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Would you trust a banking system that can be closed down on a prime minister’s whim?

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The idea that demonetisation would leave banks flush with household savings that they could lend to productive parts of the economy has been debunked.

The Indian central bank’s final tally of Prime Minister Narendra Modi’s 2016 demonetization drive, intended to take money derived from tax evasion out of circulation, showed that 99.3 percent of outlawed high-value banknotes had been returned. That’s a severe loss of face for officials, who had argued that holders of the cash would rather destroy it than return it to banks, providing a windfall for the government.

The authorities managed to produce several other defenses of the initiative, however. One in particular was appealing to financial markets: The notion that, in Finance Minister Arun Jaitley’s words, “Demonetization appears to have led to an acceleration in the financialization of savings.” Households that traditionally kept their savings in cash would now prefer to put the money into other instruments, perhaps even the stock market. This would increase the amount of capital available for companies to deploy and banks to lend, spurring economic growth.


Also read: Make no mistake: Demonetisation has been as much a political failure as an economic one


There certainly were some indicators to support the idea. For one, Life Insurance Corp. of India saw a 142 percent increase in premium collection in the month demonetization was carried out. And Indian stocks have been on a record-breaking run, even though foreign investors were net sellers so far this year.

Unfortunately, the Reserve Bank of India punched a hole in that hypothesis, too. Its annual report, as well as tallying the result of demonetization, provided a breakdown of savings by households, a category that includes small and unregistered enterprises. It turns out that net financial savings for the fiscal year that ended March 31 were 7.1 percent of overall disposable income — less than the average for the five years prior to demonetization.

Worse yet, perhaps, households are keeping far more of their net savings in cash, not less. And their net savings going to banks are almost 50 percent lower than the five-year average before demonetization. In other words, the idea that the crackdown would leave banks flush with household savings that they could lend to productive parts of the economy has been comprehensively debunked.


Also read: Each of Modi govt’s decisions after demonetisation hark back to India’s socialist past


What’s going on? Some have argued that lower interest rates are the problem. That’s not an easy sell: Over the past year, India was one of the few countries with strongly positive real rates — and savings in bank deposits were a higher fraction of disposable income back in 2012-14, when Indians were dealing with negative real interest rates.

Perhaps, instead, a change in behavior is responsible. For most Indians, the defining experience of demonetization was losing access to their bank accounts: We had to stand in long lines at ATMs, and our withdrawals were strictly rationed. In contrast, those who had piles of old banknotes appeared to be able to change them (at a black-market-determined discount) with ease.

What would you learn from this? Would you trust a banking system that can be closed down on a prime minister’s whim? For many Indians, demonetization provided their first experience of banks or digital payments. I just hope the insanity of the process didn’t put them off formal finance forever.

Still, you might say, at least the markets are doing well. That reflects households’ greater willingness to put their savings in stocks, right? And yes, the RBI data do indeed suggest that.


Also read: Demonetisation and its impact on tax collection and formalisation of the economy: Arun Jaitley


But look a little closer and things aren’t so bright. One of the reasons domestic institutional investors — who pumped $10 billion into Indian markets so far this year, while foreigners took $280 billion out — are bullish is because they believe a structural change is under way in how Indians save. They think we’re moving permanently away from cash (and gold, and real estate). A turn toward financialization means ever-higher equity prices.

The central bank data, however, suggest we shouldn’t be so sure about that. The heights being scaled by Indian markets might prove brittle.

Whatever the impact on savings behavior of demonetization, it’s clear the initiative was a policy failure, even on the administration’s own terms. I’d like to think a lesson was learned.

Not so fast: The government just appointed one of the brains behind the 2016 project to the board of the central bank. India’s era of ill-advised intervention may not be over. – Bloomberg

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6 COMMENTS

  1. Agree with the author. Demonetization was an unwarranted gamble, that didn’t pay off. However, that is history. The impact has dissipated. The NDA has also brought in major reforms like GST, IBC and RERA. Same was also true for Vajpayee era. How many reforms were introduced by the UPA in its 10 years long tenure? Yes, GDP growth rate was higher. But it was accompanied by very high inflation rate. UPA-II had average retail inflation of more than 10%. The growth was achieved by allowing excessive credit growth, which now has resulted in a mountain of NPAs. 7% GDP growth with moderate inflation is a far better scenario.

  2. During UPA’s ten year st power from 2004 to 2014 the man incharge, MMS,is a highly educated internationally renowned economist who could understand repercussions of taking such decisions as demonetisation and therefore refrained from doing so. In his place we elected NM who’s only claim to understanding economy was his gift of rhetoric/gab and nothing beyond that. With the result our country has had to contend with flight of foreign capital, job loss etc etc.
    To counter a repeat of this type of situation we should have some minimum educational qualifications for our law makers……

    • Sir, I agree with your argument completely. In addition, we should try finding out if the person has megalomaniac tendencies. There is an old saying – chuhe to mili haldi, woh khud ko pansari samajh baitha. We need to guard ourselves against leaders who only think of power and are desperate to stay in power by hook or by crook. our present leadership seems to be reflecting a limited understanding of what it is be managing a government in a democracy.

  3. One understands the need for secrecy in a decision of this nature. The circle of people privy to the move had necessarily to be small. Perhaps the CCEA, a dozen Secretary level officers, the Governor of the RBI, the CEA, even the head of SBI, since the entire banking system would be dealing with the process. Between them, assuming they could not have urged the decision itself not to be taken, they would have planned for the entire exercise to be implemented much better, avoiding the chaos and hardship that resulted. It is a tribute to the patience, fortitude, tolerance of the brave Indian people that they lived through this decision and its continuing aftermath.

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