INDIA IN TRANSITION. The politics behind cash ban

The professed reason for India’s disruptive demonetisation policy was to curb “black money” as well as to combat the proliferation of counterfeit currency tied to criminal and terrorist activities. The short-term liquidity crunch and cascading disruption to the economy have been palpable. The IMF downgraded its growth forecast for India’s GDP during the current fiscal by 1 per cent.

Economists are divided over the merits of the policy, especially on the question of whether a one-time penalty on undeclared cash hoardings is likely to curb the future flow and accumulation of black money. Some believe that demonetisation will permanently change the psyche of the tax evader. Others opine that it will lead to more sophisticated forms of tax evasion and black money hoarding, say, in gold and foreign bank accounts. These disagreements will take time to resolve. Here I consider the politics of demonetisation, as well as its implications for India’s public institutions. Critics take the government’s poor implementation of demonetisation as evidence of an arbitrary, botched operation. This, however, raises an obvious question: why would an elected government carry out such a disruptive policy, one with visible short-term costs to the public and highly uncertain long-term benefits?

One can excavate a political logic to demonetisation, even in its poorly-implemented form. Research on clientelism in poor democracies suggests that politicians have a hard time making credible policy commitments to voters. This is largely due to the institutional weaknesses of the state, which causes a breakdown between the enactment of public policy and its implementation. Because voters cannot assign credit (or blame) for the success (or failure) of a policy, politicians have little incentive to establish policy platforms on which to compete. As one consequence, broadly beneficial programmes such as education and health, which depend critically on the implementation capacity of local agencies, are likely to be underprovided.

This reasoning does not imply that poor democracies provide no public goods. Within such settings, Anandi Mani and Sharun Mukand argue, politicians deliver public goods based on their visibility. They enact those features of policy voters can ascribe credit or blame for. Extending these arguments to poor democracies in Africa, David Stasavage (NYU) finds governments expand primary schooling by abolishing school fees, for which they can claim credit.

Meanwhile, democratically-elected governments have little impact on the implementation and quality of education services, a complex process that is more difficult to monitor. Consequently, politicians reap rewards by expanding access to primary schooling, even while the system fails to deliver quality education.

Let us extend this logic to Modi’s shock announcement to demonetise 86 per cent of currency in circulation. In one fell swoop, every Indian was forced to reckon with state power. Long lines at banks across the country served to reinforce the image of Leviathan’s presence. If the goal was to convey the government’s seriousness about corruption, then it is hard to imagine a more visible display of effort. The subsequent media blitz branding demonetisation an anti-corruption measure further suggests that visibility was an important consideration to the government. Whether or not the policy achieves any of its ostensible economic aims is beside the point. From a political perspective, all that is required is for voters to draw a connection between demonetisation and an earnest attempt by the Modi government to fight corruption. State action, however punitive to the public, is a sign of political effort.

To be sure, visible disruption of this kind is a risky political strategy, for if voters can assign credit, they can also assign blame. In a poor electorate, the uneven distributional consequences of demonetisation must also be considered. The suffering has been greatest for those whose living depends on the cash-based informal economy, which accounts for an estimated 45 per cent of India’s GDP and 80 per cent of its workforce. Supply chains in agriculture were dealt a massive blow, hurting farmers at the critical rabi sowing season. A slowdown in construction and allied industries compelled migrant workers to return to their villages. The rural poor were hit particularly hard due to the low penetration of bank accounts and ATM machines outside of urban centers.

Still, public opinion may turn out in the BJP’s favour. If voters do not expect public institutions to function well in the first instance, they may not blame the Modi government entirely for implementation failures. (Corrupt bank officials may also share some blame). The government, meanwhile, can take full credit for trying to curb black money. If institutional weakness makes demonetisation a viable political strategy in the first place, it may also serve to mitigate the downside political risks for the BJP. Whether voters in weak institutional environments assign credit and blame for visible policies in symmetric fashion is an open question.

What implications do the politics of visible disruption have for the Indian state? Diminished faith in the RBI is a first-order concern. The secretive and seemingly capricious manner in which old currency was declared illegal and new notes issued has brought the RBI’s independence into question. During the first 50 days, the RBI issued 59 public notifications. Ad hoc changes to the rules for the deposit and withdrawal of money fuelled uncertainty. Logistical preparation was sorely missing as well. Public criticism, by former RBI governors and current employees, indicates serious reputational damage. If private investors lower their estimates of RBI credibility, India may lose access to capital, which it needs desperately to grow the economy.

An elite, historically competent institution like the RBI may weather the disruption. Potentially more harmful are the ramifications for everyday functions of the state. Take tax collection, for example. Recently released data show that only 1 per cent of Indians paid income taxes in 2013. India’s tax to GDP ratio of 16.6 per cent is much lower than the 21 per cent average for emerging economies and 34 per cent for OECD countries. The state’s ability to catch and punish tax evasion is demonstrably weak, a problem that demonetisation cannot tackle on its own. Tax agencies are in need of painstaking reform. Taxation capacity depends on societal compliance, which turns on the trust that citizens have in public institutions. The Government has the opportunity to reform tax agencies in a professional direction. Yet, the motivation to enact visible, disruptive policy measures runs counter to the complicated, long-term endeavour of state-building. In the end, if demonetisation “works” electorally, one must ask whether it comes at the cost of India’s institutions.

The writer is an Assistant Professor at Harvard Business School.This article is by special arrangement with the Center for the Advanced Study of India, University of Pennsylvania

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