction of corruption in the central govt had already put pressure on the real estate sectors of metro cities like Delhi.  The slow recovery that was underway is likely to be delayed further unless pro-active action is taken to facilitate white transactions in construction & real estate. RBI should bring forward interest rate reduction. Ensure credit for housing & real estate sectors to facilitate its move from being a black sector to a grey/white one.

   Tax compliance & collection will increase dramatically in the current year, because undeclared cash is being deposited in bank accounts and these will have to be declared as income in current year. This is relatively independent of how GDP growth is affected, because the initial reduction in economic activity is largely in the cash economy in which income deceleration was low and tax evasion high. The higher declarations post November 8 provide a great opportunity for tax reduction, so that better voluntary tax compliance is incentivized and sustained in future years. Union & State Govts. should plan to use part of increased revenue to increase construction oriented infrastructure spending to offset lower real estate activity due to elimination of black money.

Monetary Policy Transition

     Many theorists have misunderstood the effect of forced conversion of cash into demand deposits. This conversion leaves money supply, initially unchanged. By forcing an involuntary shift in the currency/demand deposit ratio it dramatically lowers the velocity of money and thus has a deflationary impact, till such time public has the amount of currency that it wants to hold for transaction purposes. Though banks fund position will improve immediately, expansion of money supply, through fractional reserve system is dependent on new loans being given. This will take more than usual time, because of increased uncertainty. Much of this increase in deposits is likely to be reversed as new currency becomes readily available. After all these adjustments the new monetary equilibrium is likely to be one with higher liquidity & lower interest rates.

  This analysis doesn't apply to cash that is not surrendered and becomes immobilized.  In the last demonetization this was estimated at 1/5th to 1/4th of affected currency. Applying this ratio analysts have estimated the immobilized amount could be between 3 and Rs 3.5 lakh crore. The precise amount will become clear only when the transition period for legally converting money ends(December 2016 or March 2017). At that point (other things unchanged) money supply will be reduced by the actual immobilized amount. The impact of this reduction will, however, be concentrated in the black economy, particularly real estate, jewelry and hawala currency, for the reasons given earlier. If the purpose of the whole exercise was to reduce black money Govt has no incentive to offset this reduction and RBI will not offset it. However it provides an excellent opportunity to the MPC to bring forward repo rate reductions and/or for RBI to increase liquidity/credit flow to real estate sector to encourage white transactions.

Conclusion

   Overall the money supply will pivot from black to white economy and the ratio of white to black economy will rise, with corresponding changes in their ratios to GDP. It's harder to determine what will happen to measured GDP as the % of the two types of flows in it is not known. My guess is a fraction of a % point reduction in growth rate in 2016-17 from that projected by me in March 2016. However if the authorities are unable to supply the transaction demand for currency within a month of the demonetization, the negative effects will begin to mount and spread in the under-supplied areas, and could become serious after two months.

Post-Script (8/12/16)

   The 100% incremental CRR imposed on banks negated any possibility of monetary expansion to offset the currency reduction. Thus it has resulted in a severe tightening of the monetary stance during the month following de-monitization. Data available to date suggests that the GDP growth rate for 2016-17 may lower by 0.2% to 0.5% than the forecasts made earlier (http://dravirmani.blogspot.in/2016/04/growth-inflation-and-monetary-policy.html). In march 2016 I had estimated that the growth rate for 2016-17 would be 0.2% to 0.5% above the growth rate for 2015-16. This potential acceleration has been negated. Further, the GDP deflator has transformed from a deflationary mode in 2015-16 to an inflationary mode in 2016-17. The consequential over-estimatation of real GDP that arises in CSO from using the UN system of accounts, will likely be converted into an underestimation this year. Thus GDP growth in 2016-17 as measured by CSO is likely to be 7.3% +/- 0.1%. 
   My forecast of CPI inflation (4% to 5% with 70% probability), however remains on target with actual inflation in March at the lower end of this range.

Indo-Pakistan Relations a la Nawaz Sharif

Introduction

     In an earlier note in this journal I had outlined how Pakistan policy towards use of Jehad against India is likely to evolve with the departure of US/NATO troops from Afghanistan in 2014 (http://dravirmani.blogspot.in/2013/02/pakistan-army-action-possible-motivation.html).  The recent fairly successful election in Pakistan has given rise to intense speculation of the changed prospects of better relations between the two countries.  Aggressive questions by Indian Media have forced Nawaz Sharif to express positive sentiments about peace with India and to invite the Indian PM for events normally not attended by foreign dignitaries.  This has already given rise to a counter statement by Syed Salahuddin, head of Hizbul Mujahideen(HM) and member of the Jehad Council warning him not to dilute Pakistan's anti-India policy. What is the likely policy orientation of a Nawaz Sharif led Civilian Pakistan Government and how if at all is it likely be to be different from policy under the previous Civilian Government?

Nawaz's Support Base

  Nawaz Sharif owes his clear victory in the election at least in part to, (a) The branding of PPP & ANP as "secular parties" by the Tehrik-e-Taliban Pakistan (TTP) and its deceleration of war on them during the elections (assassinations/bombing of their candidates, workers and supporteres). (b) Close relations with and support of the Jehadi parties in Punjab like the Jamat U Dawa(JuD) / Lakshar-e-Toiba(LeT) and the Jaish-e-Mohammad(JM).  Add to this the votes and seats won by Imran Khan's Pakistan Tehreek-e-Insaf (PTI) and the Jamat e Islami (JI), the religious fundamentalist base is large.  Like any good politician he is unlikely to openly challenge the objectives of these parties (e.g. Salafi/Wahabi Islamization of Kashmir), which he perhaps shares.  He may however, try to convince them to change their strategy and tactics in the interest of Pakistan's global image and failing economy. 

The other part of his support base, the lower middle class youth looking for jobs and earning opportunities and businessmen looking for profits, could in contrast provide him with an equally strong base for normalizing economic relations and exploring new avenues for mutual economic benefit.  To the extent that terrorist bombings and assassinations in Pakistan are a threat to foreign, non-resident Pakistani and even domestic investment (capital flight), the base could support strong measures to restore law and order in Pakistan.

Pakistan Army Objective

  As I wrote earlier, "As far as the Pakistan Army is concerned the most important event that will shape its behavior in the next two years is the accelerated withdrawal of the US from Afghanistan. This withdrawal provides it a golden opportunity to restore its hegemony in Afghanistan.  Ideally the Army would like to reestablish the dominant position it had before the Taliban was driven out of Afghanistan and established its headquarters and operating bases in Pakistan (Queta Shura, Wazirstan et al).  Failing this it would be happy with a regime that sub-serves the Pakistan Army’s interests.  This is likely to be the central and most vital objective of the Pakistan Army and its primary operational instrument the ISI, during the next two-three years."

I concluded that, " The hostile Pakistani army action across the LOC is a signal to the Pakistani jihadists that the Pakistan army and Government are not abandoning their anti-India policy, in their respective quests:  The Army for a dominant role in Afghanistan, financed and underwritten to the maximum extent possible by the USA and the Civilian Government for normalization of relations with India so as to remove the stigma of being dubbed “terrorist central” and to reduce the control of thee Army over the political system and government."

Democratically Elected PM

     Nawaz Sharif's assumption of the reins of government with a democratic mandate reinforces these conclusions and fleshes them out more clearly.  Nawaz Sharif in full co-operation of the Army is likely to promote a shift of Jehad related activities (promoting, training, organising, managing jehad), out of Pakistan and into Afghanistan and the badlands of the Af-Pak borders to increase deniablity.  As he said,  he will "not allow Bombay type attacks from the soil of Pakistan."  He may also try to moderate the Jehadi's anti-India & anti-US rhetoric and to keep it out of media that can be accessed easily by foreigners and foreign (including Indian) media. On the other hand he may give a freer hand to diplomats and Jehadi's on speaking about Kashmir related issues, while simultaneously stepping up the decibal level on the need for Indo-Pak peace.

Economic Relations

    If Nawaz Sharif and his party choose, they can bring about complete normalization of economic-business relations(including investment), trade and transit (to Afghanistan & Central Asia) policy and infrastructure connectivity between Pakistan (+PoK/AK) and India (including J&K). As these are mutually beneficial relations, on our side the need is to meet each other half way (there is no need for special concessions by either party).  many of these ideas were discussed at a Seminar that I attended at the Wilson Center in Washington with eminent Pakistani economists & retired bureaucrats in late 2012. If Pakistan chooses it could become the trading and transport hub for connecting thriving economies of  Central Asia, India, Afghanistan (mineral resource potential) and Iran/Gulf countries. The TAPI pipeline project could be brought more firmly on the agenda.  Permanent Normal Trading Status (MFN) is economically minor but politically important foundation on which this mutually beneficial relationship can be built. As noted by many observers, the two Punjabs could play a very important role in creating the positive narrative to smooth the political path.

     In this, I differ somewhat with Mr Shyam Saran (BS 15/5/13) who favors an incremental approach. I would favor an approach that asks the new government how quickly and how far they are willing to go on all economically related issues and be willing to move as fast as they are able to do.  I must warn that moving fast does not mean making asymmetric concessions: If the new democratically elected government of Pakistan cannot convince its on electorate of the benefits to Pakistan of economic normalization, then no amount of concessions can help in convincing the masses: They would merely be seen as attempts to bribe special interests to adopt anti-national policies.  Both bilateral and SAARC processes need to be activated to provide a greater flexibility.

        On our side, we need to isolate such non-concessional, mutually beneficial relations from becoming hostage to jehadist bombings in India.  Empty gesture that do not harm the Pakistan Military, its terrorist instrument the ISI, and the Jehadists managed by them, have no effect on their behavior.  We really have to be more innovative and bolder in disrupting the Jehad supply chain and taking the fight to them.

Conclusion

     In my view there is likely to be little or no substantive change in policy towards cross border Jehad, though it may be better nuanced and supported by a more credible civilian government narrative, which will again fool many analysts in the West (you can fool some of the people all of the time).  However, the new government has the support base and democratic mandate to take significant steps towards normalization of economic relations with India.  We should be prepared to meet them half way to wherever and however quickly they want to move on this area.

Fixing India’s Current Account Deficit

Joint Note with Prof. Charan Singh 

Dual Deficit Problem 

  The country is in the midst of twin deficits of gross fiscal deficit (GFD) and current account deficit (CAD). The GFD, though high, has been on a declining trend, while the CAD continues its uptrend and is expected to record a new high in the current year after 4.2% of GDP in 2011-12. According to the latest data released by RBI on March 28, the CAD for April-December 2012 was 5.4% of GDP (and 6.7% in Q3). Earlier, the highest recorded CAD of 3% in 1990-91 was followed by a major BoP crisis soon after. This is a worrisome situation

Sustainable Level?

     On the CAD, at the outset, it needs to be mentioned that the sustainable level varies over time. According to the High Level Committee on Balance of Payments (1993), CAD should be 1.6% of GDP which could be met through sustainable level of net capital receipts. According to the Committee on Capital account Convertibility (1997), growing degree of integration of the Indian economy with the global economy would imply variability in the size of the CAD and recommended a CAD of 2% of GDP, while the Committee on Fuller Capital Account Convertibility (2006) recommended a CAD of 3% of GDP. The parameters considered by the latter Committee and some more generally do not show a steady performance, especially rise in debt reflecting a weaker international investment position (table 1). This should be a matter of concern. 

Table 1: Select Indicators of External

Year	Total External Debt to GDP	Short term Debt to Total Debt	CAD/GDP	CR/CP	DSR	CR/GDP	Import cover of Reserves (months)
1995-96	27.0	5.4	-1.6	88.8	26.2	14.0	6.0
2005-06	16.8	14.0	-1.2	94.8	10.1	24.0	11.6
2011-12	20.0	22.6	-4.2	87.0	6.0	28.6	7.1
2012-13 End-Sep	20.7	23.1*	-5.4	na	5.8*	na	7.2

CR - Current Receipts; CP - Current Payments; DSR – Debt Service Ratio.

Source: RBI and GoI.

     The experience of other countries also shows that India’s CAD is not the only outlier in the global economy (table 2). An IMF study published in February 2013 mentions that a CAD of 4% for India in 2012 corresponds to a cyclically-adjusted 2.7% of GDP. However, as argued by Freund and Warnock (NBER WP 11823), high CAD is a cause of concern and should be addressed. 

Table 2: Current Account Balance as percent of GDP

Country	1996	2006	2012 Estimates	2013 Estimates
Australia	-3.36	-5.33	-4.08	-5.50
Chile	-3.98	4.60	-3.20	-3.00
Indonesia	-3.21	2.98	-2.11	-2.38
New Zealand	-5.86	-8.28	-5.37	-5.87
South Africa	-1.15	-5.31	-5.47	-5.85
Turkey	-1.00	-6.09	-7.54	-7.13
United Kingdom	-0.56	-2.93	-3.31	-2.71
United States	-1.59	-5.99	-3.11	-3.08

                   Source: IMF.

Trade and Exchange Rate

      The finance minister has argued that the CAD continues to be high mainly because of high oil, coal and gold imports, and slowdown in exports. The scheme to raise the limit of duty free import of gold jewellery is expected to raise the supply of gold and can also be expected to reduce the demand pressure reflected in rising imports and ballooning the CAD. It may be recollected that, in November 2009, RBI had purchased 200 metric tonnes of gold from the IMF. Since then, taking the cue, probably to hedge against numerous risks, gold imports have increased significantly from $21 billion in 2008-09 to $29 billion in 2009-10, and further to $56 billion in 2011-12

     The government could consider some more bold measures similar to those initiated in the latter period of the last year, including the politically-sensitive issue of oil subsidy. Similarly, the direct measure to correct the CAD would be to allow the exchange rate to be determined by medium term market forces that drive the CAD.

       It has been argued by many learned pundits that given the differences in inflation between the US and India, amongst many other variables, the current level of exchange rate would need a correction. As economic theory suggests that market-determined exchange rate, in this case implying a depreciation of the rupee, would boost exports and restrict imports. As commodity imports, consisting of essential commodities like fuel and fertilisers, which were highly subsidised, are relatively inelastic in the short run, the demand for these responds relatively slowly to exchange rates. But now, given that the subsidy on petroleum, oil and lubricants (POL) is being phased out, higher oil prices would lead to rationalisation of consumption by the public, private and household sector. The demand by households for other major imports like gold and silver, and electronic goods can be expected to be moderated by exchange rate adjustment. On the export front, manufactures and mineral fuels can be expected to respond to exchange rates.

      A number of econometric studies have shown that exports respond to exchange rates and external demand. Illustratively, exports responded to depreciation in exchange rates in 2008-09 and 2011-12. Though global demand was muted in some of the traditional export markets of India in 2012-13 because of the global slowdown, it is expected to improve in the next year. However, India needs to explore how it can make a dent in China’s labour-intensive exports, given that wage rates are finally being allowed to rise in China. Exchange rates driven by short-term capital flow movements also distort prices and preferences in the economy, though the impact is difficult to quantify. Therefore, a bold decision to let the exchange rate be determined by medium-term market forces will help lower the CAD

A version of this article appeared as an Op Ed in the Financial Express of March 29, 2013, under the banner,"Fixing India's current account."