On November 8, 2016, Indian Prime Minister Narendra Modi dropped a bombshell. In a televised address at 8:00 pm, he declared that after midnight—four hours later—banknotes with face values of INR500 (US$7.50) and INR1,000 (US$15) would no longer be legal tender.
These bills comprised 86% of the monetary value of currency in circulation, so to say that panic ensued would be an understatement. The market stayed open all night as people rushed to buy gold, Rolex watches, and anything else they could get their hands on to use up their cash.
During the next two weeks, gold traded for as much as US$3,000 per ounce, a premium of almost 100% to the international price. Foreign currencies traded at similar premiums.
Soon, Indian tax authorities descended on the gold market, confiscating security camera recordings to identify any transaction that might have bypassed taxation. They were raiding people’s houses with abandon.
India is already well known as a society where it is virtually impossible to find a public servant who won’t ask for a bribe, but now the number of bribes skyrocketed. Fear gripped the population—but most still didn’t realize that they were witnessing the emergence of a police state.
The government provided a one-time option to convert $30 worth of cash into the still legal banknotes, which were in extremely short supply. People’s fingers were to be marked with indelible ink to ensure they couldn’t repeat conversion. Any excess cash would have to be deposited into a bank account, which for all intents and purposes had the same effect as freezing people’s assets.
You’d see massive lines outside all the bank branches. The date by which the cash had to be deposited kept changing. Regulations that materially affected the handling of currency often changed more than once per day, until the last day of the demonetization exercise. The chaos was unprecedented.
To fully comprehend the level of turmoil, you need to know that 95% of Indian consumer transactions happen in cash.
The net effect of all these events was to rapidly stall the economy and to send it into a state of shock. Scores of disabled, sick, and old people—who had no choice but to personally take care of the currency exchange—died while standing in line at a bank all day. Many soon found themselves cash-strapped and with no means to buy staple items, including food.
Street markets started looking like ghost towns as even those with cash avoided non-urgent purchases. Next, the sudden drop in demand caused small businesses to fail. Even export houses, like diamond polishers, had to lay off their employees because they had no cash to pay salaries. The economy spiraled downhill.
Even today, vegetables sell for half as much as they normally do. This would be considered a good thing had it happened as a result of excess supply, but the reason for the price drop is the destruction of demand—resulting from lack of funds among the poor people who lost their jobs. And don’t expect any reports on this in the Indian media, which must toe Modi’s party line.
India’s salaried middle-class employees, on the other hand, were very happy with the situation: taxes are automatically deducted from their paychecks, and they want businesses and employees from the informal sector to pay their “fair share.”
The informal sector, or informal economy, is the part of a country’s economy that is neither regulated nor monitored by government entities. In developed countries, it makes up about 10% of the overall economy. Not in India, though. Here, it accounts for 90% of the economy and at least half of total GDP. 75% of all Indian businesses belong to this shadow sector, which makes this country one of the largest informal economies on the globe.
In other words, the informal sector is India’s backbone—without it, the ivory towers the salaried middle class reside in would come crashing down. Their persistent demand to tax it into submission is partly envy and partly an utter lack of empathy. Also, consider that virtually all taxes collected by the government end up in the pockets of politicians and bureaucrats, with no benefit to the people.
In recent weeks, cash has been fully replaced, but the economy continues to stagnate, and businesses continue to fail. Money—even in fiat currency form—is the lifeblood of the system. Even if you got the blood to flow again, once it stopped, clots would have appeared and organs would have failed. That’s what’s happening in India today.
Job growth was already stagnant before, but the situation is much worse now, making India’s so-called “demographic asset” a massive liability. (Hint: The rosy picture Modi’s government has painted of India’s growth rate does not match the on-the-ground reality.)
As I write, the domino effect continues to work its way up the food chain. Formal and big businesses are showing signs of stagnation. The salaried middle class are losing their jobs but fail to connect the dots. The government enjoys massive and increasing support, with the ruling party continuing to win provincial and by-elections.
It would be dishonest to blame everything on the middle class, although they should reasonably be expected to be the moral spine of any society. Ironically, most small-business owners and poor people support Modi’s drastic measures, despite the incredible suffering and the lack of a positive outcome. Again, they fail to connect the dots, which is why India will continue to mess up—politically and economically.
For a Westerner, it might be hard to comprehend how entrenched poverty, lack of economic growth, and backwardness are in India.
This is a deeply superstitious society where critical thinking and rationality is actively discouraged. I can consider myself lucky because I went to one of the better schools. Still, I was beaten up for questioning (not challenging) my teachers.
Without the glue of reason, intellectual and capital accumulation can’t happen. The people suffer from tyranny and the encroaching police state, but at the same time, they enable those things through their beliefs, ideas, and actions. There are no moral instincts, hence the lack of empathy and the dominance of envy in public affairs.
In a society like this, capital has a tendency to get destroyed or frittered away. Despite the fact that India has seen no wars in the recent past, most of the country looks like a war zone with dilapidated buildings and crumbling infrastructure.
There’s a reason why 95% of consumer transactions happen in cash. Two months ago, I used my debit card to buy a plane ticket from Delhi to London. The money left my account, but I never got the ticket. I still have no idea where my money went, and in the existing, convoluted system, I also have no idea whom to blame.
Lacking logic and reason, without the British (who left 70 years back), Indian institutions are in an advanced stage of decay. Most people simply don’t trust the banking system, if they even understand how to use it in the first place. I know many wealthy people who have never used their bankcards.
As the institutions left behind by the British disintegrate, India—which used to be a geographic area filled with hundreds of kingdoms and principalities—is reverting back to its natural form.
With the only other option being a serious economic crisis, cash is coming back with a vengeance… and so is gold.
Indians have historically invested their surplus wealth in gold—for the simple reason that a zero-yielding asset class like gold is much better than investing in the economy, which offers negative yields and capital depreciation.
While some economic growth did happen in India over the last three decades—as it did in many emerging countries—this was not because people became better educated or more liberal. It happened because of the Internet and the easy import of Western technology that followed. But now that the low-hanging fruit has been plucked, India is reverting back to its Hindu rate of growth and its focus on gold.
Wealthy Indians are rapidly internationalizing their assets and storing gold in vaults in Hong Kong and Singapore. They instinctively know that there will be more occasions when gold trades at $3,000 or more per ounce.
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