Diffusion and Demonetization: How Modi Made A Very Expensive Mistake
On November 8th, 2016, India’s Prime Minister, Narendra Modi, announced that all 500 and 1000 INR notes would be deemed worthless overnight. He justified such a shocking declaration by taking a stance on promoting the elimination of the flow of black money within India, as the total amount of invalidated 500 and 1000 notes in circulation was expected to be 15.45 lakh crore (15.45*10^7 INR). Furthermore, Modi attested that demonetization would curb the funding of illegal activities and terrorism against India, create a larger tax base that could provide revenue to fund welfare programs for the poor, and promote Indians to adopt digital-payment methods. Although the direct effect demonetization has had on the curtailing of terrorism remains a bit ambiguous, it is objectively clear that the Modi Government’s plan to eliminate India’s shadow economy was short-sighted; although 99.3% of the invalidated cash was returned to the Reserve Bank of India, nearly 107.2 billion INR remained in circulation. Moreover, Modi only allotted a time period of 50 days for a country of 1.2 billion people to return their old notes in exchange for the valid 500 and 2000 INR notes. Furthermore, the hasty act also led to reduction of India’s GDP growth rate, and it also immensely affected the industrial economic sectors.
What exactly was Modi thinking before he executed his surprise-attack on the Indian Economy? No one can know for sure. However, it is clear that he failed to consider some crucial implications that would dramatically affect the lives of thousands of his citizens: the shoe/leather costs, network effects and diffusion of people in rural areas who could not readily exchange their old bills for the new ones within such a short amount of time. As more than 90% of transactions that occur in India are made with cash and the currently invalid 500 and 1000 INR notes made up 86% of the cash in circulation, demonetization left thousands of people scrambling to find ATMs, and those located in rural areas faced immense obstacles. Aside from the lack of abundant ATMs nearby, many rural villages further relied on cash for every-day barter; adopting new technologies, like digital payments, may have been reasonable for larger cities, but for districts that lacked the adequate infrastructure to accommodate these changes, demonetization basically wiped out their entire currency.
The following map displays areas of India that were hit the hardest by demonetization:
As adopting new technologies requires an abundance of infrastructure and a financial/cultural shift in a variety of areas, one can use a diffusion model to project a hypothetical flow of demonetization effects, projecting out how far the use of digital payments and the new 500 and 2000 INR rupee notes could move throughout India, and whether or not demonetization would cause a cascade.
The following images depict this model, positioning the Indian Government in the center of the network:
Within the Indian Government, let’s say that there are two nodes, both of which start off with using the new currency/digital payments. Both nodes are then connected to 3 nodes, each of which are located in the following 3 clusters: Mumbai, Bangalore, and New Delhi, 3 major cities in India. Assuming a “q” threshold of q=2/5, that means that at least 2/5 of one of the nodes’ friends has to have adopted the new technology/use the new currency in order for that node to do the same. As residents in major cities have the infrastructure to support digitalized payments/have the highest number of ATMs per/square kilometer, it is probable that at least one node in one of those cities would be able to adapt to using digital payments and exchange their old 500 and 1000 bills for the new notes. Furthermore, the diffusion theory backs up this claim: looking at one node that is connected to the two nodes in Indian Government but is a part of the Mumbai cluster, for example, this node has a total of 5 connections. 2/5 of these connections, the nodes in the Indian government, have adopted the digital payment methods/have been able to exchange their bills; if the threshold is 2/5, then the node has to have at least 2/5 of its connections use digital payments in order to switch to digital payments/exchange its old currency. And it does. Hence at least 1 node out of the 6 in the Mumbai (and New Delhi and Bangalore) cluster(s) adopted digital payments.
However, determining whether or not the use of digital payments spreads within the Mumbai, New Delhi and Bangalore clusters is a different story. As all three cities are very densely populated with a stark range of the populations that belong to different socioeconomic classes, often segregated by different areas, it is nearly impossible for the Indian government to accommodate the exchange of every single person’s cash, as well as ensure that everyone adopts digital payments. So, it is unlikely that everyone in the Mumbai, New Delhi, and Bangalore clusters acclimates smoothly to the change brought by demonetization . Furthermore, this claim can also be backed up by the theory behind diffusion. Take Mumbai, for example: as Bandra is one of the most commercial, central, and wealthiest areas in Mumbai, it is likely that the people there would adopt to digital payments and be able to readily exchange their currency for the new bills. However, areas like Dongri and Thane, which are more removed from central Mumbai and are not as wealthy as Bandra, are less likely to adopt the new technology/change their currency as easily. Dharavi, which is one of the poorest areas in Mumbai, is seen, on the graph, to be connected to Bandra, Thane, and Borivali. Because only 1/3 of Dharavi’s connections has adopted the digital payments and the threshold is 2/5, 1/3 > 2/5, so Dharavi does not adopt the digital payments; the same scenario with Dongri and Nashik occurs, and Thane and Borivali are not even connected to Bandra, so they definitely do not adopt the technology.
Furthermore, as major cities like Mumbai, Bangalore, and New Delhi are often junctions for villages/smaller cities in neighboring states, nodes in states like Gujurat and Goa can be connected to Mumbai. However, as these nodes in the neighboring states are connected to nodes like Dongri, Nashik, and Borivali, nodes that have not adopted the technologies, the digital payments/currency exchange does not spread to these states, so a cascade across India does not occur; the same logic can be applied to the Bangalore and New Delhi clusters.
Of course, the effects of demonetization can not be completely mapped out in such a simple manner, as the Indian Government ensured that each state would have some capability to exchange the old currency for new ones. However, the adoption of digital payments directly correlates to the presence of stable infrastructure that can actually accommodate such large technological shifts in the economy. In many second-tier cities, third-tier cities, and small villages, the infrastructure is just not present yet, so it is improbable for the residents to adopt digital payments and readily exchange their cash. Such processes take time, and the hasty action of nullifying a huge portion of India’s currency overnight led to dramatic effects that the Prime Minister should have foreseen.
Sources:
https://www.babson.edu/academics/executive-education/babson-insight/finance-and-accounting/indias-demonetization-what-were-they-thinking/#
https://www.bloombergquint.com/business/demonetisation-impact-on-indian-economy-what-we-know-three-years-on
https://www.theguardian.com/world/2018/aug/30/india-demonetisation-drive-fails-uncover-black-money
-Ravin Nanda