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The Case for Financial Infrastructure: Rural Welfare after Indian Demonetization

November 18, 2016
India’s Prime Minister, Narendra Modi, recently made an extremely bold move: he took high-denomination currency, including the 1000 and 500 Rupee notes, out of circulation. With the world caught off guard and supporters cheering his name, we ask: what is the effect of this move on the rural and agrarian classes of India? How do we improve its prospects?

By Prakash Mishra

The cashless contingent won a major victory in India with Narendra Modi’s surprise announcement that higher-denomination bills would be taken out of circulation. Recent years have seen a strong movement towards cashless systems advocating that the underpinning of crime is in fact cash, and classic advocacy mentions the cases of high profile Stockholm bank robbers and the undying presence of drug dealers. [1] The world was shocked when Modi took a step towards this goal. His plan was to collect 500 and 1000 rupee notes primarily over the course of two bank day holidays, November 9th and 10th. In a world relying on cash for 85% of its dealings [2], it is no surprise that these holidays were not enough, leading to an infrastructural vacuum[3] to be addressed over the next few weeks.Modi’s reform will likely cause tax evasion and cash-based criminality to have higher opportunity costs in the short-term, forcing such parties to interact with the government. The legislation is further expected to be quickly succeeded by further tax reform that pushes the tax base beyond 4% of the nation.

There is a real problem in reporting on this story in that opinions on Modi’s Bharatiya Janata Party, or BJP, are rather diametric. The moderate ground is quite fallow and journalists have inherent biases on the issue. This piece therefore assumes the policy is being enacted in full, and does not attempt to condemn or laud the policy. We rather choose to assess its implementation, using a series of interviews and some research and analysis, and understand it on a novel dimension that warrants renewed consideration. Critically, we conclude that there is no substitute for financial literacy and infrastructure reform, and this better serves as a prelude than an afterthought in the implementation of the policy.


One of the quintessential parts of the Indian economy is the transmittance of remittances, or the transfer of money from migrants who left India to family or communities in India. In the South Indian state of Kerala, 230 crore (or 2.3 billion) rupees[4]are transferred each day via remittances, or a massive 36% of the state’s GDP . There is a real short-run problem, therefore, with collecting large denomination bills. Studies have repeatedly confirmed the prevalence of remittances in semi-urban and rural areas, where much of household leveraged assets like mortgages, car rentals, and other durable purchases [5] are largely buttressed by remittances.

Image: India is consistently the highest remittance-receiving nation in any analyses. Source: <a href="http://blogs.wsj.com/indiarealtime/2015/04/15/india-wins-the-remittance-race-again/" target="_blank">Wall Street Journal</a>Image: India is consistently the highest remittance-receiving nation in any analyses. Source: Wall Street Journal

Much of the short-term liquidity for rural and semi-urban populations comes remittances, and this becomes the source of much of their credit as well. As larger denomination bills are phased out of banks, the ability to cover the cost of durable purchases in these communities must shift in a way that can severely harm the long-term viability of credit in these communities. Even essential services like schools in many communities [6] are built on the backs of remittances.

So why does cash specifically lead to these effects? Roughly 200 to 300 million people in India [7] have bank accounts and receive money directly via wire transfer. And though the same source argues Indians can live off of bills of denomination which are less than 250 rupees, the loan market in India is critically underserved [8] and small short run fluctuations can cause major instability in small communities. There is a strong sense of vengefulness in the loan community and the number of unstructured loans which are highly volatile is notoriously large in India. It becomes all the more essential that this reform take the remittance issue into account. How does that happen? On the infrastructural dimension, Modi must provide strong liaisons to rural communities beyond bank holidays. ATMs have stopped giving out larger denomination bills already, but many rural businesspeople and small businesses are attempting to collect larger denomination bills [9] on their own in an act of self-defense against their liquidity crises. There is an intuition here; if the nation is asking people to dramatically decrease their liquid assets, they must also provide an illiquid counterpart. This is exactly what the United States financial system did not do; it deregulated securities in the late 20th century, but did not require a commensurate increase in reserves within banks. Thus, volatility went up and we faced the Great Recession.

Proposal: Infrastructural Reform

It thus follow that if India wishes to prevent a bottlenecking in rural areas due to remittance siphoning in the short run, it must provide some form of an infrastructural security for rural individuals. Perhaps this means when large denomination wire transfers are wired, providing large denominational cheques or bank notes and establishing a system in which the ruralites of India have guaranteed access to funds. In the absence of this, we only allow the problem to fester.  While electronic payments have been lauded as the future, they under-serve the communities most affected by demonetization. There must be a less development-tied piece of financial infrastructure in place for rural India before urban India further modernizes its interpersonal system. Otherwise, these markets pay the price. This should obviate that Modi’s reform is not inherently bad, and the purpose of this analysis is not to determine whether his policies unneeded or needed–that would be another argument altogether. However, there must be a greater system which can substitute liquidity in rural markets, even if it is a short term regulation on loan interest rates, or the general creation of a stronger financial infrastructure tailored to the rural poor. One could see the case for anything from microfinance to large denomination bills under conditional cash transfer parameters (e.g., if the bills are being used for durables, the money is given in larger denominations, with a slower phase out of the bills over time).

India is a nation that has been plagued by loan sharks and tax evasion. Modi’s intent is to increase the tax base and consolidate a tax base for his government while cracking down on financial crime. This short term solution is meant to bring people to banks or, in the case of rural areas, post offices, and exchange these bills for others. There is no need to comment on this strategy, as it has been repeatedly analyzed by economists from Manmohan Singh to Alan Greenspan. The critical measure of this law is what it could have been, and whether if other steps were taken it would have been needed. Inarguably, the financial literacy of the rural poor and their ability to deal with a society with less cash in the system and more lower-denomination bills are correlated. In fact, in order to deal with lower-denomination currencies, the ability to save becomes a premium skill for the rural poor. Modi’s key job is to now ensure this effort does not become the classic story of unequal gains by establishing greater infrastructure, even if it is in the form of allowing higher denomination bills in high-risk areas for key financial services (mortgages and other leveraged durables) as conditionals on financial education. There is something admirable in the consolidation of his tax base, but unless he accomplishes this core reform, there will be a short run liquidity crisis for the rural and the poor, which can lead to long term negative effects in the loan shark world.

Conclusion and Context: The Macroeconomy

As savings will go up [10] in response to the lower liquidity level of the nation as a whole we can also expect to see a rise in inflation, which actually counterweights many of Modi’s other reforms. Farmers will likely be hit as the price of their crop is actually lowered by a weaker rupee ceteris paribus, meaning we can expect further long-term effects of the reform in the agrarian class. Some argue he has accounted for this through subsidies and his fiscal policy choices, but this may not entirely be the case.

Image: India's inflation rate over the past 14 years. One can see a peak in the inflation rate around 2012, but since Narendra Modi came into office they have been fairly low. It is unclear whether this legislation may change this. Source: <a href="https://www.statista.com/statistics/271322/inflation-rate-in-india/" target="_blank">Statista</a>Image: India's inflation rate over the past 14 years. One can see a peak in the inflation rate around 2012, but since Narendra Modi came into office they have been fairly low. It is unclear whether this legislation may change this. Source: Statista

We should note that here we are assuming this decision is made in a vacuum, but this is not necessarily unfounded. Modi’s central promise to give farmers higher prices to their crop has been repeatedly downweighted by infrastructural and other reforms whose inflationary prices rather directly cause agricultural prices to go up [11]. In other words, as we challenge the effect on rural India and remittances, and ask for more conscientious infrastructure, we also must be careful in that we could destabilize Indian agriculture even more so than it has been over the past ten years. This is obviously a worst case scenario, but as conscientious financial infrastructure reform takes place in India, the critical challenge is not how fast the reform goes down. It’s who, at the end of the day, pays the price. In this case, unless farmers know how to deal with these new hurdles with cash by using the money they can’t extract in the short run to save, and in the long run develop practices that allow them to grow, then perhaps there is little to fear in the legislation after all.


  [1] http://www.newyorker.com/magazine/2016/10/10/imagining-a-cashless-world

  [2] https://hbr.org/2016/05/the-countries-that-would-profit-most-from-a-cashless-world

  [3] http://economictimes.indiatimes.com/news/politics-and-nation/demonetization-should-not-create-inspector-raj/articleshow/55321528.cms

  [4] http://www.newindianexpress.com/states/kerala/2016/nov/15/cash-crunch-hits-foreign-remittance-channel-1538651.html

  [5] http://www.hindawi.com/journals/ijpr/2013/610193/

  [6] https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3048112/

  [7] http://thewire.in/78694/paper-money-ban-rs-500-rs-1000-notes-explained/

  [8] http://www.bloomberg.com/news/articles/2016-03-14/day-of-reckoning-coming-for-india-s-pigs-with-lipstick-lenders

  [9] http://timesofindia.indiatimes.com/city/guwahati/Guwahati-traders-beat-demonetization-effect/articleshow/55364369.cms

  [10] http://economictimes.indiatimes.com/news/economy/policy/move-to-demonetize-economy-will-help-bring-down-inflation-arvind-panagariya/articleshow/55368242.cms

  [11] https://publicpolicy.wharton.upenn.edu/live/news/1193-modis-rural-challenge-balancing-poverty-and

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