Before we get into the details of Demonetisation and the how and what of it, I think some basic understanding of economics is very important. Economics is a vast subject based on the study of the relationship between man and money. Humans behave in a rather irrational manner and economics tries to put structure to this behaviour. In my personal opinion economics is as vague as psychology.
Demand and Supply are fairly easy things to understand. There is a certain level of demand for every product. When the supply is greater than demand, prices go down and vice versa.
The Indian Rupee was pegged at Rs. 66.9 to a dollar when the demonetisation was announced, it is currently doing about Rs. 68.1. The move to demonetise meant that a lot of people wanted to move their black money to gold. This caused a sharp rise in demand for black market gold which is imported using US Dollars. Therefore the demand for Dollar rose and the price went up!
Inflation is the rate at which prices rise. This is measured across a basket of products in the economy. The price rise for different products tend to be different based on the rise of input costs. When fuel prices go up, the price of almost everything goes up, since most goods need to be transported.
Inflation also makes your money less valuable tomorrow than it was today.
When I came to Bangalore in 2005, I could get a Dosa for Rs. 15 at any of the shop. Today, the same Dosa costs about Rs. 30.
If Vivek in 2005 had promised to pay Rs. 15 to Vivek in 2016; Vivek would not be able to afford a Dosa in 2016.
Prices do not rise at this rate normally. Inflation in developed economies tend to hold at around 1% - 2%.
The last decade was unique for India. India has forever subsidised fuel across the country and the government has paid for it. This used to be a huge line item in the budget. In 2010, Manmohan Singh decided to lift oil subsidies on petroleum products gradually. So the artificially lowered oil prices began to rise. Petrol prices at the pump were brought in line with the international market rates. This is why you see Petrol prices change every other week now, in line with international market fluctuation.
In the aftermath of the recession of 2008 oil prices across the world began to rise precipitously. The government was certain that it would not be able to foot the oil bill for long. Hence the move to lift subsidies was made. As a result, we wallowed with inflation that bordered 10% for half a decade. It was necessary pain that we had to go through.
Money - The Holy Trinity
Money and its circulation in any economy is greatly controlled by three institutions.
The Central Bank - Controls the issue of money as well as the monetary policy of the country. They are the people who set the base interest rates for lending as well as a bunch of dull sounding ratios. All of these numbers have a huge impact on the economy because they govern what banks can do with the money they have as deposits.
Interest Rates - The interest rate is a very important tool because this not only governs the rate at which the bank is lending to you and I, or to other businesses but also amongst themselves. Borrowing happens when you can get value that is much greater than that money that you will have to give up as interest. The lower the interest rates the more borrowing will take place.
People invariably borrow to buy high priced stuff or to invest in business. This results in increase in consumption and hence the GDP. Unfortunately due to the demand-supply thing that we talked about earlier; increased consumption means higher demand and hence higher prices. Eventually, higher inflation.
The Banks - Banks as institutions were created to act as capital exchanges. There are those who have money and there are those who need money. Banks aggregate the money and make it available in the form of loans to individuals and businesses. They are essentially in the business of debt.
The Stock Exchange - Stock exchanges are places where price discovery takes place for equity. The equity is always liquid as long as a buyer can be found. The market is supposed to factor in all of the information available and determine the rate of risk and hence the price. (At least in principle, I think it just factors in all of the emotions around a company and prices that in) Unlike debt, equity is a game of high risk and hence potentially higher returns.
So if we had a risk-return spectrum; banks are at one end of it and equity markets are at the other end. But in between there are 50 shades of grey. Finance people being finance people, keep inventing financial instruments. One such examples is Bonds which is debt, but with rates that change based on the market conditions. The deeper you dig, the more complex they become.
Currency - Currency is a state subject and each central bank can determine how much of it and in what form it gets introduced into the economy. The notes that we carry around are essentially promissory notes issues by the central bank, in our case the RBI; promising to provide the bearer the equivalent in Indian rupees. All bills of exchange or money as we like to call it are the same - promises.
Economy - The way an economy works is money keeps getting rolled around and exchanged. Let us say I have Rs. 100. I went and bought 4 kernels of popcorn at PVR (because that is how expensive it is!). PVR took that money and bought 400 kernels of popcorn and paid the company that supplies it Rs. 100. This company further buys corn from the village aggregator at Rs. 50 and he pays the farmer Rs. 10 to source.
At this point if these were the only transactions that took place in India, the GDP for India would Rs. 260. Same money, cycled over.
The money in circulation is subset of the GDP
Brings us to Demonetisation - The Indian government basically said, those old promissory notes that I gave have been copied to no ends. Terrorists are using it and some people are also holding on to it unaccounted for so we will take all of that back and issue now promissory notes. Cool!
All good till now.
So I have been looking at the news and reading a shit load, for and against, demotisation and this is what I am seeing based on the evidence available.
This all begins when Modi got elected to power. Manmohan Singh had already appointed Raghuram Rajan as the RBI Governor and since the position is tenure based, Modi has to deal with him.
Modi got elected to power on the promise of growth and prosperity for the nation. It is imperative that he is able to show great growth in order to win the next elections.
Raghuram Rajan (RR) took over the governorship when the Rupee was crashing like a hard rock in water. If you see the decimal point on the graph below, that is the day before he took office. As is evident, he did a marvelous job controlling the currency movement.
His point of view was that, the falling currency is symptom and not the problem. The problem was the banking system and the way in which the nexus between the rich and political class has resulted in some of the biggest banks in India (all of which happen to be government run) giving away a lot of bad loans. This has resulted in there being a lot of supply of money in the economy and hence a depressed value. All of this needed cleaning up in order for the economic engine to work again.
He began by increasing the interest rates in order to curb inflation. Inflation tends to make the currency less valuable and since we buy a shit load of oil from abroad, the budget would go out of control if the currency is not curbed. He further mandated that all of the banks clean up their balance sheets and that instead of issuing more debt, they get the non-performing assets to perform or clear them from the books. In other words banks had to call back the loans that they had issued to industrialists which were not being paid back or take a loss on account of their inability to do so.
Mallya was singled out and chased, he was an easy target. Many others were not subjected to the same scrutiny.
With the increase in interest rates money supply in the economy dried up and the inflation which was floating around 10% came down to 5%. There was not only less money going out as debt, banks were calling back debt which meant that even less money was available in the economy for investment.
Part of the reason, the inflation came down was the higher interest rates but also last year oil prices went from USD 120 to USD 30 in the space of a few months. In case the prices were to go up due to any geo-political reason, the inflation could shoot up again.
The government had been fighting a losing battle with RR for a couple of years to lower the interest rates. He thought it was essential to keep the inflation in check and take more time to clean up the banking system before releasing the interest rates. This would also give time for geo-political factors to settle down.
This did not auger well for the promise made by Modi. No investment, no growth!
Hence Raghuram Rajan was Fired! He was not willing to co-operate and the government wanted to make a move on interest rates to push growth. He went back to Chicago to resume his teaching position and Trump got elected! Talk about jumping from the frying pan into the fire!
Back to India.
In the meantime International Rating Agencies had cut ratings of the banking sector in India to 'Negative'.
Fitch in particular said
Though the government is committed to inject $7 bn of capital in public-sector banks by FY19, out of a budgeted investment of $11 bn, but Fitch says the government or other related entities are likely to have to inject more funds because it estimates the banking system needs around $90 bn of capital while many public-sector banks are likely to find it difficult to access new capital from other sources.
USD 90 Billion is about 6,00,000 Crores; where do you find money like that!!??
Presto! In the next few days, bad loans were wiped off the sheets!
So the questions that struck me was:
Why are none of the rich people who might have a lot of black money (cash) committing suicide?
Demonetisation was announced and you may have read about a lot of rules regarding the amount of money an individual can deposit, inking, etc. Have you heard of any limits for companies?
The PVR popcorn, I referred to cost Rs. 250 a tub. On a normal day, they would collect tens of Lacs in just concession stand sales. You cannot possible tell them 2.5 Lacs and then done! So a lot of black money that rich people have, might actually be getting funnelled into company accounts AND they will have until end of March to spend it as well in order to avoid taxes!
I have had the opportunity to visit 5 cities across India is the last week, with not a single penny in my wallet! I see so many people standing outside the banks and do you know who I see? The salaried individuals who are standing in queue to deposit money into their accounts. Their hard earned money, that they hope not to lose.
In the meantime, the small darshini's that sell Dosa and Coffee seem to be empty. All of the small retail business have lost a huge percentage of their income. I have been putting up a lot of posts on facebook about what a breeze it is drive around Bangalore since the Demonetisation took place. Truth be told, fewer taxis are being hired, fewer autos are getting rented and fewer e-commerce orders are being placed (60% of all orders are Cash-on-Delivery).
The unorganised sector cannot work at all since they depend on daily wages and all of it is in cash. Construction has all but grinded to a complete halt.
People do not react well to uncertainty. They tend of want to know that they will have certain things that they can depend on. Consumption declines the moment you introduce uncertainty and that is what is keeping the malls and retail stores empty. The way and manner in which this entire episode has been handled, we all can agree that it would take a while before we are able to get back that confidence.
The idea was to remonetise the banks and clean up the balance sheets and that may have been achieved. At the same time a by product has been the tremendous slowing down of the Indian economy. If I am right and a huge amount of black money is being funnelled into current accounts, the investment of this money during the first quarter of 2017 might make up for the slowdown. Only time will tell.
In all likelihood, I think that the GDP would contract this year. The last time this happened was in the 1970's and we were at war with Pakistan.