The Modi Government is taking a huge political gamble in trying to transform India’s financial system
Siddharth Singh | 05 Jan, 2017
Imagine yourself as a member of a low-income family working in one of the millions of informal enterprises that dot the Indian landscape, earning a few thousand rupees every month. What would you say if you woke up one morning and discovered that you’re richer by a tidy Rs 100 crore?
Sounds like the plot of a Bollywood film and not the grim life of a poorly-paid worker. But something like this did pan out in the life of Sheetal Yadav in Meerut, an industrial township near Delhi. In the last week of December, just days before the end of Prime Minister Narendra Modi’s ambitious demonetisation exercise, Yadav discovered that her no-frills Jan Dhan account had been credited with Rs 100 crore. Flummoxed, she ran to her bank branch asking officials there to help her out. When no help—or explanation—was forthcoming, Yadav and her husband drafted a letter addressed to the Prime Minister.
This is just one example of the mad rush to get rid of the old Rs 500 and Rs 1,000 notes that ceased to be legal tender after November 8th when Modi outlined his plan in an evening speech to the country.
Within hours of the announcement, gold sales across the country shot up. In Mumbai, Delhi, Pune, Bengaluru, Hyderabad and a host of other cities, hundreds of kilograms of the yellow metal was sold at a rate not seen even during the festive season. In the days and weeks that followed, curious things occurred across India.
These abuses are a classic example of what Indians love doing: engaging in jugaad. The term defies exact translation and the word ‘innovation’ does this practice a disservice. No one knows when jugaad originated—most likely in India’s socialist days when scarcity of consumer goods and services forced Indians to find ways around the system—but the practice made a comeback in the last two months of 2016. From jewellers deliberately under-invoicing sales below Rs 2 lakh to escape tax scrutiny to bank managers siphoning off scarce new currency even as ordinary people stood in serpentine queues to get hold of a few notes, India seemed to have returned to the 1970s almost overnight.
If this were not enough, the number of alarming instances of bank officials colluding to allow favoured persons access to large amounts of cash in new currency, even as there was virtual rationing of notes for ordinary customers, showed the dangers of discretionary power enjoyed by branch managers. It also pointed to the lack of prudent regulation by some banks of branch-level operations. At the moment, a number of bank officials—mainly from private sector banks—are being investigated for collusion and possibly corrupt practices during the demonetisation drive. Handing out large volumes of cash was not the only possible illegality. There were more serious infractions as well.
There is plenty of evidence to show how efforts were made to subvert the Government’s demonetisation plan. The abuse of Jan Dhan accounts—meant to be an instrument of financial inclusion for India’s poor—exemplifies this jugaad economy. Launched in August 2014, many of the millions of zero-balance accounts under the scheme remained dormant for more than two years until November last year. Data released by the Government at the end of December shows that deposits in these accounts surged by Rs 29,000 crore between November 9th and December 28th. By the last week of December, the amount in these accounts had swelled to Rs 74,610 crore. What needs to be remembered is that the upper limit for deposits in Jan Dhan accounts is Rs 50,000. Now, when the demonetisation exercise is over, these accounts are witnessing large withdrawals. In the last fortnight of December, these amounted to Rs 3,285 crore. Going by these figures, it would seem that India’s poor are doing remarkably well in economic terms. But the large number of Jan Dhan accounts that have remained dormant—around 24 per cent—shows the surge had other, less charitable, reasons.
In recent weeks, parallels have been drawn between Modi and Indira Gandhi. But the effort to limit the informal nature of the Indian economy, perhaps, points to a comparison with another moderniser: Nehru
EVEN IF ONE ignores the chaotic events in the weeks after the rollout of demonetisation, 2017 promises to be a challenging year for the Modi Government. There are three different issues the Centre has to confront out of necessity. Two of these are almost of an immediate nature, while the third, borne out its ambitious efforts to transform the Indian economy, is likely to take more time and certainly far greater effort.
The first problem is the gigantic task of checking, verifying and finally prosecuting—in case there’s evidence—the huge number of cash deposits made into accounts of various kind. This is something the Government cannot back away from if it wants its claims of cleaning up black money to be taken seriously. But if it decides to do so, it has to contend with the danger of a runaway tax bureaucracy that may not only end up harassing honest taxpayers but may even end up scaring potential investors. There are eerie parallels with the 1970s and 80s when taxmen were probably the scariest functionaries of government.
In reality, however, matters need not be so dire. A couple of cases of successful prosecution can tip the balance of expectations and make wrongdoers fall in line as well as deter potential ones.
“Technology makes it feasible to have a more efficient tax system, but how the enhanced capability is used very much depends on the individuals and institutions running it—just as technology makes it feasible to drive a car faster, but whether it actually happens depends on the quality of roads and the driver. So I do think the problem is with institutional capacity, as we saw with the implementation of the demonetisation policy, some of the siphoning of black money happened with active collusion with some bank employees,” Maitreesh Ghatak, a specialist on the political economy of India and a professor of Economics at LSE, tells Open. “It is not an insurmountable problem, though. All it would take is a couple of cases where the guilty are visibly brought to book to shift expectations.”
A second, unrelated, problem that may confront the Indian economy comes from the working of the global economic system. In contrast with the previous two -three years, this year is witnessing a hardening of global oil prices. Already, crude oil prices are hovering around $55.
A combination of databases—PAN, KYC, Aadhaar, the GST Network being created—will ensure that informal enterprises no longer evade taxes. One big source of generating black money will be checked to an extent
While India has successfully handled high oil prices earlier this year, it may prove challenging if oil heads north. One negative impact of demonetisation will be the shaving off of India’s growth rate this year. While exact estimates have been the subject of controversy, slower growth for one or two quarters will be quite likely. This is because India’s economy—except for a small formal sector—is a vast layer of informal enterprises dependent on cash to lubricate their business. An external shock due to high oil prices will be an unwelcome issue that the Government will need to tackle with urgency.
The other global economic issue that may affect India is the slow upward creep of interest rates in Western economies. This is happening, especially in the US, due to dangers of prolonged negative real interest rates, and, even if somewhat remote, fears of inflation. Seen together, the combination—hardening oil prices and rising interest rates—does pose a risk for India even if it is underappreciated at the moment. It is not that India is vulnerable in any way—deficits are largely under control—but such global cues make the task of macroeconomic management difficult and divert attention from other, more pressing, tasks that need attention. For example, if due to unforeseen global events, the Government has to undertake a spending programme, then that adds to economic pressure. Something of this kind hit the last Government in 2009. The events of the last six months, which include hints of higher interest rates from Western central banks, the rise in geopolitical risks (due to events in West Asia, South China Sea and Europe’s Russian periphery) and the deal between OPEC countries that seeks higher crude oil prices, all point to a potentially turbulent 2017.
Those headwinds will take away the relatively quiet waters the Government sailed through for the first few years, adds Ghatak.
These issues, however difficult they may be to resolve in the short run, remain insignificant when compared to the huge challenge implicit in what Modi is trying to accomplish. In the last 10-12 years , the focus of governance tilted so heavily towards day-to-day management that institutional issues became a casualty. In fact, these years can almost be seen as a series of economic and political troubles interspersed with periods of relative calm. The net result is that issues of nation-building were almost discounted totally.
Against this background, the attempt to move to a digital, cash-less economy is no less than an effort to transform India’s economic landscape from a largely informal set-up to a modern one. There has been only one earlier ambitious attempt at such a thorough transformation since 1947.
Some numbers help in understanding the context of the changes being attempted. Of the estimated 500 million workers in India, roughly 83 per cent are in the informal sector, which employs less than 10 workers per unit. The actual informal employment is a bit higher, around 90 per cent. The informal sector is not regulated in any way. Most establishments—factories and production units—do not pay taxes and are not registered with any government agency. This work is not illegal, but the truth is that it generates black money—money that is not taxed.
The word ‘informal’ suggests something that is ignored very often. The productivity of this sector is low. One reason for this is the very few incentives that such ‘shops’ have for investing money in plant, equipment and skilling of its workforce. It is a vicious cycle: for such investments to be viable, the size of the unit will have to be increased. But once that happens, the owners of these units will have to pay taxes, something they are loath to do. The net result is that workers in the sector barely eke out an existence, and the sector—which has potential to generate employment— is trapped with outdated technology and few skills needed to survive in a modern economy.
Modi’s final challenge is to fix what India has seen for a very long time: a government being run by jugaad
In the heyday of socialism, the Jawaharlal Nehru Government sought to overcome this problem by creating a modern public sector that was expected to industrialise India. That sorry story need not be repeated here.
Instead of replicating that experiment, Modi has approached the problem from two different angles.
On the one hand, the effort to reduce reliance on cash and vastly increase digital payments will bring these undertakings on the regulatory radar. A combination of databases—Aadhaar, the GST Network being created, PAN, KYC to name a few—will ensure that informal enterprises no longer evade taxes. One big source of generating black money will be checked by this measure to an extent. This does not mean that black money won’t be created, but that making it will become increasingly costly even as the cost of paying taxes and complying with government regulations will make more sense.
On the other hand, these enterprises need help to survive in the modern economy. This is the context of Modi’s December 31st speech, where he announced a number of measures for small scale enterprises, enabling them to avail credit. Among the measures he announced, the key ones included the promise to guarantee/ underwrite loans up to Rs 2 crore instead of the current Rs 1 crore for small businesses. Further increases in lending by banks and a change in the way income tax is calculated for small businesses topped up the slew of promises. Viewed dispassionately, this combines a generous dose of credit availability with an incentive for these businesses to submit to the tax net voluntarily.
Can this help transform India’s economic landscape?
“The weight of global economic history is against [Modi],” says V Anantha Nageswaran, a keen observer of the Indian economy. Along with Gulzar Natarajan—a civil servant who worked in the Prime Minister’s Office under Modi—Nageswaran is the author of Can India Grow? Challenges, Opportunities, and the Way Forward, a book that looks at this issue without blinkers.
In a conversation with Open, the Singapore-based Nageswaran highlighted the challenges ahead. “In terms of being an enabler, you need to do much more than provide credit. That is only one part of the job of transforming the informal sector,” he says.
There are two problems at hand, says Nageswaran. One, you need much more than credit availability to survive in a modern economy. It is true that small Indian firms, especially those who want to work, often find it tough to get credit, but this is only one aspect of the problem. To compete with enterprises in the formal sector, small enterprises—a huge number of which are no more than small workshops—need skills. “Otherwise you get squeezed out. The danger of that happening in India is very real,” he adds.
It is not as if the Government is not aware of this: the emphasis on skill development through the National Skill Development Corporation and the effort to revamp educational policies appears to be a part of this package. The issue is that all these efforts have to fall in place together, a task rendered difficult by India’s institutional weaknesses.
The other potentially serious risk, says Nageswaran is that “these efforts may not lead to the desired transformation—at least to the extent desired—and the generous credit given to these enterprises may lead to banks holding more bad debt.”
Perhaps it is unfair to ask a first-term Prime Minister in his third year to sort out what are arguably long-standing problems. But then this is the gauntlet he has picked up. His final challenge perhaps is to fix what India has seen for a very long time: a government being run by jugaad. India is perhaps alone among countries of its size and economic output that has a very low tax-to-GDP ratio (the percentage figure is in the mid-teens). Libertarians—who believe in minimal government—have an expression called ‘starving the beast’ whereby state intervention is minimised by reducing the amount of tax available to government for expenditure. The Indian Government by this measure has been starved for a long time if one looks at the scale of its commitments, from defence to higher education, healthcare to providing employment guarantees to poor citizens. If even a right-minded government were to eschew spending on these programmes, India’s governance infrastructure—from its outdated bureaucratic structures to the weak governance capacity of state governments—cries out for modernisation. That requires money and investment in technology and training of manpower. Since liberalisation, if not earlier, this has remained a rather low priority area for most governments. The situation is incongruous when one compares the number of taxpayers with the size of the electorate: the former pales into insignificance
As if all these challenges are not enough, there are rising demands to either slash the rate of income tax or, more extremely, even get rid of it. While the Government can safely ignore these demands, the political pressure for them is very real. An economic case for lower taxes does not exist, Ghatak argues.
“Only 1 per cent of Indians pay income taxes and it is out of line even allowing for India’s low per capita income. Whether it is the informal sector or the agricultural sector, people whose income is above a certain threshold ought to pay their fair share of taxes. The middle-class gets all sorts of sops through subsidies (such as for fuel), public education, not to mention the income guarantee that being part of the salaried class provides, a luxury most of the population does not have,” he says.
So where does this leave Modi and his efforts to impart a modernising push to India? In recent weeks, especially after demonetisation, parallels have been drawn between him and Indira Gandhi. But the effort to limit the informal nature of the Indian economy, perhaps, points to a comparison with another moderniser: Nehru.
“The comparison with both Nehru and Indira Gandhi is very valid… he is trying something very different but also very similar. ‘Garibi Hatao’ (remove poverty) and a strong government were Indira Gandhi’s hallmarks. In his own way, by trying to promote entrepreneurship and using technology, Modi is trying to change India. Let us not forget that he is a policy entrepreneur,” says Nageswaran.
Soon the Modi Government will present its third Budget. In India, usually after the first Budget, governments hunker down and just get on with the business of day-to-day running of the country while keeping an eye on the next election. The idea of taking risks is anathema to most governments. It is a rare government that has the courage to take huge political gambles as it enters its third year. The surprises that have come in the last decade have been of the populist, welfarist kind that have proven expensive. Given its record of the past years, there may be more policy surprises in store from the Modi Government. Don’t rule them out.