“Economic Shock & Awe” turns into “Nightmare Without End”

By Don Quijones, Spain & Mexico, editor at WOLF STREET .

On Tuesday November 8, Narenda Modi, the prime minister of India, the world’s second most populous nation and Asia’s third largest economy, announced in a public address to the nation that India’s two biggest denomination notes, the 1,000 rupee and 500 rupee bills, were now worthless and would have to be replaced with newly designed bills.

That was six days ago. Since then all hell has broken loose.

Official Motives

There are plenty of reasons for the government’s action. Partly it was intended to flush out the cash hoardings of black market operators and stop the rampant corruption permeating all levels of business and government in India. It is also part of the government’s plan to thwart counterfeiters and bring more stashed currency into the banking system.

One of the biggest beneficiaries will be the nation’s nascent digital economy. Paytm, India’s largest digital wallet startup, hailed the move. “This is the golden age to be a tech entrepreneur in India. Especially a fintech one,” tweeted Vijay Shekhar Sharma, the company’s founder, whose investors include Alibaba Group Holding Ltd. “Keep the money digital.”

The coffers of both the nation’s government and banks are also expected to benefit handsomely. According to some reports, banks’ non-performing loan ratios have already shrunk in recent days as small and mid-sized businesses that had been defaulting on repayments suddenly started rushing to banks to repay the money they owed. As for the government, it hopes to boost its tax revenues from the current anemic level of 17% of GDP to somewhere closer to the OECD average of 34%.

The problem is that India is not an OECD nation and it does not have the financial logistics or architecture to accommodate such a bold move. In fact, even the world’s most advanced economies would struggle to cope with such a radical financial shake-up.

“Economic Shock and Awe”

Taken together, the 1,000 rupee bill (worth just over $14.50), and the 500 rupee bill ($7.30) account for 86% of the cash economy, in a country where over 90% of retail transactions are performed with cash. In other words, Modi’s move is the economic equivalent of “shock and awe” — the BBC’s choice of words.

The result so far has been pure chaos. Millions have converged on banks to change their now defunct bills for newly designed or lower denomination notes, only to find the banks out of cash and the ATMs empty or out of order. As the FT reports, India’s new Rs2,000 ($30) note, with which the government intends to replace some of the 22 billion currency notes scrapped on Tuesday (despite the fact the new note is double the value of the highest value nixed note), is slightly smaller than existing notes and hence incompatible with the nation’s approximately 200,000 ATMs.









Even those lucky enough to have acquired the new Rs2,000 notes are displeased, as the chronic shortage of smaller notes for change makes them illiquid, unable to be used for small purchases. Naturally, those who can, have used debit or credit cards to make purchases but even they have proven far from infallible as severs have crashed under the sheer weight of transactions.

“A Nightmare Without End”

If things are bad in India’s big cities, they’re even worse in the rural economy that supports those cities, which has ground to a near-halt in the last few days, as many residents have had to travel to neighboring cities to try to change their money, often without success.

Across vast swathes of the Indian countryside small traders and shopkeepers are struggling to maintain their cash flow while small local markets have closed for business in what the Times of India describes as “a nightmare without end.” In the village of Dalan Chapra, nestled in India’s northern hinterland, the cash crunch is forcing residents to resort to the most primitive form of exchange of all: barter.

The disruption has also hit the movement of goods, reports Bloomberg.

More than half of an estimated 9.3 million trucks under the All India Motor Transport Congress have been affected as drivers abandon vehicles mid-way into their trip after running out of cash, according to Naveen Gupta, secretary general of the group. India’s roads carry about 65 percent of the country’s freight.

Crisis Brewing

Such widespread disruption is bound to have serious macroeconomic consequences. The question is how big and for how long. Kaushik Basu, a former World Bank chief economist, believes the government has seriously underestimated the potential economic damage of such “shock therapy,” as significant quantities of both black and white money are taken out of circulation.

It’s “a very risky correction of money supply”, Mr Basu told FT. “Ordinary salaried people, retirees and small farmers who store their legitimate incomes in cash for future durable and rainy-day purchases, will not be able to change all their money for fear of harassment and not being able to explain how they got it,” he said.

“This can be very disruptive, increasing the costs of small business and trade and causing a drop in aggregate demand in the economy, thereby slowing growth.”

According to analysts at UBS, 1.2 percentage points could be shaved off India’s economic growth, which at more than 7% is currently the fastest among major nations. And that’s if cash supplies remain in disarray for just three more weeks, as Finance Minister Arun Jaitley has rather optimistically predicted. A new report warns that currency normalization may take as long as four months, which would be a long time for chaos to eat into the fabric of India. By Don Quijones, Raging Bull-Shit .

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