India's Cash Woes Are Just Beginning
“Give me 50 days, friends,” Indian Prime Minister Narendra Modi asked citizens after he canceled 86 percent of the country’s currency notes. After Dec. 30, if Indians saw his decision as flawed, he promised to “suffer any punishment.” But, he said confidently, if they could bear 50 days of disruption, they would have the “India of their dreams.”
It is now January. While Modi’s deadline has passed, the pain hasn’t. Indeed, it may just be beginning: Measured by the purchasing managers’ index, or PMI, Indian manufacturing actually began to contract last month for the first time in all of 2016. This can’t be blamed on sluggish global demand; the equivalent measure from China suggested that manufacturing there is expanding quicker than expected. Indian companies are suffering from supply-chain disruptions and customers with no cash in their wallets.
True, in some ways things aren’t as bad, at least in metropolitan India, as they were a few weeks ago. The lines at ATMs are shorter and the government even felt comfortable enough to raise the limits for ATM withdrawals from 2,500 rupees a pop to 4,500 rupees (from $37 to $66). But overall cash limits haven’t been eased; most Indians can still only withdraw 24,000 of their own hard-earned rupees -- a little over $350 -- a week, or 50,000 rupees if one has a business account. That’s simply not enough cash to keep supply chains going.
Lines at ATMs thus aren’t the most useful indicator. Even if more cash is getting into the economy, the question is whether Indians are still artificially constrained in how much cash they can access. If so, things haven’t returned to “normal.” And the longer there’s a cash constraint, the larger the ripple effect on the economy.
Here’s a thought experiment, based on how informal, cash-based economies work. For the first or second month that you’re short of cash, your creditors and your debtors, the people you buy from and the people you sell to, are all short of cash as well. Plus, everyone knows the cash crunch isn’t your fault; it doesn’t reveal any adverse information about how healthy your business is or isn’t. So you extend and receive credit relatively easily.
Things can run on such relationships for awhile in the informal economy. But when the outside world -- the formal economy -- intrudes, the system breaks down. When it comes time to pay your electricity bill, or a loan installment to the banks, you’re forced to call in your debts. You may not face enough formal demands in the first month or two to pose a problem. But as time passes, they add up.
A similar process unfolds in the formal economy. Initially, producers will adjust to lower demand by running up inventories; as the economist Ajay Shah has noted, last November, even as car sales fell by 37 percent annualized, production rose by 96 percent. Companies only cut back production when demand doesn’t recover and inventories reach worrying levels. This can take several months. The recent PMI numbers may thus be a harbinger of worse times to come.
In other words, it’s ever more urgent to get cash into the economy, not less. Yet by many accounts, the supply of currency won’t return to “normal” for months. Certainly, the withdrawal limits aren’t being lifted anytime soon. And even if the first-order pain of demonetization -- the absolute lack of cash -- is easing, the second- and third-order pains born of supply-chain problems, production cutbacks and so on are still to be felt.
Modi’s speech to the nation on New Year’s Eve acknowledged that distress was continuing; in response, he announced the raising of working capital limits and the deferment of some loan repayments for smaller companies. It’s not yet certain how much of a difference this will make, though. And the more such measures strain banks in order to help companies, the more likely it is that banks themselves -- already struggling with a bad-loan crisis of unprecedented proportions -- will suffer a post-demonetization hit.
Put all this together and it’s difficult to see how Modi has met his initial promise. Given that nearly all the demonetized notes have been returned, the program doesn’t even seem to have flushed so-called black money out of the system as originally intended. Yet the political consensus is that the Prime Minister won’t “suffer any punishment,” since he’s successfully sold the pain of demonetization as a feature of the program, not an unintended consequence. It’s a great “sacrifice,” he said in his speech, one that will “cleanse” the country. The more pain you feel, the more virtuous you are -- and the more the country is being cleansed. Either way Modi, despite being an awful economic manager these last few months, wins.
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