Modi's demonetization: chaos is a feature, not a bug

Prime Minister Narendra Modi's aggressive demonetization of the 500 and 1000 rupee note is causing plenty of chaos in India. A general shortage of money has emerged, massive lineups have formed at banks, and cash-based business has come to a standstill. All this would seem to indicate that the process has been ineptly carried out. But I'd argue that the problems listed above are exactly what one should expect of a well-designed aggressive demonetization. Chaos is a feature, not a bug.

As I mentioned in my previous post, a regular demonetization isn't meant to harm anyone. To ensure that no one is left behind, legacy note are gradually replaced with new ones, a process that often takes decades to carry out. See for instance the below pamphlet published by the Bangko Sentral ng Pilipinas (BSP), the Philippines central bank. It shows a slow and staged approach to replacing old peso notes with new ones. The goal of an aggressive demonetization like Modi's is exactly opposite: to leave people behind. To get this effect, the demonetization has to begin suddenly and end quickly.

Why didn't Modi make more preparations for the retirement of the Rs 500 and 1000 note? For instance, to reduce lineups at banks and ATMs the Reserve Bank of India could have begun supplying banks with extra 100 rupee notes several weeks ago in order to ensure that there was sufficient supply come November 8. And maybe the RBI could have nudged banks to purchase more safety deposit boxes to hold cash and hire extra staff to handle the rush.

Or take ATMs. One reason for lineups is that with the demise of the 500 and 1000 note, ATMs are running at a fraction of their capacity.  Indian ATMs have four "cassettes", each holding around 2000 notes. Two cassettes are typically configured for the old 500 rupee note, one for the legacy 1000, and one for the still-existing 100. They typically do not dispense 50s. Thus the maximum an Indian ATM can provide in a post-demonetized India is one cassette worth of 100s, or 200,000 rupees (US$3,000). If everyone in the lineup removes 2000 rupees, the daily limit, that means just 100 people can be served. That's peanuts.

To get ATMs up to full capacity, all four cassettes need to be dispensing some combination of new 500 notes, 2000 notes, and/or existing 50 and 100 notes. The problem is that each ATM cassette need to be re-calibrated to hold a certain denomination since notes are not uniformly shaped. With every single ATM in the country needing to be modified, and only so much staff trained to do so, it's taking a lot of time.

So why didn't the government begin working with ATM companies a few months ago to make all the modifications in time for November 8? This would have surely reduced the awful indignities that regular Indians must undergo as they wait for hours to withdraw cash.

Unfortunately, any attempt to modify ATMs ahead of time would have caused Modi's aggressive demonetization to fail. In order to inflict maximum damage on those who depend on "black money" (i.e. income obtained illegally or not declared for tax purposes),  an aggressive demonetization needs to be executed suddenly. If rumour gets out that a demonetization is about to occur, the element of surprise will be lost. Those working in the underground economy will simply switch their high value banknotes into low ones ahead of the demonetization, thereby avoiding being damaged. And of course it is the rich, not the poor, who have the best networks for gleaning information. To reduce the potential for information leaks, the number of people 'in the know' needs to be kept to a minimum, and this means that all large-scale preparation—including a huge reconfiguration of the ATM network—must be avoided.

So if you support the idea of a demonetization—specifically one that is designed to hurt the underground economy and, in so doing, draw people into the taxed economy--then you should just accept that this was always going to be a messy affair. If it had been a smooth one, then that would have been a sign that it wasn't being effective.
Once the dust is settled, India will be made better off by the demonetization. While many Indians in the underground sector will grudgingly comply and deposit their funds in an account only to withdraw that same amount in new notes later, others will keep their funds in the banking system. To change, people sometimes need to be prodded. This should be a shift in the right direction given that a banked economy is stronger than an unbanked one.

My back of the envelope calculation tells me that the demonetization will generate real pain on the underground economy. Consider that there are Rs 12.2 trillion worth of 1000 and 500 notes in circulation, or US$181 billion (source). Assume that 40% of these notes, or Rs 4.9 trillion (US$72.7 billion) circulate in the dark economy and lack a paper trail. Further assume that thanks to Indian ingenuity, or jugaad, half of the black money will sneak through the demonetization. That still leaves the remaining Rs 2.4 trillion, or US$36 billion, stranded. That's a painful writeoff!

To build and effectively run a nation, a government needs to be able to efficiently collect taxes. Many will shrug off the immense losses caused by the demonetization and go back to using cash as a way to evade to avoid the tax man, especially now that the government has (somewhat puzzlingly) introduced a new 2000 rupee banknote. But a large enough contingent will migrate to the tax-paying economy for good. Once bitten, twice shy.

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