The spat between the government and the RBI is primarily in the realm of macroeconomic issues like the size of the reserves the central bank should hold and the methods of monitoring loans that could go bad. Yet, the political intensity of the government’s moves cannot be missed.

Apart from bringing the never-before-used provision of Section 7 into play, it has also loaded the RBI board with its loyalists. This has allowed the Congress to promptly claim that the ruling party is seeking to tap RBI reserves for an election year spending strategy. And given the credibility of the political class this is a contention that cannot be lightly brushed aside.

The story, though, goes a little deeper than the political rhetoric would suggest. The government’s focus on loans to small business could be a long delayed official recognition that the two major economic initiatives of the Modi government — demonetisation and GST — have had a debilitating effect on small business. The party apparently now believes that if it does not do something to ease the pain on this class, there will be a price to pay in urban constituencies in 2019.

As with all Indian governments since Indira Gandhi’s loan mela days, the instinctive official response is to lend their way out of political trouble. Increasing the access to loans is expected to help small businesses step up their investment on the path to recovery. The trouble is the government may have, once again, got the wrong end of the economic stick. The problems small businesses face are not so much the availability of funds, as the collapse of demand.

When 86 per cent of the currency is withdrawn it is inevitably a major blow to spending. This may well have been one of the short-term pains that Prime Minister Modi spoke of when he announced demonetisation. What the government has not been prepared for is its longer-term effect.

Shifting the goalposts

When the government shifted the goalposts of demonetisation from the removal of black money to the growth of the digital economy, it kept down the supply of cash for several additional months in the hope that it would force people to make the transition to a cashless economy. But this critically underestimated the resilient role of cash in the Indian economy.

A worker who buys her rations every day from her daily wages cannot afford the luxury of taking a cheque even if she has a Jan Dhan account. And with the process of demonetisation making it amply clear that the government can stop you withdrawing money from your own account, the rational thing to do was to hold on to cash. This reduced the circulation of cash, thereby further increasing the shortage.

The lack of cash impaired the ability of those small businesses whose workers had to be paid in currency notes alone. The slowing down of these businesses constrained the demand of both the owners of the business as well as their workers. This decline in demand further reduced investment leading to a further decline in demand, or what economists call the multiplier effect.

Having failed with its unconventional instrument of demonetisation, the government may have felt it was following more economist-approved lines with GST. But economists like to think in abstract terms and are surprised when reality does not obey their abstractions.

The value added tax component of GST was to ensure that each succeeding player in the value chain would claim the tax paid by her predecessor. She then had reason to monitor the taxes her predecessor had paid in order to claim a refund. In reality this tracking is proving to be very difficult. In case there is a mismatch who do we fault, the claimant or her predecessor in the value chain?

Even if the government were to completely overcome that problem, small businesses would still be hurt by GST. Ironically, enough this would happen through the concession that exempts small business from the tax.

Since they do not pay tax those who buy from them would have no refunds to claim. Those at the next stage would then prefer buying from larger companies that have paid the tax. This further reduces the demand for small businesses.

By forcing the RBI to ease lending norms to businesses that have a demand problem, the government is only further compounding the already serious crisis of unpaid loans on our banks. The lesson to be learnt from demonetisation and GST is that we can keep kicking ourselves with knee-jerk reactions.

The writer is a professor at the School of Social Science, National Institute of Advanced Studies, Bengaluru.

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