Currency reform: A political gamble

“Demonetisation is not the end but the beginning of our deep and continuous struggle against black money and corruption,” said Prime Minister Narendra Modi while addressing members of Parliament from his party on Tuesday. Few decisions affect citizens directly on a scale comparable to the Modi government’s move to replace high-value currency notes.

Unsurprisingly, the issue is dominating the public discourse since its announcement over a fortnight ago and has also caused multiple adjournments in both houses of Parliament. Like many other policy decisions, this too has costs and benefits. But the difference is that this decision is by far the biggest that this government has taken and could have significant long-term political and economic implications.

As noted by the Prime Minister, currency swap is part of a larger policy initiative to check the menace of black money. Since this will only attack a part of the black-money stock and not the flow, broader policy action will be required to stop the generation of unaccounted wealth. Among other benefits, at least in the short run, this exercise will weed out counterfeit currency notes from the system, primarily used for financing terror. Further, money coming back into the banking system has resulted in lower bond yields and might help bring the lending rate down, though the actual impact will depend on the extent to which funds remain in the banking system after the cash crunch eases.

However, if the entire process is not completed smoothly, it will significantly affect the large informal section of the economy which operates outside the formal banking system and can be a drag on economic growth in the short to medium term. In the absence of investment demand, the Indian economy is largely being driven by consumption demand, which will directly be hit because of this contractionary monetary shock. Therefore, it is important that the process is completed in the shortest possible time.

A lot of what this government will be able to do in the rest of its tenure will depend on the outcome of this decision. If the government is able to complete the process smoothly with minimum impact on the economy and show a respectable number in terms of reduction in black money—the amount of money that will not return to the banking system—it will gain enormous political capital which will help in taking politically difficult decisions. This will not only help the government to take more steps in the area of eradicating back money, but also provide enough impetus to pursue other politically difficult policy reforms. It is possible that the momentum will carry till 2019 and take the game away from the opposition.

But on the other hand, if the Modi administration is not able to implement the currency exchange as desired, and if the pain begins to mount because of a cash crunch in terms of loss of economic activity or hardship, in general, among the masses—it will perhaps do irreparable damage to the credibility of the government. Consequently, it will become extremely difficult for the government to take even moderately difficult and politically risky decisions in the future. The government could become risk-averse in the second half of its tenure.

It is fair to assume that the top leadership of the government weighed all political possibilities and likely consequences of this inherently risky decision. As noted in this space before, it is possible that the government is now reflecting the interests of the rising middle and neo-middle class which is affected the most by corruption. This segment was instrumental in voting the Bharatiya Janata Party (BJP) to power in 2014.

For now the decision is, by and large, getting public support. A recent survey showed that more than 80% of people admitted that the currency swap has caused inconvenience but supported the move as a step in the right direction. But this support could easily wane if the entire process takes longer than expected and the cash crunch begins to significantly affect economic activity. There will be a pain point when public opinion starts turning against the government. India is predominantly a cash-dependent economy and if the cash crunch does not ease soon, patience could begin to run out even in the new support base of the BJP. The daily tinkering with rules suggests that the government is facing difficulties in implementation, though it is also true that there were real limitations to the extent preparations could have been made in advance.

Politically, there was no compelling need for the government to take such a risky decision as it was cruising smoothly with favourable ratings for the Prime Minister. But the government decided to do this to perhaps keep one of its biggest electoral promises. This currency swap is a big political gamble. How this decision pays off will be keenly watched in the coming months as it could well become the biggest turning point for the Modi government.

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