Tuesday, 24 January 2017


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.