Demonetization in India: The Bigger Picture

demonetizeDemonetization is a buzzword in India today; tune in to an India news and I will probably hear the word “demonetization” about a 100 times in 15 minutes, followed by rumors, comments and suggestions. So, today, in this article, I’m presenting my views on this topic and trying to portray a bigger picture in front of you by dwelling a little bit into the history of India. I welcome your views and thoughts on it.

4 decades ago, in 1969, Mrs. Indira Gandhi, the then Prime Minister of India, indiragandhidecided to nationalize the Indian private banks. Following this move, critics attacked her, calling her approach pro-poor and anti-rich. When the after-effects, similar to today’s cash crunch, erupted after the bank nationalization move, critics criticized her, saying bank nationalization should have been planned better; bank nationalization should have been restructured to have one/two central banks and several regional banks.

I see the similar phenomenon happening to Mr. Narendra Modi’s move to demonetization; people making a fuss out of the entire scenario. In fact, I just shared an article of The Financial Express in the Facebook, which states the words of Steve Forbes, the Editor-in-Chief of Forbes magazine, who calls Mr. Modi’s move as “massive theft of people’s property”. He went on to use words like “sickening” and “immoral”.

I cannot stop people’s comments and statements to drive their news, but demonetization, in my opinion, is going to be a marked event in the history of India, in creating a lasting financial deepening just the way bank nationalization did after its implementation. Let’s delve into it a little more.

Nationalization of banks helped Government banks expand its presence and network into the interiors of India and capture small savings of millions. As a result, the household savings rate increased from 8.1% of GDP in 1968-69 to about 14.5% ten years later, causing the overall savings rate mount from 12% to 21%. This access to the low-cost savings enabled the public sector banks to become profitable decades later. Additionally, Government strategy to keep 70% of the banking system in the hands of public sector created efficiency and stability in the banking system.

Mrs. Gandhi, thus, created a disruption in the financial system that resulted in a lasting impact over a long period of time. I see Mr. Modi’s move of demonetization creating such an impact in the long run.

Demonetization, as I see, is not geared towards curbing black money or moving to a so-called “cashless economy “, but to, primarily, create a financial deepening that began with nationalization of banks. Just like bank nationalization brought a large number of citizens into the banking system, demonetization promises to create individual relationships and bring traders, merchants and small and mid-size enterprises in to the banking system. This will give banks access to more deposits and a larger portion of low-cost savings, which will result in the gradual decline in the interest rates. Once the cash flows are routed through the banking system, we will have more transparency. This will translate to more lending to small and emerging businesses that has higher yield than that from corporate bank loans.

The fall in the interest rates will help in capital gains of banks holdings in government securities and enable recapitalization of public sector banks. According to a study, banks have profited about INR 1,000 billion last quarter, and will gain another INR 1,500 billion in the next 6 months through 1% decline in the interest rate.

Commotion and criticism against Mr. Modi’s demonetization with arguments such as standingqueuemore legal tenders could have printed in advance, more notes with small denomination, etc. are valid, but the distress that has erupted in the public is short term. As we all know, the biggest threat to a fast growing economy is not creating new jobs, but the state of the banking system. We cannot control global economic conditions, but we can definitely improve the state of the banking system; demonetization is one such move to address key challenges in revitalizing the banking system; it’s a promise to bring the banks to a faster track to growth in the mid-term.

No doubt I have to stand today in a long queue for hours to withdraw INR 2,000 from an ATM or probably return empty handed after such an effort, but I think Mr. Modi’s move to demonetize legal tenders is a game changer for a better economy, just the way Mrs. Gandhi’s move to nationalization of banks was to improve the financial deepening.


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