By Bhaskar Chakravorti
India is in the throes of an unprecedented social experiment in enforced digital disruption, and the world has much to learn from it.
Prime Minister Narendra Modi launched a surprise in early November, demonetizing 500 and 1,000 rupee bank notes. Modi’s war on cash is not without international precedent: Singapore, for example, withdrew its largest currency recently; the European Central Bank eliminated the 500-euro bank note; South Korea plans to eliminate at least all coins by 2020.
And yet India’s initiative had the potential for chaos. Here’s why: the government effectively took 86% of cash out of circulation in an economy that is close to 90% cash-reliant.
One of Modi’s strongest motivations for this action was corruption — to expose undeclared “black” money, i.e. income illegally obtained or not declared for tax purposes, in Asia’s third-largest economy. But the government seems to have failed in meeting this objective. As of December 3, about 82% of the demonetized bills, amounting to about $185 billion, had been deposited in bank accounts and validated to be legitimately earned money (or legitimized after any additional taxes owed are accounted for). In other words, very little of the estimated $2 trillion black money estimated to be stashed overseas has been captured.
In the meantime, retail and wholesale markets have stalled around the country. Supply chain transactions, real estate deals, and even weddings and funerals have been frozen. Consumers are coping with lines that are frustrating even for Indians used to standing in lines or waiting for basic services. People up and down the income spectrum are dealing with changing cash withdrawal policies and empty ATMs. The nation’s status as the world’s fastest-growing big economy has been severely imperiled and its currency risks being further devalued, a situation made worse by prospects of a strengthening dollar after the U.S. election.
Sounds bad, right? But there is a question that hasn’t been asked: Is there a digital upside to this crisis?
A digital idealist might argue that the demonetization move is a welcome shock necessary to get a cash-intensive society weaned off its addiction and onto modern systems of digital payments. Indeed, since the chaos erupted, the prime minister has tweeted: “Time has come for everyone, particularly my young friends, to embrace e-banking, mobile banking & more such technology.” He has urged the other side of the market to digitize as well: “I want to tell my small merchant brothers and sisters, this is the chance for you to enter the digital world,” he said in Hindi on television, encouraging mobile banking applications and credit-card swipe machines.
This is an unusual form of digital disruption of an enforced kind, about as far as one can get from the textbook kind. Consider a few of its most salient aspects:
- This drastic shift affects the world’s fastest growing large economy, a population of 1.25 billion, and consumers whom we have identified as bearers of some of the highest “cost of cash” in the world (see our HBR article: “The Countries that Would Profit the Most from a Cashless World”). In other words, if a significant amount of the country’s payments were digitized, the benefits would be monumental.
- This disruption originates not from one of the e-wallet insurgents or from one of the global payments mega-players, but has been engineered top-down by the government.
- The biggest beneficiaries of this disruption, arguably, would be the incumbents, i.e. Reserve Bank of India, India’s central bank, and the banking institutions. According to our study, the Cost of Cash in India, these institutions spend $3.5 billion annually in currency operations costs.
- Ironically, the primary losers in this disruption, at least in the near term, are the consumers themselves. The disruptive action did not originate in a small segment of the market; it was launched nationwide. The burden has been regressive, as it has been hardest on the poor and the unbanked, who have had to forgo wages to stand in lines or have lost jobs because of non-functioning markets.
So can the demonetization shock push digital payments into the mainstream? Some early reports are suggesting that, indeed, it has had an effect. The leading digital payments players have experienced a bump since the demonetization experiment began.
That said, it is important to keep in mind that this bump builds on a low base. According to a 2013 Mastercard study, India was in the “Inception” category of both absolute level of cashlessness and the trajectory of change. Furthermore, there are three fundamental structural factors to be mindful of as we understand the Indian context:
India’s ties to cash are strong, even by developing country standards. India uses a lot of cash by any measure. Our Cost of Cash in India study found a remarkably high level of cash usage even when compared with other emerging markets and otherwise digitally under-evolved countries, according to our Digital Evolution Index, reported earlier in HBR. The ratio of money held in bills and coins to the amount held in demand deposit and savings accounts in India was 51%, as compared to Egypt (29.3%), South Africa (8.9%), and Mexico (8.7%). Moreover, the value of notes and coins in circulation as a percentage of GDP in India was 12.04%, compared to 3.93% in Brazil, 5.32% in Mexico, and 3.72% in South Africa.
There are strong reasons underlying this degree of cash reliance. Consider some of the most significant ones we found when we analyzed the 2014 landscape. Most Indians lacked the means to use non-cash payments, even if they want to. India’s infrastructure for payments was growing, but from very modest beginnings. Fewer than 35% of Indians above the age of 15 had used a bank account. Less than 10% had ever used any kind of non-cash payment instrument. Less than 3% of the value transacted used cards in the year ending March 2014. The growth in value of ATM transactions had far outpaced the growth in the value of card payment transactions.
Moreover, in India, the total value of ATM transactions increased more than five times between 2007 and 2012, from about 3 trillion to about 18 trillion rupees, while the value of card transactions barely doubled in the same period from 1 to 2 trillion rupees. Despite the improvement in telecommunications, India lagged its peers in mobile payments. Fewer than 2% of Indians had used a mobile phone to receive a payment, compared to over 60% of Kenyans and 11% of Nigerians.
Financial inclusion policies are bank-led rather than telecom-led. Much of India’s recent approach has focused on the supply side of financial inclusion. The priorities of the Reserve Bank (RBI), India’s central bank, are to promote safe, efficient, accessible, inclusive, interoperable, and robust payment systems. India has addressed these priorities both through the creation of national champions, such as the National Payments Corporation of India (NPCI) and its subsidiaries. The result is that India has built the capacity to clear and settle payments. Access to that infrastructure on a sustainable and profitable basis is a key reason behind India’s investment in universal identification (known as Aadhaar)-enabled payments services.
The problem is that RBI chose a bank-led model over a telecoms-led one to achieve its financial inclusion goals. As a result, telecoms firms had only recently been allowed to enter the payments space in India, and were limited only to partnerships with banks. Compare this situation to that of Kenya, for example, where a surge in mobile payments has been engineered by the efforts of Safaricom, the major telecom company. The net result of a bank-led approach has been an insufficient investment in the necessary digital infrastructure and inadequate marketing of its potential uses and benefits. Consumers have been left unaware of how they might use mobile phones for services other than communications, texting, or Facebook.
The costs of cash to the Indian consumer are among the highest in the world. In our analyses of the cost of cash across over 70 countries, we found that the cost of cash to consumers – in terms of time spent to get cash and fees — are high in some of the world’s most populous countries. Unsurprisingly, cost to Indian consumers was among the highest. When weighted for population, India fared poorly in terms of ATM access compared to even lesser-developed countries, such as Kenya, Nigeria, or Egypt. Moreover, smaller cities in India had larger problems. Long before the current crisis, we found that residents of Delhi spent 6 million hours and $1.5 million to obtain cash, while residents of Hyderabad spent 1.7 million hours and $0.5 million to do the same. Hyderabadi consumer costs were about twice as high as that of Delhiites on a per capita basis.
With this structural understanding in mind, how do we evaluate the potential impact of the demonetization move in getting digital payments past a tipping point?
I would argue that, despite the high costs of cash, telling people – as the prime minister did — to go cashless is putting the cart before the horse. The horse in this case is the digital infrastructure and establishing a threshold of trust in the system; beefing up this digital ecosystem should come first. India’s digital state (it ranked 42nd out of the 50 countries we studied in our Digital Evolution Index), does not engender the threshold of trust needed for cashlessness to take hold in a meaningful way.
Despite a billion mobile phone subscriptions, just about 30% of Indian subscribers use smartphones. A little over a third of the population has internet access. India lacks infrastructure needed to reliably expand access. Connections are patchy and unreliable and there is great disparity in connectivity: 70% of those with mobile internet access are in cities; only 17% of Indian women use the internet, according to the Pew Research Center. With women responsible for much of household purchases, this does not provide a strong foundation for the spread of digital payments where it really counts.
According to Google India and The Boston Consulting Group, by 2020, digital transactions will happen at 10 times the current level. That may well come to pass; maybe demonetization may serve as the needed catalyst. But let us be clear: in the absence of a systematic and concerted investment in digital infrastructure and Internet access, cash will stubbornly resist wholesale digital displacement.
It is useful to keep in mind that any form of currency, cold hard cash or digital, involves an “equilibrium mindset” — a mutually self-reinforcing logic — whereby the parties across a transaction must share a belief in the currency and trust that it works and holds value. If there is a shadow of doubt that affects one party’s trust in a particular form of currency, the other will prefer to not rely on it. Cash, unlike digital alternatives, has the benefit of being acceptable (almost) everywhere. If there is concern about the viability or acceptability of digital payments, venturing forth without cash will make consumers feel insecure.
When we studied current habits in India, in the Cost of Cash in India, we found that there is great level of comfort in keeping moderate to significant levels of cash in hand, especially in small towns and rural areas. Even credit card users keep significant amounts of cash in hand, and they keep higher balances. The proportion of respondents who keep more than 2,000 rupees as minimum cash in hand is 29% in case of credit card users, as compared to 12% in case of cash-only users. The average amount of minimum cash carried by cash-only users or “debit cash and cash” users is relatively lower than the amount carried by credit card users. The proportion that carried minimum cash in the range of 100 – 500 rupees was 13% among credit card users, as compared to 27% among the cash users.
What seems like a major push from physical to digital money will, in reality, happen at a slow pace. While I do not intend to demonize the demonetizers, this unfortunate crisis is a case study in poor policy and even poorer execution. Unfortunately, it is also the poor that bear the greatest burden.
(Editor’s note: We clarified how money that’s deposited in banks is considered legitimate.)