> Posted by Jayshree Venkatesan, Financial Inclusion Consultant

On November 8, 2016, the Prime Minister of India made an announcement that notes of denominations Rs. 500 and Rs. 1000 would become illegal tender overnight in a move that was termed demonetization. In turn, the government would issue a note valued at Rs. 2000, which would replace the notes taken out of circulation. According to the RBI’s most recent annual report, the total currency in circulation in India was INR 16634.63 billion (~USD 256 billion). The withdrawn notes constituted nearly 85 percent of this currency.

Phasing out old notes and replacing them with new ones is a standard practice followed by central banks globally. In the Indian context, however, there were two factors that contributed to this standard practice resulting in chaos and an economic shock on the poor.

The first was the short span of time given to react. The announcement was made on television after business hours on November 8, and the affected tender was rendered illegal by midnight of the same day. As a result there is enormous pressure on the banking system, and a frenzy of citizens trying to make the necessary adjustments. The second factor was the disproportionately small share of Rs. 2000 notes ready to replace the phased out currency. While the short span of time resulted in an instant shock to several segments of the population that predominantly operate in the cash economy, the limited Rs. 2000 notes translated into a cash crunch that has brought large parts of the economy to a grinding halt.

This leads one to wonder if Indian policymakers and the decision-makers behind this decision truly understand the financial lives of the poor.

How do the poor manage their money? Lesson 101

Poverty is not a static phenomenon. Several research studies show that it takes just one financial shock to drive a vulnerable family back into poverty. This is due to a combination common to those who are financially vulnerable: uncertain incomes and the absence of a financial cushion to absorb the impact of unpredictable life events. For example, health shocks or a death in a family may require huge (in comparison to income) financial outlays. In the absence of access to relevant formal financial services, the poor devise their own solutions, which may be sub-optimal to effectively protect them from these external shocks. The Global Findex 2014 reported that India was home to 21 percent of the world’s unbanked adults. Even amongst account holders, the same report found that dormancy rates were high at 43 percent.

Globally only 40 percent of adults who save do so in formal financial instruments, according to the Global Findex. Most people use a combination of formal, informal, semi-formal, and in-kind savings instruments. Semi-formal savings mechanisms include instruments like chit funds or rotating savings and credit associations (ROSCAs), or even “liquidity farming”, which is the cultivation of relationships with family, friends, employers, money lenders, and others who can supply cash when needed. Many people simply store their money as cash.

The reliance on informal or semi-formal mechanisms in spite of access to formal bank accounts is driven by factors like dignity, trust, convenience, and accessibility. The poor are often uncertain that they will be able to access their money when they need it the most, like in the middle of the night for a health emergency, or when banking systems don’t work.

But India received a high rating on an enabling environment for financial inclusion…

Results from the recent 2016 Global Microscope study, which rated country environments in terms of being conducive for financial inclusion, showed that India ranked third globally and had made the most progress of any country. Account ownership had risen dramatically between 2011 and 2014 from 35 percent to 53 percent. A leading task was to reduce the gap between access and usage and government policies between 2014 and 2016 seemed aligned to this effort. Through Direct Benefit Transfers from the government, by April 2016 $900 million were transferred to 300 million customers under 56 government schemes. A huge drive was conducted to solve the persisting access challenge through the Pradhan Mantri Jan Dhan Yojana (PMJDY) program. Challenges in documentation were overcome through the Aadhaar national biometric identity program. In fact, as of April 2016, about 221 million accounts were opened as part of the program, according to claims by the Ministry of Finance.

Access to a savings account, however, does not mean all savings are held in these accounts. For the poor, the economic costs of travelling to a bank branch several kilometers away and waiting, and in the process foregoing their daily wages, can be significant. Additionally, if this is the first time clients are interacting with formal financial institutions, there are psychological costs of transacting with banks that can be seen as unfriendly or intimidating. Even in the southern part of India, which has the highest number of bank branches in the country (the four southern states have about 25 percent of the total bank branches in India), a study by Amy Jensen Mowl and Camille Boudot (2015) found that psychological costs associated with visiting a bank can impose a high barrier to banking. In areas with fewer bank branches, this fear is compounded by the time and economic costs. The poor, therefore, by and large continue to hold savings in the form of cash.

 India’s large informal economy and the impact of the recent policy

The Reserve Bank of India published a working paper in 2013 which revealed that despite access to formal institutions, over two-fifths of rural households in India continue to depend on informal sources of credit, including professional money lenders, agricultural money lenders, friends, and family. All of these are transactions that take place in cash. The government’s demonetization actions have jeopardized all such lending.

Chit funds, which provide much needed liquidity in times of need, are also useless since they operate by rotating cash. This is not an insignificant consequence. The regulated chit fund industry in India is estimated to be Rs. 350 billion (~USD 5.4 billion). A study on the chit fund industry by IFMR showed that about 5-10 percent of the total household population in every state participates in chit funds.

The recent move by the government has resulted in the elimination of these lenders and savings in chit funds, without commensurate replacement by formal credit or liquidity, resulting in a standstill of transactions in wholesale commodity markets. The agricultural sector in India employs about 50 percent of the workforce. At the time that the government made its announcement, markets were either preparing to harvest the kharif (monsoon) crop or making preparations to sow the rabi (winter) crop. Farm labor has been spending the past 10 days waiting to exchange their notes, delaying the harvest. In instances where the harvest has been completed, the absence of storage and lack of liquidity are resulting in losses. Others do not have money to purchase critical inputs. Most people who work in the agri-supply chain do not operate through their bank accounts, leaving them with large amounts of currency which has been made useless overnight. Even regulated bodies like chit funds, which could act as a buffer, have been immobilized. On the other hand the increase of savings deposits in the Jan Dhan accounts is being viewed as possible money laundering, creating more fear in the minds of first-time users.

For a country that has just been rated highly on their enabling environment for financial inclusion, the recent demonetization announcement and subsequent implementation has been designed without any understanding of the financial lives led by the poor. In fact, beyond the detrimental economic impact that the move is likely to have on many population segments, the inconveniences caused may dial back the progress made thus far in financial inclusion, eroding trust in both the government and formal financial institutions.

Have you read?

Country of the Year: India

In the Case of India’s PMJDY, Considerations for Avoiding Account Dormancy

What Does India’s Demonetization Experiment Mean for Financial Inclusion?