FAQ: What is your view on demonization?
Mehrab Irani: Demonetization is nothing but removing the
legal tender of paper money. Demonization is surely a good move but
badly implemented. Black money is a problem created over the past 70 years
which cannot be solved in 70 days! In the
short term, demonization is likely to cause slowdown in the economy resulting
in contraction in demand, loss of employment and purchasing power; over the
medium term, it might result in some redistribution of assets but that can
easily be crowded out by loss of income and over the long term it should be
economically neutral as the system learns to live the new way of life.
FAQ: When and under what circumstances is demonetization used as an
economic tool and how common is this practice worldwide?
Mehrab Irani: As a tool for economic
surgery it has been used elsewhere, but not in the context it has been used in
India. Where it has been used largely is where currency has totally lost its
value, where one has to carry sackfull of currency to buy one’s daily supply.
There the currency was abolished and new currency created. But India is not in
that situation.
We have to remember one thing that in today’s age,
money is currency or paper notes printed by the Central Bank along with a
promise to pay the bearer goods or services in return for the same worth as the currency note. The rules of money
permanently changed in the year 1971 when the then US President Richard Nixon
took the US off the gold standard and
granted itself the license to print money. Since then, the US dollar and other
world “currencies” have depreciated while prices of all commodities measured
against it — be it precious metals like gold, silver or industrial metals like
steel, copper, aluminum or agricultural commodities — have gone up and will
continue to go up over the long term. That’s why we call money as currency. And
this is what is “monetary inflation”.
Although we all love money but invariably we are
all fooled by it. The problem is that while most of us love money we don’t
realize how to value it. If you think closely, you will realize money is
nothing but paper and has no value in itself except that it can be exchanged
for goods and services. Thus, the value
of money is not intrinsic but what it can be exchanged for in return. And the
more the goods and services we derive for a given amount of money, the more the
value of money, and vice versa. Now, imagine the situation that suddenly
the “exchanging power of money against actual goods and services is removed or
abolished”. This is effectively what demonization does. Hence, generally
demonetization is used in circumstances of extreme emergency when the currency
itself is losing value rather swiftly.
FAQ: Does demonization have any
economic benefit?
Mehrab Irani: Yes, demonization certainly
has economic value when we can reduce the overall supply of money. For example,
if out of Rs.14.5 lac crores of Rs.500 and Rs.1000 rupee notes in circulation,
say 20% or Rs.3 lakh crores were to never come back to the banking system than
it extinguishes the RBI’s liability and reduces the overall money in the
economy. As value of goods and services are valued against money, with
reduction in money the price of the goods or services automatically comes down.
For example, assume that in the whole economy there are two Rs.10 notes and a
single loaf of bread. Therefore, the two Rs.10 notes can be exchanged for that
loaf of bread thus pegging the price of that bread loaf at Rs.20. Now, assume
that one Rs.10 note is extinguished than what happens – only one Rs.10 remains
with the single loaf of bread. Automatically, the price of bread has come down
from Rs.20 to Rs.10! Hence, demonization
results in reduction in inflation and enhances the purchasing power of money,
provided some amount of money is extinguished and never returns back to the
banking system.
FAQ: Does demonization have any side effects?
Mehrab Irani: Oh Yes! Demonization has
lot of economic side effects. When the government suddenly removes money out of
the system through demonization, there is a significant fall in the velocity of
money. In macroeconomics, velocity of money is the rate at
which money is exchanged from one transaction to another and how much
a unit of currency is used in a given period of time. Velocity of
money is measured as a ratio of Gross National Product to a country's
total supply of money. I think the
government might have underestimated the power of this reduction in velocity of
money in a large cash economy like India. The monetarists think that the stability of income velocity of money is
important, whereas Keynesian have
criticized the notion of stability of velocity of money. The quantity theory of money continues to be
the most fundamental benchmark reference point for any monetarist analysis
involving the causal relationship between monetary aggregates on the one hand
and output and prices on the other. The theory, which is essentially an
identity (Stock of Money * Transaction Velocity of Money = Price Level * All
transactions in Money), has often been very simplistically interpreted to drive
the message that “an increase in money supply causes proportional change in the
price level”. Even if someone does not agree to the monetarists argument, it
should be acceptable that an increase in money supply and consequent increase
in the velocity of money raises the aggregate demand and shifts the IS-LM curve
which is the relationship between interest rates and asset markets and vice
versa. The velocity of money affects the money supply and interest rates and
shifts the IS-LM curve resulting in
contraction in demand and output. A corollary of this theory would be that interest
rates are further heading downwards in India. This shift in the IS-LM curve would affect the demand for many goods
including 2-wheelrs, cars, consumer durables, gold, costly items like
jewelleries as well as housing and other related industries like cement over
the next few months / quarters.
FAQ: Does demonization has any long term benefits on the economy?
Mehrab Irani: Yes certainly. Over the long term is
should result in expanding the country’s GDP as a large part of the
unreported economy becomes part of the reported economy, tax revenues improve as
the unreported economy starts paying higher taxes, boosting India’s low
tax-to-GDP ratio and household financial savings rate increase as households
would have low compulsion to invest in physical assets to hide wealth once they
report their true incomes. The businesses and self-employed professionals in
the ‘black’ economy may have to reassess their finances in the context of large
losses suffered by them from the recent demonetization measure, the
government’s previous actions against black money and worries about future
measures against undisclosed income and wealth. However, as a carrot and stick
measure, it would be ideal if government were to reduce direct taxation rates,
both for corporates and individuals, so as to facilitate higher income
disclosures and to welcome the new entrants in the tax paying universe.
FAQ: Was the Indian economy facing a crisis that needed such a swift and
heavy surgical strike?
Mehrab Irani: Not at all. In fact, our
macro-economic indicators were reasonably good. But the real point is, what
does this move achieve? According to the government, there are two objectives.
One is curbing terrorist financing and counterfeit currency and the second is
that the black economy has become very large and it is the source of poverty
and many related problems in India, so we rightly need to get rid of the black
economy.
The question is does demonetization overcome these
two problems. As far as counterfeit notes are concerned, according to the RBI,
there are only Rs.400 crore worth of counterfeit currency. Total currency in
circulation is Rs.17.5 lakh crore. Terrorists need financing. So they print
these fake notes and circulate it. But once they have given the money to
another person, it’s circulating within the economy. So they have to print more
and more money. That is what has to be stopped. And how does one stop that? I
am not sure whether demonetization is the answer for it, because there are
state actors involved in counterfeiting and therefore the first thing to be
done is to remove corruption from its very roots. If corruption continues, counterfeiting
the new currency notes is also possible.
FAQ: Does demonization curb black money out of the system?
Mehrab Irani: I am not sure of this but
it’s a gamble which the government has taken. Let us understand the cycle.
First one earns income, out of which one saves and creates wealth. Whatever
income one has, one consumes a part, saves a part of it, and that saving gets
invested in various assets. That creates wealth. Now, wealth is held as a
portfolio—one can put it in real estate, gold, equities, fixed deposits or hoard
it as cash. Cash is only one component of one’s wealth— possibly one per cent
of the total wealth. The black economy, which according to various estimates is
around 40% to 60% of GDP, for the current GDP of Rs.150 lakh crore, we are
generating Rs.60 to 90 lakh crores this year as black income. Black wealth
could be atleast three to four times more so like about Rs.200 to 250 lakh crores.
Out of that, maybe Rs. 3 to 4 lakh crores would be held as cash which we can
call black money. Hence, we have to understand
the difference between yearly generation of black income, hoarding of black
income as cash and deployment or investment of that black income into various
assets which might primarily be gold or land or transferred out of India.
FAQ: India is said to have a huge and thriving parallel economy. Will striking
this parallel economy affect the normal economy as well?
Mehrab Irani: Black economy and white
economy are largely intertwined in India. That’s why when the black economy is attacked;
the white economy is also affected. Demand is going down. Just understand that
if one takes out 85% blood from somebody’s body and then every week puts 10%
back into it, the person will fall severely ill, alteast in the short term. The
same is likely to happen to the economy in the short term as 85% of the
currency has been suddenly removed from the system and 10% is being put back
every week. Travel will fall, eating out will be cut down, functions will have
to be cancelled, small traders will lose business and so on. The large trader will
also suffer as discretionary spending falls. The circulation of money which is like the blood flow is slowing down,
leading to a decrease in demand. When demand slows down, production slows down,
employment drops and investment falls. And when investment falls it will have medium
term consequences on business, jobs and income levels.
FAQ: Will the demand for currency from people actually rise?
Mehrab Irani: Yes, indeed that might be happening.
And it’s simply because the public at large are hoarding currency because they
are not sure when the supply will be normalized. As a result, the demand for currency will be up at a time when the
supply for currency is down causing further contraction in the velocity of
money resulting in contraction in demand for goods and services, deferment of
private capital expenditure, loss of employment, reduction in earnings power
and further curtail in spending!
It’s like a husband has regularly given money to
his housewife for household expenditure out of which she spends some and saves
some month after month which has accumulated into a decent sum of money after
few years. Now, suddenly one day the husband says that all the saved money is
worthless and slowly I will give you new money over a period of time! The wife
will then totally go into a negative tailspin and not even spend money for
legitimate household requirements.
The people who will suffer the most are those in
the unorganized sector, as they don’t have credit or debit cards or card
readers. They are the ones who need more currency in circulation. Almost the
entire agriculture is in the unorganized sector. This sector is also a major
component of manufacturing and services.
FAQ: Does Demonization affect
the average Indian women?
Mehrab Irani: Of course yes. The average
Indian women or particularly housewife who was saving money from the household
expenses month after month suddenly finds her “saved wealth” valueless. Also, a
housewife’s income in the form of payment towards household expenses by her
husband would fall, atleast in the short term, as he himself struggles to
accumulate cash and adjust to the new system for his business and other
expenses. Hence, it is always prudent not to hoard or save money in the form of
cash. Money has to be properly invested in a portfolio of assets including
equities, fixed income, gold and real estate so as to derive the best risk
adjusted return over the long term. And that rule applies to a women or
housewife as well.
FAQ: At the moment we are feeling the discomfort. When do you think will
real pain start?
Mehrab Irani: The real pain for the poor
is already on. Real pain for the middle classes is less because they use credit
cards, electronic money etc. It will start when their income gets affected.
When production slows then middle class people will face lay off. And then they
will begin to feel the pain. Hopefully, things should stabilize before such an
eventuality but as of now we can’t say anything with certainty.
FAQ: Does the move of demonization solve the problem of black money?
Mehrab Irani: Over the short term,
certainly not as it only creates inconvenience amongst the people. With more
than 94% of employment using currency as means of transaction and wage
payments, due to the fall in money supply by almost 250 bps and reduction in
the velocity of money, almost 250 bps to 300 bps to be shaved off the GDP
growth over the next few months. Over the medium term, upto certain extent yes but
it leads to slowdown in the economy which eats into any of its benefits. Over
the long term, it will add some basis points to the GDP as some amount of
parallel economy joins the normal economy but it cannot solve the problem of
black money on its own unless the root cause of black money – corruption – is
permanently removed and stemmed out of the mindset, culture and system of India.
We have to remember that this black money has been generated over the past 70
years and it cannot be removed out just in 70 days. And we have to understand
the root cause of black money which is corruption. Therefore, if we have to permanently solve the problem of black money on
a sustained long term basis than we have to remove corruption from the system.
Till corruption is there, corrupt people will find ways and means of
accumulating and protecting their black money.
Wishing a prosperous and a corrupt free India.