Thursday, 8 December 2016

Cost-benefit analysis of demonetisation - Part I

Demonetisation of currency notes worth Rs. 15 lakh cr. is the greatest risk Prime Minister Narendra Modi could take. Even in autocratic regimes similar measures failed. In our country ‘black’ and ‘white’ have been closely entwined for a long time, use of cash to avoid taxes and accountability has become a norm rather than exception and there is a strong vested interest in perpetuating more and more use of cash. If he succeeds, he will be remembered as   the strongest and most revolutionary leader India has produced, a leader who revolted against everything that was ugly and dangerous in India: black money generated and accumulated by corrupt, counterfeit currencies and activities of criminals, from terrorists, naxalites and drug and human traffickers to local musclemen.  November 8 will go down in the history as the day of ‘White Revolution’. If the measure fails to achieve its objectives, Modi may lose all his charisma. His detractors will be the happiest persons on the earth. Manmohan Singh will say that ‘before general election in 2014, I had warned the countrymen that Modi as Prime Minister would be a disaster and the people should elect Rahul Gandhi who has all the credentials to become a good prime minister.’ Dr Singh will say that he rightly accused Modi of being guilty of ‘monumental mismanagement.’   

Only time will tell who has the last laugh, Modi and his supporters or his detractors. In this brief paper, I have tried to present a quick cost-benefit analysis (CBA) of the impact of demonetisation in a bid to identify the challenges ahead. CBA, a method of quantitative analysis, involves:

      (a)  Identification of all elements of costs (i.e. benefits foregone) and benefits (attributed to the action being analysed), direct and indirect, tangible and intangible. If beneficiaries and losers are different groups of people, net benefit is equal to the difference between gross benefit to gainers and (real or deemed) compensation to losers.

    (b)  Quantification of various components of cost and benefits in a common numeraire or accounting unit.

(c)  Discounting of  streams of costs and benefits accrue over a period of time to present value because money has time value (a rupee today is more valuable than a rupee in future). The discount rate is compound rate of interest calculated backwards. The results of analysis can be presented either as internal rate of return (IRR, which is the discount rate at which the NPV of streams of cost is equal to the NPV of streams of benefit) or net present value (NPV, which is the difference between discounted value of streams of benefits over the years and the discounted value of the streams of cost). For the calculation of NPV of projects undertaken for the benefit of the economy, economists suggest a discount rate determined by policy makers which is determined taking into account several factors. NPV is calculated also to find out the number of years needed to recover the cost (i.e. benefit forgone). 

(d)  To take care of uncertainties in estimates of costs and/or benefits over the years, the time frame and discount rate, sensitivity analyses are carried out assuming  variations in costs and benefits, number of years and discount rate.

All the pains and pleasures, costs and benefits, being talked about can be divided into three broad categories: (a) cost (pain) and benefit (pleasure) to the individuals and households, (b) cost and benefit to the political players, and (c) cost and benefit to the economy in terms of GDP.

 Cost and Benefit to People (individuals and households)

Theoretically CBA of pains and pleasures to individuals is possible. In the 1970s, an American researcher got PhD on CBA of marriage. However, it is not an easy task. There is bound to be high dose of subjectivity in quantification making acceptability of results difficult. A research published on December 1, 206 in the American Sociological Review, has estimated that on an average motherhood results in loss of 4% of income which could be as high as 10% for highly skilled but it has not quantified the value of pleasure motherhood gives.

The online survey conducted by Prime Minister himself indicates that 92% of the people are in favour of demonetisation. They are pleased at the prospect of the corrupt losing their ill-gotten money amassed at the cost of common people. At the same time,  vast number of people who instead of doing their usual work are wasting time on the unproductive work of standing for hours in queues before banks and ATMs. Large number of people are facing hardship because they have lost their means of livelihood because of lack of demand and fall in economic activities due to shortage of liquidity. At some places poor are reportedly borrowing at 20% interest. There are also reports of loss of human lives because of physical and/or financial strain caused by demonetisation. It is very difficult, almost impossible, to quantify all pains and pleasures to all the people. At best, attempt can be made later when researchers collect data. I have not attempted CBA of pain and pleasure to human beings.

Cost and Benefit to Politicians

The conventional CBA methodology cannot be applied to measure costs and benefits to political players in terms of loss and gain of popularity ultimately reflected in the number of seats in elections and financial loss and gain to contestants. All the electoral victories and defeats cannot be attributed to a single factor. Prime Minister Modi has taken a risk in the hope that it will not only benefit the economy and thereby will also improve the prospect of his winning the second term in 2019. BJP's recent victories in the by-elections and elections to the local bodies have been interpreted as support to demonetisation. This may or may not be true but with no end to wait for hard cash, even the enthusiastic supporters are losing patience. Unless he is able to make up well in time, Modi will make his opponents very bold in 2019. Incidentally, Modi must have incurred wrath of large number of his own party men and supporters.  In his own constituency, Varanasi, thousands of weavers are sitting idle.

Most of the opposition politicians are in state of shock.  There is widespread popular belief that they have lost most of their hidden treasure. Rahul Gandhi, Mayawati, Kejriwal, Mulayam Singh and Mamata Banerjee, all have gone berserk.  Though the Congress has taken the moral stand that the party is not against demonetisation per se, it is against mismanagement in its implementation, Rahul Gandhi has condemned it as 'completely useless'. Since these politicians' demand to roll back demonetisation could not be met, they are paralysing the Parliament and going to places to inform people about their (people’s or their own?) hardship. Mulayam Singh says that ‘entire black money was in the possession of just a hundred families and one of them was PM’s friend’. Mamata has described the Centre a ‘government of dacoits.’ Mayawati is crying that ‘PM has made people bankrupt’.  What they do not admit openly is that they have become poor but charter helicopter operators are telling stories of the poverty of their clients who are cancelling bookings.  They are all hoping that even though they have lost money-power to contest elections, they will gain by using their lung-power.   Anyway, I leave the analysis of loss and gain to politicians to political analysts.

Devendra Narain

(A former head of the Project Appraisal Division of the Planning Commission)
December 08, 2016

Linkk for  Cost-benefit analysis Part II (CBA of impact of demonetisation on the economy):

Another article worth reading: Who are sabotaging objectives of demonetisation?