Published On: Thu, Jan 19th, 2017

The Real Goal Behind India’s Economic Reforms

The prime minister’s decision to demonetize India’s currency is as much about centralizing power as economic reform.

Summary

India’s recent demonetization drive reflects both the government’s vision to transform the Indian economy and the inherent weaknesses that prevent it from successfully doing so. India is composed of many states with regional identities and interests that undermine the national government’s ability to govern. Indian Prime Minister Narendra Modi executed the controversial demonetization measure with the aim of gaining more power in the central government. However, the government must overcome differences among the states in order to consolidate power, thereby making economic reforms possible.

  • The Indian government demonetized 500-rupee ($7.35) and 1,000-rupee notes knowing that it would harm the economy in the short term.
  • Modi placed the demonetization within an anti-corruption framework to weaken political opponents and other stakeholders who challenge the government.
  • Previous demonetization efforts in India have failed. While the most recent effort is bolder than those in the past, there is no reason to believe it will be more successful at single-handedly reducing black market activity.
  • India’s multinational nature places inherent constraints on the central government, making it weak. Overcoming these constraints is a prerequisite for the success of economic reforms.

People waiting to exchange demonitised Indian currency, show their old 500 and 1000 Rupee notes near the closed gates of Reserve Bank of India in Bangalore on January 2, 2017 after acceptence of the banned notes at banks and RBI ended two days ago. / AFP / Manjunath KIRAN (Photo credit should read MANJUNATH KIRAN/AFP/Getty Images)

Introduction

The intent of Indian Prime Minister Narendra Modi’s aggressive economic reforms and their success or failure is the focal point of our 2017 forecast for South Asia. Since 2014, Modi has pursued policies to boost foreign direct investment in the world’s seventh largest economy. Modi envisions an Indian nation-state with a coherent economic strategy. However, Geopolitical Futures does not expect Modi to achieve his ambitious objectives due to the underlying nature of India as a coalition of many states with divergent interests, policies and laws. The recent and unexpected demonetization of 500- and 1,000-rupee notes provides a concrete example of how Modi’s objective to create a coherent national economy fails to align with a central government that is weak due to India’s multinational nature.

The Nov. 8 decision to remove 86 percent of the economy’s cash supply was an ambitious move, both in scope and reach. It was clear in advance that demonetization of this size would cause immediate negative impacts on the Indian economy. Cash flow in the Indian economy is the equivalent of 12 to 14 percent of India’s GDP. (In comparable countries, cash flow is closer to 5 percent.) Furthermore, much of the Indian labor force depends on cash payments. Eighty percent of the country’s workforce operates in the informal sector, where cash transactions are the main form of employee payments. An additional 12 percent of the workforce is considered casual or contracted, meaning workers are paid by various means but not integrated into the country’s social security system. Only 8 percent of the workforce is fully integrated into government systems, another sign of a weak central government. The nature of India’s economy means that cash is king, lack of participation in the registered economy is high, government collection of taxes is difficult, and removing such a significant amount of cash from circulation brings the economy to a temporary halt.

Modi’s Motivation

Both the Indian government and private financial institutions recognize that demonetization will have a negative impact on economic activity in the short term. In the wake of demonetization, the government lowered its growth forecast for this year from 7.8 to 7.1 percent. Former Prime Minister Manmohan Singh warned that the measure would cause up to a 2 percent loss in GDP growth for the year. Private estimates from both HSBC and Indian investment rating agency ICRA put 2017 growth at 6.2 and 6.8 percent, respectively. Economists estimate that it will take two to three quarters from when the measure was enacted for the economy to adjust to the change in cash flow and introduce new bills into circulation. According to the Reserve Bank of India, Modi’s demonetization removed 16.42 trillion rupees, or 1.64 million crore rupees (crore rupees indicates 10 million rupees), from circulation, and banks reported receiving about 1.5 million crore rupees by the Dec. 30 deadline. It is expected that the chaos will remain and a new status quo will not be established until March at the earliest, and possibly as late as June.

And yet Modi still demonetized the currency notes. On the surface, the justification for such a measure was to fight black market activity, terrorism financing and tax evasion. However, the government also had to have known that the move would have only a marginal direct impact on targeted activities. The element of surprise delivered a hit only to black market activity in the short window of time between getting cash and converting that cash into other assets. Furthermore, only 5 to 6 percent of illicit wealth actually takes the form of cash as most illicit businesspeople quickly convert their cash into physical assets like real estate, gold, jewelry and so on. Counterfeiting will be temporarily sidelined, but that will only remain true until counterfeiters discover a method for counterfeiting the new currency notes.

Examining the demonetization as a singular event makes it difficult to understand why Modi took such an action. The action is counter to his desire for economic growth, and it is also unable to solve the problem of corruption in one fell swoop. But it does make sense when viewed in the context of Modi’s larger ambitions and when structural government constraints are taken into account.

A strong central government is needed for India to fulfill Modi’s vision of a coherent economic strategy. His demonetization tactic was a calculated risk aimed at helping him gain more control over the central government. At the same time, it illustrates that the central government still lacks enough power to be considered strong. The measure is supposed to help clear a path for debilitating government opponents while improving the political presence of Modi’s party in government, without alienating the general public.

Demonetization is just the first step in concentrating power in Delhi and moving toward a stronger central government. Placing it within an anti-corruption framework gives Modi the leeway to debilitate competing stakeholders in India’s power system, such as the wealthy. For instance, attacking the real estate sector, which is an asset class frequently used to hold undocumented wealth, will be the next target for aggressive reform. Groundwork for addressing the real estate sector was laid when the Benami Transactions (Prohibition) Amendment Act of 2016 took effect on Nov. 1. The measure addresses the common practice of property being held in one name but being provided or paid for by another person. The amendment puts restrictions on property recovery by the real owner, and such properties are now liable for government confiscation. As a follow-up measure, the government is planning to more closely inspect suspicious real estate titles with the ultimate goal of updating real estate records and land registries. Anonymous tax officials have told Indian media that they expect to spend a lot of time this year using tax records, bank data and other information to clean up real estate titles. This will allow the government to discover those who hold property under false names to avoid formal declaration of income with the aim of generating a large influx of tax dollars.

On a more tactical level, demonetization also played into the hands of Modi’s Hindu nationalist Bharatiya Janata Party (BJP). Next month, the states of Punjab, Goa, Uttarakhand, Uttar Pradesh and Manipur will hold legislative elections, and BJP victories in these states are not a given. In 2015, the BJP unexpectedly lost elections in Bihar and Delhi. In 2016, the BJP had its first victory in Assam and won its first assembly seat in Kerala. These wins were interpreted as informal mandates for the national government, and February election results are also expected to measure the government’s popularity. Modi’s BJP currently holds power in Punjab and Goa, but the opposition United Progressive Alliance and Samajwadi Party hold political power in the remaining three states. Cash is the primary means of political funding in India, which can include directly bribing voters. Demonetization has severely hampered opposition party campaign efforts in these states. It has also created an opportunity for Modi to improve his public image by reminding voters of the corruption in political parties and highlighting his efforts to combat it.

A Historical Perspective

Looking at India’s two prior demonetizations – in 1946 and 1978 – can also help us better understand Modi’s ambition by offering a point of contrast. The first demonetization occurred on Jan. 12, 1946 when India was still under British colonial rule. In an effort to decrease black market activity and address a post-war economic slump, the government decided to remove 500-, 1,000- and 10,000-rupee notes from circulation. People were given 10 days to exchange their notes, followed by a 17-day grace period. The measure was not seen as successful. It removed a total of 143.97 crore rupees of the high-denomination notes, of which 134.9 crore rupees were exchanged. In other words, this measure turned out to be more of a conversion rather than a demonetization. Furthermore, black market activity remained, and the demonetized notes were reintroduced in 1954.

In 1978, the government publicly announced the demonetization of 1,000-, 5000- and 10,000-rupee notes and gave people three days to exchange currency. Again, the government was motivated to take such action as a means of controlling illegal transactions. In this instance, the government removed from circulation about 73.1 crore rupees’ worth of high denomination notes from a total of 9,170 crore rupees. By the end of the following year, the introduction of smaller denominated bills resulted in over 1,700 crore rupees being added to the cash flow. In other words, more currency was circulating in the economy after the demonetization than prior. Not only did no demonetization occur in real terms, but black market activity persisted once again.

In both cases, the impact of demonetization was minimal. There were reports of long bank queues in 1978, but on the whole it was not disruptive. It’s also telling that relatively little information is available about these two prior incidents. The fact that no detailed studies of these demonetizations have been prominently featured in principal works about India’s economic history further speaks to the insignificance of India’s previous demonetization efforts. For additional perspective, consider that Modi’s demonetization is of a much larger scale, having removed 1.64 million crore rupees from circulation, with banks reportedly receiving about 1.5 million crore rupees by the Dec. 30 deadline.

India’s Multi-State Nature

When compared to past efforts, it becomes clear that Modi’s demonetization is a serious power play. Modi’s vision is to push free market reforms in India, increasing the ease of doing business. Modi hopes to attract investors and foreign companies, and he wants a free economy. However, to achieve this goal, his current policies (including demonetization) need to create a strong central government that is capable of carrying out such reforms. His campaign promises to revitalize economic growth, fight corruption and rationalize taxes were meant for Indian voters as well for the international business community. Since taking office in 2014, Modi has adopted measures to improve business and economic conditions in India. In doing so, he is also reshaping the country’s image. While one can argue that corruption can never truly be eliminated, it is important to meet basic anti-corruption standards as they facilitate the flow of international business. This marks the intersection between Modi’s vision, the government’s anti-corruption campaign and demonetization.

However, Modi’s current ambitions do little to address the problematic multinational nature that exists within India’s borders wherein the states have different internal demands and approaches regarding foreign business. Under this structure, India cannot be thought of as one coherent economic entity, nor can it be expected to behave like a textbook nation-state.

In terms of economic development, there exists a great disparity among different states. The map above divides India into its constituent states and shows the variation in GDP per capita between states. GDP per capita is particularly low in the highly populous states of Uttar Pradesh (with a population of about 200 million people), Bihar (approximately 100 million people) and Jharkhand (30 million people). Further to the west, the large states of Rajasthan and Madhya Pradesh are essentially extensions of Delhi, Maharashtra and Gujarat. These states include some of the richest areas of India. More importantly, many of India’s states have different rules and regulations for the operation of foreign businesses. On a practical level, this means that while India seems to be an obvious candidate to replicate the Japanese or Chinese growth models, this isn’t possible due to its diverse nature and the central government’s historic inability to impose consistent standards and policies across the country.

The government faces similar challenges in terms of political and administrative organizations. At least 48 different political parties are registered in the country, with some focusing on regional power rather than a national presence or affiliation. This is reinforced by laws that give power to local governments and complicates attempts to centralize power. The three-tiered taxation system illustrates this difficulty. The current system is not only convoluted but inefficient in terms of collection and enforcement. For example, state regulations do not always comply with national regulations, making it difficult for the national government to enforce its rules and collect taxes. Only about 1 percent of the population pays income taxes, and this primarily consists of employees at large corporations. One of the benefits of demonetization is that it gives the government the opportunity to funnel additional tax revenue into federal coffers while also increasing the number of individuals entered into government registries. (This occurs because proof of income is required to exchange demonetized notes with a cumulative value in excess of a certain amount, and those unable to prove legal earnings must pay a heavy fine.) That the government resorted to demonetization to perform what should be a routine government operation is another sign of the central government’s weakness.

Conclusion

The tremendous variation within India results in diverse, competing interests. This may be stating the obvious (it is no revelation that over a billion people do not see eye-to-eye on everything), but nevertheless, it is worth underscoring. Developed cities like Mumbai coexist in the same country where a quarter of the population does not have access to electricity. Approximately half the country’s workforce is dedicated to agriculture activity despite the activity only contributing 17 percent to GDP, according to the latest World Bank figures. The needs of rural farmers are not the same as those in the services industry, which accounts for 53 percent of GDP while only accounting for just under a third of the workforce.

The states’ diverging interests make it difficult for any national policy to meaningfully address their individual needs. The result is a massive divide in addition to a general lack of cooperation with the central government because states act in the best interest of their local populations. Because of this dissent, Modi’s attempts to turn the Indian economy into that of a coherent nation-state will be ineffective. Modi’s pursuit of a coherent free market national economy requires a strong central government, which he does not have. In an effort to gain power, he has chosen a strategy that involves increasing the state’s role in the economy and, at times, clear intervention. History has shown that state-planned or centrally planned economies succeed only under strong central governmental authority. China and the former Soviet Union are cases in point that illustrate how strong a central government must be for drastic reforms to succeed in a state-planned setting. Given India’s size, its many internally competing interests and a relatively weak central government, it will be hard to get local governments to carry out and enforce new measures. This is the stage at which Modi finds himself today. The type of state structure necessary for Modi to carry out his reforms does not exist. His real challenge is not instituting a new economic policy but increasing the central government’s authority. He’s massively constrained by the states’ varying rules and policies and thus faces an uphill battle. From this, we derive our forecast: Modi will not succeed in achieving his objectives to strengthen the Indian economy, and the negative fallout will manifest in lower GDP growth and increased political infighting in 2017.

 

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