Public policies are best when a lot of reason goes into their formulation and passion into their implementation. Those looking for an effective recipe for formulation could learn a lot from Brazil. It has demonetised its currency as many as eight times since 1942, and thrice it simply knocked off the last three digits of its currency overnight—say, a 10,000 cruzeiro (then Brazilian currency) will be 10 cruzeiro from the next morning!
Lessons from 1830s to 1942
Even before from 1830s, Brazil has been compelled to experiment with its currency due to evolving politics. The early experiments are to do with metallic convertible bases like silver and gold, metallic copper coins, birth of parallel paper money, etc.
In the early 1830s, in order to stabilise the external value of mil-reis (then currency), the centre starved supply of currencies, reducing the circulation of copper coins in the provinces. The provinces responded by issuing their own notes to neutralise demonetisation. In fact, Promissory Notes issued by the commercial banks valid for 15 days by law began to be accepted far beyond their due dates.
Some other time, commercial banks were allowed to issue bank notes (like in Hong Kong where currencies were issued by Standard Chartered and HSBC till accession). This led to loss of control of central authority and dilution of monetary policies.
Brazil, through its history, has proved that no one can ‘starve’ the people of currency for far too long.
From 1942 to 1994
This period was mostly about high government expenditure, unbridled fiscal gaps and high inflation. Brazil demonetised eight times before the last one in 1994. It has had to change its currency—the ultimate from of demonetisation—for every conceivable reason: to tackle black money (Indian objective), to tackle hyper inflation, to tackle daily cumulating interest rates of 3% (which is nearly 50,000% per annum), base erosion, commodity price volatilities especially in copper, or just to avoid confusion (if Brazil had retained its currency the same as in 1942, it would be written now as 2,750 followed by 18 zeros).
They, in fact, have been far deeper than the Indian-type demonetisation—the entire spectrum was replaced and the currency itself renamed.
The last in 1994
The most recent, in 1994, seemed Quixotic. It was aimed more at breaking the psychology of inflation. With 100% inflation consistently for 14 preceding years (in four years, over 1,000%), shops had to revise prices three times every day. That is when the government decided to use two currencies simultaneously—one virtual for counting the real value of currency and another for payments and settlement—and every shop having to display its prices in both and revise it three times a day.
But, unexpectedly, people started anchoring their values against the real value (which was set near 1 real value unit = $1). Within a quarter or so, it was clear people were not rushing any longer to shops to avoid their currency buying less than when they started from home. Inflation abated and the real value became the ‘real’, the official unit. It was perhaps one of its most successful experiments that has lasted till date.
Lessons from Brazil
People will seek ways to settle transactions in the most cost- and effort-efficient ways. For many transactions in much of India, using currencies across the counter is still the most efficient option. In the 1970s and 1980s, when there was a coin shortage of sorts, the Chinthamani Co-operative Superstore in Coimbatore used to issue own tokens. These slowly gained acceptance with the public, so much so that even government-owned buses and offices used them.
The parallel systems will start issuing notes and IOUs, which will be strictly ‘enforced’ amongst its members through extra-legal authorities.
One thing Brazil has always got right (between 1942-1994) is to have the 1, 2, 5, 10, 20, 50, 100 note sequence—considered the most friendly from transaction settlement point of view.
Currencies are as much about psychology and convenience as values for accounting and transaction, as the 1994 experiment so decisively proved.
The best way to demonetise is not to have one—avoid inflation, avoid unjustifiable or unimplementable tax systems, and not to issue too much of it anyway. Brazil has about 3% as currency/GDP, whereas India’s is 11-12%. The government should have incentivised and reduced it by 1% every year rather than force it in one lump.
A parade of demonetisations has not curbed either parallel economy or corruption in Brazil. Corruption and black money is so rampant that their president was recently impeached for corruption—their biggest real estate tycoon is behind bars and may have to spend the rest of life there if not politically rescued.
Why black money or parallel economy, there is a near parallel administration being run by the mafia through drugs, extortion, violent thefts (one murder every 10 minutes, i.e. 140 a day, down, of course, from 600 a day not so long ago), etc, none of which will be happening through tax paid cheque money transfers.
In summary, Brazil offers three ground rules—perhaps not with successful examples as much as negative narratives:
(1) the way to tame inflation is not periodic demonetisations, but curbing state populism;
(2) the way to curb black money and illegal economy is not starving people of cash, but well thought out tax policies and effective punishments;
(3) the way to protect free trade from causing domestic unemployment problems is to maintain the external value of the currency, which, in turn, is achieved by restricting external capital inflows to just what is required for financing current account deficits.
One would give credit to both the government and RBI for curbing state populism within FRBMs. But given the levels of corruption in tax collection systems itself, black money curbing through demonetisation seems an ill-fitting solution. Unemployment is rampant and growing due perhaps to highly overvalued rupee and extraterrestrial real interest rates.
The daily dose of RBI circulars indicates that someone is extremely alert at the wheel, but whether he knows the destination and if it will deliver enough gains for the pains people are experiencing, time alone will tell.
V Kumaraswamy is CFO, JK Paper. He is the author of ‘Making Growth Happen in India’