Paper trade

India's move to demonetize its currency might harm export reputation

By: Eric Johnson
Photo: Wittayayut/Shutterstock
   The story of the craziest government-overseen currency end-run in recent times, for me, starts with a personal tale.
   Between 2007 and 2012 I lived in a suburb of New Delhi, the capital of India. In that time, I befriended dozens of local business owners, largely men in their 20s and 30s who had taken a leading role in their family enterprises or used the blanket of their family’s business success to forge a new company of their own.
   Inculcated in these men was an entrepreneurial spirit that is fairly alien to the salaried classes predominant in western cultures. That spirit, in a positive way, manifested itself in the bravado of self-sufficiency and creation of wealth.
   But there were negative aspects to this entrepreneurial DNA. Cockiness, and a sense of being above the law. Paying meager bribes to police officers to avoid speeding tickets. Paying larger bribes to government officials to get around permit issues. The stories I heard were too numerous to discount them all.
   And yet, one instance sticks out most clearly in my mind. An acquaintance of mine, the owner of an aluminum cookware manufacturer (re: pots and pans), bragged to me one blazing hot night in July he had paid 57,000 rupees (around $1,200 at the time) in income tax for the year.
   He said this to me on the balcony of his posh, four-bedroom condo, his gleaming white Audi sedan and slick black Mercedes S-class parked in the basement below. Both cars would have been subject to sky-high duty rates for imported luxury vehicles, costing upward of 40 percent more in India than they would in the United States.
   This man was no tycoon. By any metric, he was a run-of-the-mill small business owner in India, his business seeded by family money (some his family, but mostly from his wife’s). And yet, there’s no possible way his business could have yielded an income so paltry as to merit $100 in monthly taxes. For context, the lowest tax bracket at that time was around 10 percent. This man was expecting me to believe his net profit for the year was $12,000?
   I immediately thought back to this experience the night I heard that India Prime Minister Narendra Modi was announcing his government would be pulling existing currency notes from circulation.
   The announcement was made Nov. 8, the same evening of another momentous occasion half a world away, and it’s hard not to think it was calibrated that way. The plan was hatched in such secrecy that, according to local reports, no one bar a few of Modi’s closest cabinet members even knew of its existence.
   The rationale for the plan, as laid out by Modi, was simple: bring all the black money coursing through the Indian economy to light, as a health inspector with an ultraviolet light may do to a seedy hotel room.
   The black economy, often estimated to be equal in size or larger than India’s on-the-books economy, is largely made up of three types of assets: gold (in bar or jewelry form), other hard assets (like cars or property), and cash.
   Not only is it common for property deals to be transacted (in part or in whole) with gym bags full of cash, it’s considered standard. Cars worth tens of thousands of dollars are bought outright in cash.
   And that’s largely because India’s entrepreneurial spirit had evolved into companies figuring out ever-more complex ways to shield earnings from the taxman. Things like 5 percent discounts at retail shops for cash transactions.

Multinational shippers might very well see Modi’s gambit not as a daring plan to make India a fairer place to do business, but as another brick in the wall of chaotic India.

   Modi’s move was hailed in some circles as genius. Businesses and individuals that were hiding taxable income would have to turn that cash (actual cash, mind you) into banks and bring it into the public sphere. The country’s now robust software-based income tax department systems would enable this to occur.
   Cynics, however, argued that the salaried and lower classes would be the ones hurt the most. By pulling the country’s two most common currency denominations from circulation in a short period of time, they would be the ones standing in interminably long bank lines. They would be the ones left without cash to pay for groceries, or natural gas cylinders, or gasoline for their cars. The business people who had long figured out ways to evade taxation would just find another means to do so.
   It remains to be seen whether Modi’s ploy will be successful, whether he will immeasurably grow the nation’s tax base and begin to root out corruption in the private sector.
   But there’s another dimension to this story. And that’s how this move affects India’s uneven rise as a force in world trade. Because multinational shippers might very well see Modi’s gambit not as a daring plan to make India a fairer place to do business, but as another brick in the wall of chaotic India.
   Certainly, the implementation of the plan has not gone as smoothly as Modi would have wanted. The idea was to give holders of currency the chance to go to banks and exchange the two types of notes they held that were to be demonetized and exchange those for an equivalent amount in new notes being issued by the government.
   The problem was supply of new notes. The government couldn’t funnel enough new currency to bank branches across the country to satisfy demand. What’s worse, the currency switch plan was slow going. The government had planned to lift limits on the amount of new notes that could be withdrawn from banks each day on Dec. 30, in tandem with a deadline to turn in any notes that were to be demonetized. But the Financial Times reported that by Dec. 19 banks had replaced just 38 percent of the 15.3 trillion rupees in demonetized notes that were to be withdrawn from the system. Raise the withdrawal limit on Dec. 30, and banks were unlikely to have enough cash to satisfy demand.
   This upheaval is part of a larger perception problem India has long struggled with since it began opening its economy in the early 1990s. In the decades after it won independence from Great Britain in 1947, India’s leaders set a course based on self-reliance.
   That precluded the country from joining the stream of Asian economies leveraging the export potential to be gained by increasingly efficient international freight transportation from the 1970s on.    That development largely occurred in east Asia, as India continued to look inward.
   But over the last 25 years, India has incrementally sought to grow its presence as an exporting nation, only it has been hamstrung by poor transportation infrastructure, thick layers of government bureaucracy, and endemic corruption.

India’s entrepreneurial spirit had evolved into companies figuring out ever-more complex ways to shield earnings from the taxman.

   That intense sense of entrepreneurial spirit I referred to earlier (forged in part by the drive toward self-reliance and in part due to survival instinct) has stood the country in good stead in terms of exports. Where there’s a will (and a buyer), there’s a way.
   But despite being more open to foreign investment, to global manufacturing and technological and supply chain best practices, India still lags as an export nation. Modi attempted to address this early in his tenure as prime minister. In his most public campaign prior to the demonetization effort, he championed India’s manufacturing capability in his so-called “Make in India” program, designed to bolster the country’s exporters.
   According to World Bank figures, India’s export of goods and services as a percentage of GDP was 19.9 percent in 2015, not far behind China’s rate of 22.1 percent. But in raw exports, India lags well behind its neighbor – $264.4 billion in 2016, compared to $2.2 trillion in exports from China., according to the World Bank.
   Comparisons between the two nations aren’t always easy to make, or justified, but considering their populations and geographic expanses are relatively similar, the gap is startling.
   So one question, as Modi’s big gamble progresses, is how the demonetization effort might impact India’s export potential?
   Let’s look at a few areas that might be positively and negatively impacted by the plan to shine a light on black money:

   1. Exports of consumer goods are very dependent on the country’s network of small businesses. These businesses act as suppliers to multinational buying houses and retailers. Short-term, gutting the cash position of these small businesses hurts their ability to pay workers and for raw materials. It also crimps their more basic ability to run their businesses effectively (since attaining cash to buy things like paper or garbage bags becomes more difficult).
   2. More broadly, demonetizing the black money that many small businesses transact in will compel these companies to pay more in taxes down the road. That’s, of course, the aim of Modi’s plan, but it will make it harder on exporters. Higher taxes on an unchanged price of goods means smaller margins.
   3. Long term, bringing more collective tax revenue into government coffers could theoretically allow for building of better logistics infrastructure (in particular, secondary and tertiary roads). By some estimates, $2 in taxes go uncollected for every $1 that is collected. A tripling of the country’s commercial tax base would be a huge boon. Hypothetically, it could also induce the government to lower tax rates on middle class and poorer citizens, which might lead to more discretionary income for those groups. But if India is successful in growing its tax base, there will be many demands on any new government revenue in a country with needs spread across virtually every sector, and where extreme poverty remains a problem for more than half the population. Logistics infrastructure might not be the highest priority.
   4. Ultimately, exporters face a tricky decision – if more of their income has to be reported as taxable, they can either try to raise the prices of their goods and preserve margins, or keep the prices of their goods stable and take a hit on margins. The first option is not ideal in a hyper-competitive global market for consumer goods suppliers. Textiles, for example, can be manufactured in low-cost countries on virtually every continent.
   5. Another variable here is the exchange rate. The rupee currently trades at roughly 65 to the dollar, a 33 percent devaluation from 2012. As long as the value of the rupee remains depressed, exporters will have a chance to compete. Could the value of the rupee go even lower to help exporters compensate for lower margins associated with higher true tax burdens?
   In general, the more comfortable a foreign company feels in a sourcing nation’s rule of law, and the more it feels corruption is being monitored, the higher the likelihood it will buy from suppliers, or invest directly, in that nation. Modi’s bet is that the move to bring the country’s black economy into the open will be seen internally and externally as a move toward structure, modernity and legal integrity.
   The problem he faces is that, from the outside looking in, the plan adds to the chaos that most associate with India.