This Indian Professor tells us exactly how the demonetization will fail to curb black money.

Amidst a growing culture around the world characterized by “if you’re not with us, then you must be with ‘them’”, I hope my post will be read with an open mind and will be taken in the right spirit.

A lot of eminent people have lauded the recent move by the government to ban R.500 and R.1000 notes as bold and a master stroke. Any objections to this move have been primarily based on the day-to-day inconvenience it is causing to common people. Proponents of the move have urged their fellow citizens to bear with these inconveniences for the larger good - the interest of the nation. But is there a clear case for its effect on the economy to be positive?

The key assumption behind the move is that the large informal economy in India (estimated to be almost equal in size to the formal economy), will now be forced to integrate with the formal economy giving it a huge boost. While the note ban would no doubt stifle the informal economy, have we created the other necessary conditions for the informal economy to join the mainstream? Clearly, no. If we do not create these facilitating conditions alongside with the measures to restrain the informal economy, then we are addressing only a part of the problem, and further aggravating the situation. It is like demolishing slums without creating alternative housing for the slum dwellers. Let me explain it better by taking the example of one important part of the informal economy - the informal lending market.

The informal lending or credit market exists in parallel to the formal credit markets such as banks (state, private, co-operative), non-banking finance companies (NBFCs), micro-lending institutions etc. The informal credit market, which is estimated to be nearly equal in size to the formal one, consists of local moneylenders, pawnbrokers, politicians etc. The annual interest charged in this market could range from 18% to 300% and the lenders are typically portrayed as villains. Despite their many ills, many studies around the world have established the important role played by these players and the informal credit markets in supporting the formal economy.

This is because the borrowers in this market are typically small entrepreneurs, uneducated and unskilled laborers, slum dwellers etc. who are assessed as non-creditworthy by the formal lending institutions and hence do not have access to formal credit. Informal markets are the only source of credit for these borrowers, who nevertheless contribute significantly to the economy through millions of small businesses. The scale of operations in this market is very small with the loans ranging from R.500 to R.5000, there is hardly any collateral and the entire money circulation is typically in cash.

Now I urge you to assess the impact of the note ban on this constituency. Because the high denomination cash is rendered worthless, a major part of the supply is cut off, at least temporarily. But the demand is still there! And there are no alternative sources of credit available to these borrowers. It is true that millions of bank accounts have been opened under the recent Prime Minister Jan Dhan Yojana, but that doesn’t make a difference as the banks’ lending conditions (need for collateral etc.) remain unchanged. Do you think banks will start lending to them overnight? No chance! So you will see a skyrocketing of interest rates in the informal market in the short term, much beyond the already exorbitant rates.

Over a period of time new cash will be generated, but meanwhile, the squeeze on the borrowers, who are probably the true middle class, will be immense. A significant proportion of this borrower-base consists of small entrepreneurs who contribute to a large portion of our economic activity. It will be great if they can be brought into the mainstream economy but any measures for doing that are conspicuously missing in the recent announcement.

So the ‘inconvenience’ to the common man is not going to be merely temporary as being assumed by the government. In fact, unless the government comes up urgently with a series of mechanisms to facilitate the integration of the informal economy with the formal, this move has all the potential to even bring down the government in the next election.

To repeat, it has similar political and moral implications to demolishing slums without creating alternative housing. The key difference, in this case, is that the affected population is not just marginal, but actually constitutes the core India, arguably the real India. Politicians can go against them at their own peril. Viewed from this perspective, you have to agree with the experts that it is indeed a bold move!

The author is Dr. Raveendra Chittoor, Associate Professor of Strategy and Canada Research Chair, University of Victoria, Canada