Prime Minister Modi’s announcement of the demonetization of the large denomination bills is a significant initiative. While he indicated terror financing and corruption as the main causes for the initiative, there are many ramifications this move will have on legitimate business activities as well.
India is known for its love of cash. Uber is primarily a cashless service elsewhere in the world, but more than 50% of Uber trips in India are paid for in cash. This preference for cash transactions arises primarily from following reasons:
- The majority of Indians are still not familiar with card-based or electronic payments, irrespective of the relentless focus of the Reserve Bank of India toward changing their behavior.
- Merchants in India are forcing the choice of cash payments on customers because electronic payments eat into their margins — just like everywhere else in the world.
- Even more significantly, cash payments allow merchants and professionals like doctors, lawyers, and accountants to keep such transactions off the books and avoid tax.
These reasons have allowed India to develop a significant pile of unaccounted cash in the shadow economy — by some estimates, anywhere between $200 billion and $1 trillion.
In parallel, Modi government has undertaken a series of reform initiatives to make India support the transition away from cash economy. These initiatives, while very successful, have simply been able to create the conditions for a cashless economy but not change the behavior of the Indian people. Some of them are:
- Jan Dhan Yojna. A large-scale financial inclusion program focused on bringing the unbanked population in to the banking system. This program has helped open an astonishing 254 million new bank accounts that come with a debit card.
- AADHAR-enabled banking. This biometric authentication system has simplified the processes of opening a bank account and seeding it directly with funds from the various government programs.
- Payment bank licenses. The decision to allow 11 banks to operate as payment banks and increasing the FDI limits in banking are aimed to bring innovation in the banking and extend its reach to the masses.
- Unified Payment Interface. This major initiative extensively simplifies the payment process while reducing the transaction cost for the merchants, in the process creating the right incentives for them to switch away from cash.
What India needed shock therapy to spark a change in behavior, and the demonetization initiative does just that. When combined with institutional and systemic support for citizens to switch to electronic payments, it is going to make people and businesses explore electronic payments and funds transfers as an alternative. Merchants will also have the right incentives in the form of the carrot of lower transaction costs and the stick of penalties for hoarded cash.
This move towards being cashless will have a direct and immediate impact on the financial services and retail sectors. Longer term, the move will benefit the Indian economy as it widens the tax base, allowing the government to spend more on much-needed infrastructure projects.