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Demonetization: Minimum Governance, Maximum Gundagardi
An activist of Congress party holds banned 500 and 1000 rupee notes during a protest against demonetization in front of Reserve Bank of India. in Hyderabad India (Nov. 28, 2016).
Image Credit: AP Photo/Mahesh Kumar A.

Demonetization: Minimum Governance, Maximum Gundagardi

 
 

As the two-year anniversary of India’s demonetization approaches, it offers an opportunity to review the gutsiest decision by Indian Prime Minister Narendra Modi and provides a lens to look at the decision-making mindset and process of the current Indian government. Modi’s willingness to believe that India’s weak bureaucracy could smoothly implement the draconian measure and ingeniously uncover mythical amounts of black money, and his willingness to ignore data and expertise to plan and execute the move that disrupted markets across the economy, is the strongest indication that Modi ideologically does not share, or understand, the mantra of minimum government and maximum governance that many of his supporters hoped he would embrace. Instead, Modi is pursuing a course of minimum governance and maximum gundagardi – or thuggery.

Whether it is quixotic moves like Smart Cities, Make in India, or Ayushman Bharat, or other thuggish moves like severely restricting the cattle trade, the common thread of policies devised by this government is the same: A large and expanding view of the benefits the state can bring, without any regard for the actual capacity of the state that implements such policies. While such a view might look good on paper, in the prime minister’s speeches, and on WhatsApp groups, adding responsibilities and powers to a bureaucracy where capacity remains weak and largely unchanged worsens bureaucratic performance and potentially increases arbitrary interventions that hurt India’s economy and governance. The promise of such programs also distracts from the conversation needed to galvanize support for important structural reforms that are needed to address fundamental challenges.

Putting Incompetent Foxes in Charge of the Hen House

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The largest protagonists (besides the prime minister himself) in the story Modi sold to the country on November 8, 2016 were Indian banks and tax authorities. Demonetization was based on the belief that wrongdoers would be so scared of banks and tax officials that they would either never deposit their “black money” or take whatever tax penalty the government offered. As one could have predicted, none of this happened.

Why Modi or his team believed anybody would be scared of these weak institutions is astounding. All signs indicate that neither India’s banking sector nor its tax authorities were equipped to implement such a rigorous policy.

India’s banking system, which is largely publicly owned, has a long history of being inept at the most basic aspect of banking, making loans, which has been a major cause of reoccurring non-performing loans crises. Recent disclosures indicate that a state-owned bank had such weak procedures that a diamond merchant — with the help of a few employees — managed to sneak guarantees that left multiple government owned banks with liabilities potentially over $3 billion. There was no indication, and none remains to this day, that Indian banks had the capacity to differentiate between legitimate and illegitimate deposits that poured in after demonetization.

India’s tax administration is also not known for its efficiency. While estimates vary, the tax system is estimated to have a large tax gap, where the actual revenue collected is substantially lower than potential revenue. It’s unclear why and how the tax administration, which has underperformed for decades, was supposed to change its structurally weak performance based on one drastic step.

In addition to their institutional weaknesses, it’s an unanswered question whether Indian banks and tax authorities should have been considered suitable allies in the fight against black money. According to data from India’s Chief Vigilance Commission (yes, that is an actual government department), of all government bureaucracies and enterprises, only India’s railways and local governments received more corruption complaints than Indian banks and tax authorities. For all the secrecy in the planning stage, the government apparently gave little thought to who would manage the currency deposit and exchange process once the scheme was implemented.

While even an efficient bureaucracy would have likely struggled to implement the administrative challenge set forth by demonetization, India’s banks and tax officials certainly did not have the capacity to execute such a mammoth task, and their institutional weaknesses probably allowed some officials to take advantage of their privileged position.

Too Smart for Data

Those who ideologically believe in limited government realize that all interventions, especially drastic ones like demonetization, carry with them a whole host of intended and unintended consequences, which is why governments are expected to study and deliberate about major policy moves. Demonetization broke almost all standards that have been set for the basic due diligence a government must perform, and display, before embarking on a major decision in a large democracy.

While government officials regularly tout the success of demonetization, in the almost two years since the move, the government has not released any study, model, or academic paper that it relied on to assess that demonetization was a worthwhile policy exercise. When announcing the decision, the prime minister claimed to have done his research, but not providing any documentation implies that either none exists or what exists was so flawed that the government finds it more suitable to leave it unshared.

Eighteen days after demonetization was announced, Bibek Debroy, a senior economic official in the government, in a public forum provided several estimates of possible positive impacts of demonetization, but always after noting that these were based on back of the envelope calculations. Why a senior member of the government that had undertaken one of the largest monetary policy experiments had to rely on back of the envelope calculations is puzzling. Debroy estimated that up to 15 percent of the currency that was demonetized would not come back and would be “destroyed,” thereby allowing the Reserve Bank of India and the government to benefit from the reduced liability; however, less than 1 percent of the currency failed to return to the banking system, which is indicative of the poor or non-existent homework that backed the move. (The 99 percent that came back does not include rupees that were in Nepal and Bhutan, and with any unfortunate soul who trusted that the RBI would honor its words when they left the country with any 500 or 1000 rupee note.)

Too Honest for Transparency

Those who argue for limited government also generally realize the importance of having a transparent one, since knowledge of government policy moves provide incentives to profit from them. The Modi government in the two years since demonetization was implemented has not explained who was chosen to be part of the planning and how were they vetted, or why groups of people whose involvement could have helped planning were excluded.

Press accounts of who knew about demonetization highlight that a small group of people in the Prime Minister’s Office, Finance Ministry, and the RBI knew about the plan. Those accounts also reference that PMO members included those who had worked on the Modi campaign, but those accounts or other government communication do not mention how they were chosen, if they are part of the government or private employees, or if there was any due diligence to ensure they did not benefit from the inside knowledge.

As important as who was included in the planning is who was left out of the group. As demonetization crippled Indian agricultural markets and the construction sector, it became apparent that the respective ministries had no forewarning, let alone planning, for the liquidity shock that hit their sectors. The government justified its decision to leave out people, by noting the need for secrecy, but if the prime minister could not find a single person in each of the ministries who could be trusted, it makes one question if Indian citizens in turn should trust these ministries as well.

In a day and age where the benefits of including diverse groups in decision-making is regularly being highlighted, it should come as no surprise that a group of older men with similar backgrounds who did not trust or consult any person beyond their insular set made a decision that they were convinced was brilliant, but had poor outcomes.

Minds Full of Indianness, But Void of Ideas

The Modi government was rightly credited early in its tenure for bringing in experts like Arvind Subramanian and Arvind Panagariya, but its habit of ignoring such expertise, epitomized by demonetization, and its supporters’ propensity to hurl taunts and abuses at experts has led to a gradual brain drain from the government. Subramanian not only generated and elevated the economic discourse in India with the economic surveys he authored, but also laid out the policy background work on the Goods and Services Tax and helped make the case for the bankruptcy framework, two of the government’s largest achievements. Yet due to his academic work in the United States he was frequently pestered by a segment of Modi’s supporters who question any expert who has spent time overseas on their “Indianness.”

Moreover, despite his impressive contributions, Subramanian was not consulted on the demonetization decision. Not consulting the individual who the government itself appointed as Chief Economic Advisor on one of the most important economic decisions serves as an indictment of the government’s judgement.

Panagariya stepped down in August 2017 and was replaced by Rajiv Kumar, who in his first public column noted the negative impact of “Anglo-American” influence on Indian policymaking and hinted that decision making would tilt toward those who understand “ground realities.” However, rather than championing reforms, Kumar has engaged in debates such as highlighting the moral arguments for demonetization.

In addition to ignoring expertise within its own ranks, the government is now targeting prudent policymaking at the RBI, and the central bank’s independence, by invoking a clause that has never previously been used in India’s history to force the RBI to ease lending curbs on Indian banks and possibly transfer part of its rupee reserves to the government.

Attacks from Kumar and nativists are particularly damaging because India’s seminal economic moment, the 1991 economic reforms that changed the country’s direction, benefited from economists who had spent substantial time overseas, including then-Finance Minister Manmohan Singh, and advisers like Rakesh Mohan and Montek Singh Ahluwalia. These attacks not only drive away some of the best minds India might have, but also put a chill on those who stay, who have to consider if advancing necessary reform ideas would make them a target.

No Problem Too Large for a Government Program with a Catchy Title

While demonetization would have been damaging enough on its own, the mindset that drove the risky decision is evident in a series of government policies. The Modi government excelled at making progress on the reform agenda it inherited, including passing the GST and setting up a new bankruptcy framework, but its own ideas have consisted largely of announcing high-profile government programs that are heavy on style but light on substance.

Instead of advancing land and labor reforms and changing incentives to secure additional investment to overcome India’s infrastructure gaps, the government announced Make in India, a grand pronouncement full of administrative tweaks and anecdotal successes, but an initiative that contains no key reforms. As Make in India has faltered, with manufacturing as a share of GDP declining, the government has resorted to increasing tariffs on international goods as a desperate and hopeless attempt to encourage domestic production, undoing years of positive steps on reducing trade barriers.

Instead of addressing systemic problems in India’s education system, Modi announced Skill India, and as the government announced the Smart Cities and Swachh Bharat initiatives, the lack of local government funding and planning were left largely unaddressed.

The list of programs that the prime minister has announced, which add a shiny band-aid on systemic problems, goes on and on. The latest buzzword policy initiatives are Modi’s announcement to push state-owned banks, which remain saddled with non-performing loans, to approve loans for small businesses within an hour; and Ayushman Bharat, a health insurance scheme that promises health insurance for a majority of India’s 1.2 billion population, but has a budget allocation of less than $300 million.

The government also happily intervenes to disrupt markets to accomplish narrow religious goals. New Delhi in 2017 introduced rules that made it challenging to transport and sell cattle, disrupting the supply chain in the sector, and empowering cow vigilantes who harass and at times murder minorities in the trade. The move eventually resulted in a court challenge and, after slowly realizing the harm caused by its policy, the government decided to scale it back.

When Modi was elected in 2014, he became the first Indian prime minister to have a parliamentary majority in decades. That majority in the midst of India’s demographic transition presented a unique opportunity to solidify India’s economic trajectory. However, Modi’s approach, epitomized by demonetization, reinforces India’s statist tendencies, with his social media marketing and Hindu nationalist flair. With national elections in several month, Modi, or whoever will replace him, must realize that for India to succeed, minimum government, maximum governance will have to be an ethos and not just another slogan.

Shezad Lakhani is a former economic analyst with the U.S. government whose career focused on South Asia issues. The views expressed in this article are of the author alone and do not reflect those of his employer.

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