Devesh Kapur on demystifying India’s demonetization

Devesh Kapur is the Director of the Center for the Advanced Study at the University of Pennsylvania. He is Professor of Political Science at Penn, and holds the Madan Lal Sobti Chair for the Study of Contemporary India. Dr. Kapur has also served as the Associate Professor of Government at the University of Texas at Austin, and the Frederick Danziger Associate Professor of Government at Harvard. His research focuses on human capital, national and international public institutions, and the ways in which local-global linkages, especially international migration and international institutions, affect political and economic change in developing countries, especially India.

Devesh Kapur is the author of Diaspora, Democracy and Development: The Impact of International Migration from India on India, published by Princeton University Press in 2010, Defying the Odds: The Rise of Dalit Entrepreneurs (co-authored with D. Shyam Babu and Chandra Bhan Prasad), published in 2014 by Random House India, and The Other One Percent: Indians in America (co-authored with Sanjoy Chakravorty and Nirvikar Singh), published in 2016 by Oxford University Press. His latest edited works are Navigating the Labyrinth: Perspectives on India’s Higher Education (with Pratap Bhanu Mehta), published in 2017 by Orient BlackSwan, and Rethinking Public Institutions in India (with Pratap Bhanu Mehta and Milan Vaishnav), forthcoming in May 2017 by Oxford University Press.

In 2012, he received the ENMISA (Ethnicity, Nationalism, and Migration Section of International Studies Association) Distinguished Book Award for Diaspora, Democracy and Development: The Impact of International Migration from India on India. 

Dr. Kapur is the 2005 recipient of the Joseph R. Levenson Teaching Prize awarded to the best junior faculty, at Harvard College. He is a monthly contributor to the Business Standard. Professor Kapur holds a B. Tech in Chemical Engineering from the Institute of Technology, Banaras Hindu University; an M.S. in Chemical Engineering from the University of Minnesota; and a Ph.D. from the Woodrow Wilson School at Princeton. 

Devesh Kapur was interviewed by Aleena Ali CMC '17 on February 12, 2017. Photo and bio courtesy of Dr. Kapur.

In November 2016, Indian Prime Minister Narendra Modi announced the demonetization of India’s 500 and 1000 rupee banknotes. Can you explain briefly the basic rationale behind Prime Minister Narendra Modi’s decision to remove large-denomination notes from circulation? 

The official rationale was to target black money, which is money that has not been declared to tax authorities and is held in different forms, such as real estate, gold, and cash (usually in high denomination notes). The policy was based on the idea that by calling in high denomination notes, individuals possessing large amounts of undeclared cash would have to reveal the source of their income when depositing it. Therefore, if a person held a large amount of black money in cash, he would either not return it since he would not want to get caught, or if he did, would have to pay penal tax rates. This did not prove to be the case in the end, as most of the outstanding cash was returned. This indicates either that there was less black money than anticipated (which is unlikely), or that those who have black money predominately store it in forms other than cash (such as real estate, shell companies or gold), or that they have found others way of returning the money, perhaps through relatives or household help. 

A second rationale that emerged later, was to gradually shift India from an economy that utilizes unusually large amounts of cash to a digital economy with people using digital payment systems. Because digital payments can be tracked, the gradual transition towards digital transactions would allow the government to bring the large informal part of the economy to the formal part. Demonetization aimed to serve as a shock to persuade people to change their behavior in this regard. 

The Indian economy is heavily reliant on cash transactions. What factors explain and underlie the high degree of cash-reliance in India?

All poor countries will have a high reliance on cash as degrees of financial inclusion, formal banking systems, and credit card usage grow as incomes increase. However, for its level of income, the amount of cash used in the Indian economy is larger than it ought to be. This is due to a number of reasons. First, India’s agriculture sector continues to be quite large and a large part of its population continues to be rural. As most transactions in rural and agricultural markets are in cash, a large portion of the Indian economy is still cash-reliant. Second, there are very severe distortions in the real estate market. The real estate market comprises a large portion of the black economy and a considerable fraction of the transactions and payments in this market are made in cash. Third, the very success of India’s electoral democracy might be feeding into India’s cash-reliance. As elections require money, the frequent holding of competitive elections requires more money. The high usage of illicit funds by politicians causes them to need a lot of cash, creating a higher demand for it. Therefore, several factors are responsible for cash reliance in India, such as the structure of the economy, cash-reliance in specific sectors, and the nature of the election finance system that increases demand for cash. 

What have been the consequences of demonetization so far? Which groups have been hurt the most? Has there been pushback against Prime Minister Modi?

As poorer and lower-income groups are highly reliant on cash in their transactions, they are most affected by cash shortages, even if it is for a short period of time. In terms of the impact on different sectors of the economy, small and marginal farmers and landless laborers in rural areas were heavily affected. The construction sector was also affected through the impact of demonetization on the real-estate market. The adverse effect on the construction sector further impacted low-skilled and medium-skilled workers employed in that sector. There has also been a drop in real estate prices as people had less black money to buy property. Furthermore, almost all paths of the informal economy were affected, and the informal economy affects the formal sector through supply chains. Businessmen and traders were also affected to the extent that they kept their black money in high-denomination notes. In general, there was a short-term contraction of the economy and the rural population, as well as poorer urban groups, were affected more. 

In his New Year's Eve address, Premier Modi introduced various procedures aimed to cushion the blow from demonetization, with special provisions for senior citizens, villagers, entrepreneurs and small businesses. Were these sufficient to counteract some of the adverse consequences of demonetization on these groups?

Perhaps even more than the measures Prime Minister Modi announced, the most important way to return to counter the adverse effects of demonetization was remonetization. The remonetization effort was initially quite difficult to manage, both because it takes time to replace the 3.5 billion pieces of notes that were demonetized and inadequacies in planning and implementation. Cash is a physical item that needs to be printed utilizing high security paper and inks, and then physically transferred to remote parts of the country. The management of this procedure was extremely challenging in the early weeks. However, the situation has improved as the Reserve Bank of India announced that there will be no limits to cash withdrawals by the end of March. While the measures the Prime Minister introduced were helpful, it is the ability of the RBI to bring large amounts of cash back that will have a more fundamental impact. 

Does demonetization have the potential to achieve some of Prime Minister’s Modi’s political goals, such as curbing corruption, shrinking the shadow economy, and disrupting cash flows between the illicit economy and the electoral financing system? Are additional reforms needed in this regard?

Demonetization is likely to have short-term effects on all of those objectives. However, in most South Asian countries, people are quite ingenious in circumventing government rules. Therefore, its effects will only translate into the medium and long-term if a range of complementary measures are introduced. In order to enable the population to move to digital payments, the government will have to make substantial investments in large-scale digital payments infrastructure, ensure low-cost smartphone access and internet connectivity in remote areas, establish point-of-sale terminals, and ensure the roll out of 4G mobile networks. In order to reduce the portion of black money in the economy, the government has to bring the real-estate sector within the tax bracket of the new Goods and Services tax and ensure that stamp duties are low so property-buyers do not have an incentive to give lower property value estimates.

To clean up election financing, reforms need to be passed that prohibit cash contributions, increase transparency about contributors, improve auditing of political parties’ balance sheets and introduce severe penalties if balance sheets are not in order. Therefore, a range of reforms must be passed. Demonetization acted as a shock, and it is unclear whether it will continue to have an impact in the medium and long-term, and whether the government will adopt these essential complementary measures as well. 

One of the goals of demonetization was improving state tax collection. Do you expect this goal to be achieved? Is India’s tax administration adequate to advance this goal?

India’s tax administration is quite a distance from where it ought to be. In addition to the parts of the tax administration being corrupt, the structure of taxes, characterized by high tax rates and exemptions, provides incentives for individuals and companies to cheat. The steps the government is currently taking are in the right direction. It is replacing current tax structures with a Goods and Services Tax (GST). This reform, which is likely to come into effect later this year, is the most fundamental tax reform in independent India and it has major implications for India’s federal system. It is a massive undertaking and due to its implications for India’s fiscal federalism, it is very politically-sensitive. However, the states do not want real estate to be in the federal tax net or to qualify for GST. Instead, they want to be able to tax real estate themselves. If they are able to do so, that would have a negative impact since a lot of black money is utilized in the real estate market. 

The International Monetary Fund, the Asian Development Bank and the World Bank all have reduced forecasted growth rates for the Indian economy. Is the impact of demonetization on growth rates likely to be limited to the short-term? What additional reforms are needed to counteract the impact of demonetization on falls in consumer spending and reduced cash flows in markets?

Generally, people believe that the impact will be short-term and India’s growth rates will continue to be driven by fundamentals within the country and by economic changes taking place worldwide. India had hoped to emulate China’s export-led growth path but that clearly cannot occur given the retreat from globalization and openness to trade occurring worldwide. The structural reforms within India, like the GST or sectoral reforms especially in factor markets in labor and land, will play a larger and more fundamental role than the recent demonetization did, which was only a one-time shock. 

Could Modi’s demonetization campaign have been better implemented, avoiding some of its adverse consequences?

Definitely. However, there is an inherent tension. Demonetization can only work as a shock; it can achieve its goals only if very few people are aware of its onset. It had to be kept as a secret. On that front, the strategy worked very well as everyone was caught by surprise. Only a handful of people were aware of it despite preparations for it commencing in spring of 2016, when orders for specialized ink and hundreds of tons of specialized paper had to be placed. 

Yet for implementation to work in practice, the government needs to bring in many stakeholders, such as commercial banks that had to ensure that ATM machines were re-calibrated to the new notes and that supply chains were in place to ensure that notes were supplied from printing presses to distribution centers, main and sub-bank branches, and local ATMs. For this to occur smoothly, stakeholders need to be brought into confidence so that they are prepared. However, the government could not have kept it a secret if it had brought in more stakeholders to ensure better implementation. In sum, this fundamental tension reduced the ability of the government to put into place a better implementation strategy. 

Where does the Modi government go from here in terms of its broader efforts to modernize the Indian economy? Will he continue this policy which appears to be very costly in economic terms?

The government faced a major electoral test a few months after demonetization.. Although many analysts predicted electoral losses, just the opposite happened.. For the most part, however, it did not appear that demonetization played a major role in voters’ electoral choices. What is remarkable is that despite a lot of hardship for millions of people, very few people protested. In the opinion polls and interviews, people who were adversely impacted expressed support for the policy. Prime Minister Modi has shown that he has been successful in getting the public to view black money as a large scourge and a moral challenge facing the country. However, it is one thing to identify a problem and another to find answers to it. Demonetization can best be characterized as a person attempting to climb up Mount Everest and reaching base camp. This is only a first step, and there is a long and arduous climb ahead.

Aleena Ali CMC '17Student Journalist
Featured image source: "People queue outside a private bank to deposit and exchange 500 and 1000 currency notes at the sector V, Salt Lake City, Kolkata." by Biswarup Ganguly — Own work. Licensed under CC BY 3.0 via Wikimedia Commons —
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