The background to this ‘demonetisation as surgical strike’ is worth recounting. During the UPA 2 period ending in 2014, there was a massive, popular upsurge against corruption in high offices, the scourge of crony capitalism. Middle classes were united in anger against scams that involved public offices; they ranged from allocation of spectrum in telecommunications to coal mining. In the background were mounting unpaid loans of big business houses (Non-performing assets)) of the public sector banking system. This public fury was also based on ground level despair about poor public services for the common man, unemployment, inflation and yawning inequalities.
A popular campaign against corruption gained momentum culminating in the defeat of the ruling government. The BJP had led the attack inside the Parliament and was its major beneficiary. Its election campaign thereafter was replete with promises of clean capitalism with strong, good governance and recovery of ill-gotten wealth for distribution among the people; its victory was a land slide.
Two and a half years into their rule, no significant benefit of the so-called strong, clean, good governance was visible to the people. Economic growth had recovered from sluggishness, crossed 7.5%, driven by domestic consumption and global low fuel prices, but that growth number did not translate into low food inflation, jobs, improved public services or welfare delivery. Looking for multifarious ways to keep up the momentum of public support for impending local and state elections, yet another rabbit was pulled out of the bag. On 8 November 2016, in an unprecedented move, the Prime Minister (PM) and not the RBI (Reserve Bank of India) Governor announced that Rs. 500 and Rs. 1000 notes would cease to be legal tender. This was a framed as a purification drive to flush out black (unaccounted for money, estimated to be 20% of GDP), push cash back into the banking system where it can be accounted for, and instill honest tax payment habits. It was claimed that this exercise would also end counterfeit currency circulating in the country that was used to finance anti-national activity. This was supposed to be a master stroke, simultaneously managing public perception, delivering good governance with patriotism.
Within weeks, the exercise unraveled to become an unprecedented economic contraction caused by a shortage of the medium of exchange. A bulk (86%) of the currency in circulation had been withdrawn in a cash based economy, but there was no provision of replacing it with small and large denomination notes to quickly plug the shortfall. In rural areas where banks to exchange notes are too few, strangely, cooperative banks and regional rural banks were kept out of the exercise. Even in urban areas, short-staffed and poorly supervised banks were slow to disburse new currency. While adequate supply of new currency notes just did not exist, an illicit market grew around exchange of old notes for new, in which it is reported that bank officials also participated. Within a month it was out of control and banks were not only rationing cash withdrawals, but declaring that there was inadequate supply to feed ATMs. The impact on the informal bulk of the economy, entirely dependent on cash is also expected to be severe. This means that production, employment and income flows will be stalled, if not lost, in successive time periods.
For now, new notes for old will demonetise only those notes that do not come back into the banking system. Banking officials expect almost all the old notes, worth 14 trillion rupees, to come back into the system, leaving it to the Income Tax authorities to decide which portion of the inflow is unaccounted money, to be fined and taxed. An exercise, that may go on and on for a long time causing an erosion in business confidence. That is the best case scenario. Twenty thousand tons of paper is being imported for printing currency; however, if some events slow down injection of new currency, loss of trust in banks and more disasters that follow, may be unmanageable.