Demonetization: Behavioral Economics Working Towards Financial Inclusion in India

In November, India’s Prime Minister Narendra Modi announced the demonetization of 86% of the currency in circulation. Undeniably, the demonetization process had negatively impacted the economic activity of the country, and the financial inclusion sector has suffered a slowdown in collections and disbursements. However, this economic shock is expected to be temporary. According to Nomura, the Asia-based financial services group, the resilience of nominal rural wage growth despite demonetization, and amid lower inflation, suggests that the current slowdown in rural demand is fleeting.

India’s government is betting that the negative short-term effects will be more than outweighed by the goal of reducing corruption and tax evasion, and increasing use of banking services in conjunction with digitalization in order to generate long-term economic benefits.

The behavioral change catalyst

Prime Minister Modi’s objectives are bold and difficult to achieve as they demand a major change in behavior. Before demonetization, the Indian economy was 98% cash dependent. As behavioral economists point out, behavioral change first requires a change in habits, catalyzed by a variation in the environment. Another key element is the reduction of friction costs, or obstacles that complicate the desired course of action, such as having to install an app or create a new username in order to complete a financial transaction. No one is going to change their behavior if the new method is confusing, time-consuming, or more expensive. If the obstacles themselves are unavoidable, introducing incentives can be another way to reduce friction costs.

The Indian government’s announcement of demonetization with both a tight deadline and cash withdrawal limits is a variation in the environment, hopefully one that will catalyze change. The government has provided incentives for digital transactions such as discounts and lower taxes to reduce friction costs. Furthermore, in advance of demonetization, the government worked on other measures to facilitate the infrastructure to digitalize the economy. The Indian government has created IndiaStack, which includes unique identification via Aadhaar and eKYC to create (demographic or biometric) authentication, electronic sign, and a unified payment infrastructure that is interconnected with the banks, allowing customers to make transfers from their phones at a minimal cost. For customers without smart phones, payments can be made through Unstructured Supplementary Service Data. Merchants can use the Aadhaar Pay app to make digital payments on their smartphones connected to a biometric reader at cheaper rates than point of sale (POS) machines. This infrastructure has the potential to further increase the access to payment and banking services.

With the creation of the IndiaStack, the government applied another behavioral economic principle: offer a limited number of options — enough that people feel they have choices, but not so many that they can’t make a final decision. This is especially true for people under financial stress, such as rural populations. This population segment would prefer an intuitive, affordable, and secure technology platform that could easily integrate products and services. Yet, it is expected that a good percentage of India’s rural population will still depend on agents to access payments and financing due to lack of mobile penetration, illiteracy, and lack of trust in the technology.

Increase in savings and digitalization

Since demonetization, India has increased their use of digital transactions and deposits. Deposits rose 13.9% to INR 105 trillion (US$1.5 trillion) even though some banks reduced their interest rates. According to the Reserve Bank of India, the share of electronic transactions as part of total transactions in the system climbed to 84.4%. Prepaid card transactions increased 140% while mobile wallet transactions jumped 150% and POS daily transactions almost doubled.

Post-demonetization, microfinance institutions (MFIs) have increasingly looked to use digital channels for their disbursement and collections. This trend is expected to continue with eight MFIs converting into small finance banks and the launch of 11 payment banks, since regulation requires them to use more technology than traditional MFIs to operate. In contrast to MFIs, small finance banks and payments banks can offer saving products. This means MFIs would have the opportunity to tailor their products to both clients who would be introduced to the formal economy for the first time and those who have made due with informal financial services, including friends or family, savings circles, and money lenders.

Formalization of the economy

Pre-demonetization, India’s state and central governments struggled to manage their revenues properly, given the high levels of tax evasion, especially in the real estate and jewelry markets. Black money is estimated to be greater than 15% of the INR 17 trillion (US$258 billion) in total currency that is in circulation in India. A study conducted by the Indian Statistical Institute suggests INR 700 million (US$10 million) in fake Indian currency notes are pumped into the Indian economy every year.

Therefore, demonetization is as an opportunity to formalize the country’s economy and direct those gains into economic growth. New currency notes have come with advanced security features which are harder to replicate. The Finance Minister, Arun Jaitley, said, “Demonetization has gradually increased the process of integrating the shadow, parallel, and informal economies in far greater number with the formal economy, and the new indirect tax regime will make India one single market, eliminate multiple assessments, check evasion, and bring more revenues into the system.” As part of its 2018 budget, the government announced a tax rate reduction for small firms and individuals with personal income between INR 250,000 (US$3,639) and INR 500,000 (US$7,278) to incentivize them to report their taxes.

Demonetization as an opportunity

Demonetization is the external change India needed for long-term development. This measure has been accompanied by a strong digital infrastructure that facilitates financial inclusion, fosters economic activity, and is targeted to reduce corruption and tax evasion. Indian society should work together to make sure this opportunity enables the country to reach financial inclusion, increase equality, and reduce poverty.

-Adelina Dasso, Principal Manager, Accion Gateway Fund

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