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No money, Mo' problems

25 November 2016 By Una Galani

Narendra Modi’s gamble will cost India the title of the world’s fastest-growing large economy, at least in the short term. That is the result of the prime minister’s shock move, announced on Nov. 8, to outlaw 500 and 1,000-rupee notes. That removes almost $250 billion of bills, 86 percent of the currency by value, from circulation. Breakingviews examines the far-reaching consequences.

Why has Modi outlawed 86 percent of India’s currency?

To tackle corruption and forgery. Modi sees undisclosed wealth as a barrier to eradicating poverty in a country where GDP per capita is barely one-fifth of China’s. It follows a recent tax amnesty and a tough new law that threatens jail for Indians who stash undisclosed wealth overseas.

How is he doing this?

Through the banking system. Holders of the 22 billion now-outlawed notes have until year-end to tender at bank branches; they get the full value back as a bank deposit. There are limits on cash withdrawals, with a growing list of exemptions for various groups like farmers, hospital patients, and wedding parties. The taxman may scrutinise any cash deposits above 250,000 rupees ($3,600).

How will this affect the economy? 

This is a big shock. Cash accounts for 90 percent of transactions in India. Three weeks into the experiment, queues outside bank branches are getting shorter but many ATMs remain empty. It is taking a long time to distribute new bills.

That is paralyzing activity, leaving trucks stranded and workers unpaid. Analysts at Ambit Capital reckon growth will slow to 0.5 percent in the six months to end of March 2017, bringing the full year down to 3.5 percent from a previous forecast of 6.8 percent. The pain will be acute for the informal economy, which accounts for as much as 40 percent GDP and most employment.

Sluggish growth and downward pressure on inflation will create room for further interest rate cuts. The price of real estate could fall dramatically too. It adds to the big uncertainties India faces ahead of the rollout of a “goods and services” tax in April.

The cash crunch could permanently hurt productivity. Businesses that were profitable partly because they dodged taxes will now become unviable, potentially putting millions of livelihoods at stake.

What does it mean for India’s banks?

It’s less positive than it first looks. Citizens deposited almost $75 billion at domestic lenders in the first nine days, equivalent to 5.5 percent of system-wide aggregate deposits last year. But no one knows how sticky these deposits will be.

For lenders, it will be tough to put that money to work productively. Credit growth remains weak and yields on benchmark government bonds have fallen about 60 basis points to 6.3 percent. Ashish Gupta of Credit Suisse warns banks may be wary of locking themselves into these rates. State Bank of India, the country’s largest lender, has slashed deposit rates to protect net-interest margins.

The cash crunch and slowdown may also lead to a spike in non-performing assets in a banking system already struggling with bad debt. Microfinance houses that lend to the poor are particularly vulnerable.

What are the potential benefits? 

The big hope is that India’s tiny tax base will expand. Barely 1 percent of the population pays tax. The move could also spur adoption of bank accounts and digital payments. Paytm, the Alibaba-backed mobile wallet, has seen a surge in app downloads and transactions.

New Delhi could also enjoy a big windfall if some shady cash hoarders do not tender currency. Suppose that applies to one-fifth of the notes in circulation: currency worth almost $50 billion, or 2 percent of GDP, could suddenly become worthless.

In theory, that reduces the liabilities of the central bank, which could pay the amount back to the government. There is fierce debate on this issue but the reality is that the RBI faces pressure each year to boost its payouts to New Delhi.

Modi could spend the funds on infrastructure or recapitalising ailing state banks. Or local media reports suggest he might distribute cash back directly into individual bank accounts. That would fit nicely with the wider narrative of effectively converting “black money” into white.

Will it work? 

Yes and no. Counterfeiters can copy the new notes and there are plenty of ways to circumvent the crackdown, such as backdating bills. Nor does the move address the stock of illicit wealth, most of which is stored in assets like property and gold.

The fear may have a more lasting impact, especially if Modi follows with further radical moves. These might include a limit on personal holdings of gold or a crackdown on participatory notes, which are widely used to launder money and invest it back into the stock market.

Modi has demonstrated his commitment to reform but if the pain of the cash crunch is prolonged this will become a major political problem. Former Prime Minister Manmohan Singh accuses the government of “monumental mismanagement”.

A sustained backlash will make it hard for Modi to pass key reforms and will cost him in local elections. India’s biggest state, Uttar Pradesh, goes to the polls early next year. It will also hurt his chances of winning a second term in 2019. The next few weeks will be critical. There is a lot riding on this for Modi, and for all of India.

 

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