Indian banks respond to Modi's demonetization shock therapy

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November 8, 2016, will go down in history as the day Donald Trump, a real estate mogul and reality TV host, was elected the 45th president of the United States and leader of the free world – but, in India, it marks a perhaps equally surreal event: demonetization. Can the scrapping of bank notes used in the bulk of the nation’s cash transactions finally catapult this long-time financial laggard into the 21st century?

By Elliot Wilson

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Illustration: Kevin February

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India’s premier Narendra Modi, a wily politician with a businessman’s mind, has a penchant for the strategic gamble. On the evening of November 8, he gave notice of his decision to demonetize Asia’s third-largest economy; at the stroke of midnight, the two largest-denomination rupee notes, the Rs500 ($7.50) and Rs1,000, were declared null and void for commercial use. 

“This was shock treatment, and sometimes India reacts positively to shock treatment,” notes Rana Kapoor, CEO and managing director of Yes Bank, one of the country’s private-sector banks.

By daybreak, India had entered new territory. Modi’s thinking was simple: India’s shadow economy, which by some estimates is between a fifth and a quarter of GDP, had to be tackled by going after black money, the cash that is hoarded in safes and under mattresses, and used to dodge taxes, pay bribes and fund terror attacks. Demonetization – used twice before in India, in 1946 and in 1978 – would, in theory, rid the country of this scourge. 

Modi faced two big problems. First, India depends on cash. US consultancy AT Kearney reckons 90% of transactions use paper money, while the two largest-denomination bank notes accounted for 86% of all cash in circulation. Second, demonetization is horrible shock therapy. Just ask Nigeria, which in 1984 recalled all its bank notes overnight in an effort to fight corruption, only to see its economy all but collapse. 

At first, fears that scrapping the notes would cause chaos seemed well founded. Farmers struggled to buy seeds or find buyers for their goods; cosmetic-surgery and blood-testing labs, their procedures routinely paid for in cash, went out of business. Economists warned that economic growth would slow, while across the country people raided their closets and shoeboxes for old notes, which they deposited in bank accounts. 


The whole banking sector has been upended in barely a few months 
 - Rana Kapoor, Yes Bank

Tales of winners and losers abounded. Millions queued for hours at ATMs only to find them empty because the replacement Rs500 and Rs2,000 notes proved too large to fit into cash machines, a problem exacerbated by a national shortage of the new tender. 

Both of India’s main stock indices were hit hard by the double news of demonetization and Donald Trump’s election win in the US. The BSE Sensex fell 6.1% the next day, and the NSE Nifty dropped 5% over the next two trading sessions. Shares in the big property firms took a knock, because the government was intent on cracking down on the black money used to buy cars and real estate. Shares in DLF, India’s largest commercial property developer, tumbled 17% the day after demonetization was announced, while shares in Indiabulls Real Estate, another big property developer, slumped 18.2%.

On the other hand, bank chiefs welcomed the move as truckloads of undeclared cash were brought into the formal economy. In just two weeks in November, Rs1.2 trillion was deposited at the nation’s largest lender, State Bank of India. 

Given the gamble India’s premier was taking, surely senior bank chiefs must have been kept informed about rolling events, allowing them to prepare for the big day?

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Arundhati Bhattacharya, chairwoman of the State Bank of India

Not a bit of it. The shock extended to the very top of the financial community. SBI chairwoman Arundhati Bhattacharya was sitting in a waiting room at the Reserve Bank of India’s headquarters in Mumbai, chatting with a select group of bank chairmen, CEOs and managing directors. She assumed it was a regular catch-up with central bank governor Urjit Patel until she saw a headline roll up on one of India’s many financial news channels. 

“We saw the announcement live on TV, along with everyone else in the country,” she tells Asiamoney in the quiet confines of the bank’s corporate boardroom in Nariman Point, a stone’s throw from the central bank. “There were no special telephone calls to us, no special information.” 

Asked about her immediate reaction to the news, Bhattacharya laughs, a genuinely cheerful sound that comes from deep inside. “It was just: ‘Wow! We’d better get working’,” she replies. “And the place we were sitting in the Reserve Bank, the cell phone signals are very poor. Maybe they have a jammer at work or whatever. So we were not even able to phone our subordinates. We all wanted to get out of the room and start dialling, because we knew there was an enormous amount of work to be done.” 


[Demonetization] will result in a far faster pace of digitization than we could ever have expected 
 - Arundhati Bhattacharya, SBI

Finally, the doors to the RBI’s inner sanctum opened and Bhattacharya and her peers were ushered in. Governor Patel outlined the demonetization plan, then still little more than a work in progress, whereupon the room emptied, the country’s bank chiefs grabbed their mobile phones and jumped in their cars. “It was already quite late when I got out, around 9.15pm, and everyone had gone home,” Bhattacharya remembers. “So I called all my senior staff to my house for a meeting that went on very late into the night.”

Other members of India’s banking community were also caught on the hop.

Aditya Puri, managing director of HDFC Bank, only found out via the television while he was on holiday in the Himalayas.

 “I was at a tiger reserve in Nepal when I found out,” says Puri, who has overseen one of India’s biggest and best-run private lenders since 1994. 

“I’d just finished a long day out on safari and I’d ordered myself a cold beer, which I was happily getting down to, when a very nice English lady, a wildlife enthusiast called Ellen who’d decided to shift out of London because of Brexit, walked up to me and asked me: ‘What is demonetization?’ I looked at her blankly and my first reaction was: ‘What is demonetization?’ My second was: ‘Do I look like a banker or what?’ But she just repeated the question, so I went running to see what had happened. My reaction when I finally found a TV set was: ‘Wow’.”

Rashesh Shah, chairman and CEO of Edelweiss Group, one of India’s largest investment banks, found out from his daughter. “That evening, I was working at home on my computer, and she walked in and asked me why the government had cancelled all the 500 and 1,000 rupee notes,” he remembers. 

With all the fake news flying around, Shah scotched the idea at first, assuming it to be internet tittle-tattle. But his daughter lingered in the doorway. “She said she’d seen the prime minister announce it himself, so I turned on the television, and sure enough, there it was. So with Trump becoming president, there were two areas of unexpected excitement that day, if you can call it that.” 

It seems incredible that a policy decision affecting billions of people could be implemented with such stealth in an era when information seems to leak as a matter of course. 


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Aditya Puri, managing director of HDFC Bank


No one in the banking industry saw it coming. “A handful of people knew,” HDFC chief Puri says. “The RBI chief and a few very senior people in government, and that’s it.” 

Modi himself skipped out of India the day of the announcement, heading to Tokyo for a state dinner, leaving the RBI and finance minister Arun Jaitley to mop up the mess. 

Yet India’s premier has also made a series of swift, shrewd moves, designed to mitigate any political fallout. At the height of the chaos, when ATMs ran out of cash and shops, unable to disburse change, closed early, Modi convinced the nation’s leading bank chiefs and corporate CEOs publicly to back his plan – which, for the most part, they did. 

A few dissenting voices can still be heard. “It should have been planned better,” mutters Deepak Abbot, senior vice-president at Paytm, India’s leading fintech specialist and a company that benefited from the initial carnage. “Shutting down the ATMs for two weeks and forcing people to deposit all their cash caused a lot of hardship for people. If the banks were better prepared, the initial view of demonetization would have been more positive.” 

Anshuman Jaswal, India country head at Shanghai-based financial consultancy Kapronasia, adds: “Modi’s timing was impeccable as it took everyone in India by surprise. I was very happy about the impact it had on corrupt individuals. But the lack of follow-up by the central bank in providing the new notes to replace old ones, and the chaos that ensued in bank branches and at ATMs took some of the sheen off the move.”

Yet by and large, criticism of the premier and his plan has been muted. That is largely a reflection of India’s ability to adapt. After the initial shock, most people quickly found ways around the cash crunch. They signed up for digital wallets via their smartphones. Many of those who had avoided the banks rushed to open accounts in order to get paid. Merchants learned how to invoice and settle payments digitally, often for the first time.

India’s economy stuttered briefly before regaining its footing. 

Annualized growth in the three months to the end of December came in at 7%, against 7.4% the previous quarter, according to data from the Central Statistical Office.

Side effects

Sales of big-ticket items dipped sharply in December, the first full month after demonetization. According to data from the Society of Indian Automobile Manufacturers, sales of motorbikes, which account for three-quarters of all vehicle sales in India, fell 22% year on year in December, marking the sharpest monthly contraction in 20 years. Housing starts in the residential sector fell to 40,396 in the three months of the fourth quarter, against 72,933 units in the same period the previous year, according to property consultancy Knight Frank. 

Modi himself was quick to mock economists’ predictions of a dramatic slowdown. But Modi has been lucky, benefiting from a series of unforeseen but important side effects. 


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Rana Kapoor, CEO and managing director of Yes Bank


At first, the government said demonetization was necessary in order to stamp out corruption and tax evasion. But by December, as the cash machines filled up, the narrative shifted. 

“The whole demonetization thing was a direct swipe aimed at black money,” notes Kapronasia’s Jaswal. “But when it became clear that no black money was being unearthed, the goalposts shifted, and the government started talking about digitization and the importance of a cashless economy.”

It was at this point that the Modi administration finally saw demonetization for what it was: a serendipitous chance to build a new, digital-based financial economy. After all, countries such as Sweden, Estonia and the Netherlands have all successfully shifted away from the use of cash in the economy, a move that cuts down on tax evasion and illegal transactions. Since coming to power in 2014, Modi has pushed hard to transform a country blessed with great IT firms, but where smartphone penetration is low, financial inclusion lags and paperwork trumps digital processing in the bureaucrat’s mind. 

Only 58% of Indian households have access to a bank account, against 79% of households in China, while just 27% of Indian villages have a bank branch within a five-mile radius. With so many workers paid in cash, tax authorities struggle to collect money. A mere 3% of adults pay any kind of income tax, according to official government data. 


I’m not worried about Paytm. But I am worried about what Alibaba can get them to do 
 - Aditya Puri, HDFC Bank

That is finally changing. Come summer, India will introduce its first national goods and services tax (GST), replacing a labyrinthine tangle of competing local levies. A broad cross-section of corporate India, from the postal system to mobile carrier Airtel, are now launching payments banks, which offer a limited set of banking services to the financially excluded

Whether by luck or design, the impact of demonetization on lenders, from their day-to-day operations to the way they see themselves and each other, has been dramatic. Kapronasia’s Jaswal calls it a “Big Bang-style revolution” that will rank alongside GST and post-1991 economic liberalization as “the biggest regulatory change India has ever seen”.

The impact is being felt across the financial system. Take Paytm, far and away India’s largest and most-influential fintech firm. Founded in 2010 in a suburb of New Delhi, Paytm grew slowly at first, accelerating when it struck a proprietary deal with ride-sharing app Uber and again in 2015, when it sold a majority stake to Chinese e-commerce giant Alibaba for $625 million. 

Then came November 8. With consumers struggling to adapt to a suddenly cashless economy, many turned to Paytm, a brand already well-known in first-tier cities. Within two weeks, the number of Paytm users had doubled to 150 million; at the end of February this year, the firm said subscriber numbers had passed the 200 million mark, with 8 million transactions processed daily. Before demonetization, the only language in which it operated was English; it has since added 10 more, including Tamil and Telugu, Marathi and Malayalam. 

“In two months, more than half our traffic has converted into non-English,” says Paytm’s Abbot. “Over the same period, the share of users based in rural or semi-urban areas has gone from 2% to more than 25%, and is on track to pass 50% this year.” 


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Deepak Abbot, senior vice-president at Paytm


Nor has Paytm been content to sail with the storm. Its sales team has been busy educating Indian shopkeepers about the benefits of digitization. Fewer than 1 million shops used Paytm at the start of November, but Abbot says 5 million merchants now sport a Paytm sticker somewhere on their counter or shop window and he expects the number to exceed 10 million by the end of this year. Compare that to the 700,000 traditional payment machines reckoned to be in use around the nation.

And this may just be the start. In February, the firm launched Paytm Mall, an Android app for smartphones modelled on Alibaba’s business-to-consumer portal Tmall and designed expressly to compete with Amazon and local outfit Flipkart. Next up, Paytm plans to roll out asset management services that mirror those offered by Alibaba’s financial affiliate Ant Financial, which has attracted more than 300 million smartphone-based investors in mainland China. 

Yet the firm’s future is far from assured. A senior executive at an Indian bank, who has helped to develop Paytm’s payment-processing systems, sniffs at the firm’s inability to convert promise into hard cash. “I’m not seeing huge growth on the revenues side,” he says. “They don’t make any money and they are constantly out of pocket, which is common in the technology space but uncommon in banking.” 

Digital wallets

Paytm made a loss of $225 million in the 12 months to the end of March 2016, according to the Registrar of Companies, the latest financial figures available for the private firm. Adds a senior banker: “It will be six or seven years before they make a big impact on banking. They know a lot – the customer data they suck in every day is invaluable. But you don’t make much profit in India with digital wallets.” 

HDFC Bank CEO Puri notes that digital wallet providers still rely on banks to act as financial intermediaries. And he scoffs at Paytm’s chosen way of bulking up quickly, which is to offer cash back to new customers who use its platform to pay utility bills. 

“The only reason Paytm is making a big noise is because of their user numbers, and the only reason people sign up is because they get Rs300 cash back when they pay a Rs500 bill,” he says. “That business model isn’t viable. All these firms are running losses.” However, he can’t afford to be complacent, given the financial savvy of Paytm’s biggest shareholder. “I’m not worried about Paytm,” he says, adding pointedly: “But I am worried about what Alibaba can get them to do.” 

You need to look beyond Puri’s words, though, and to the actions of the bank he runs, to view the startling effect that demonetization and the rise of fintech specialists – and would-be full-service financial players – like Paytm are having on mainstream lenders. 

HDFC already offered well-regarded mobile and internet banking services, but the events of November 8 have forced the bank to accelerate internal innovation. A month after demonetization was announced, Puri took a weeklong trip to Silicon Valley. On his return, HDFC unveiled plans for a new digital wallet called Chillr, a new asset management app, and a service enabling customers to secure a loan within seconds, at the tap of a smartphone. All bar the latter are services already offered and seemingly inspired by India’s leading financial disrupters. 

Yes Bank, India’s fifth-largest private lender, is going a step further with its ambitions to become a technology firm. “The whole banking sector has been upended in barely a few months,” says its CEO, Kapoor. “In the short term, we will live two lives, maintaining our conventional banking model while accelerating to become a full-service digital bank.” 

Payments banks offer hope for better
financial inclusion

Amid the chaos surrounding India’s decision to demonetize virtually the entire economy, a quieter financial revolution has gone all but unnoticed. 

In the last week of January, a division of the country’s postal system launched India Post Payments Bank (IPPB), a new lender offering a set of basic financial services to customers in two small cities in the east of the country. 

It followed the November rollout of Airtel Payments Bank, another new financial services provider owned 80%/20% by mobile carrier Bharti Airtel and financial services group Kotak Mahindra. Several more will open in the months ahead, starting with conglomerate Reliance Industries and fintech specialist, Paytm. 

Payments banks, an idea championed by two former central bank governors, Duvvuri Subbarao and Raghuram Rajan, are new to India and constrained in terms of the range of products they can offer. They can issue debit cards, offer mobile banking and foreign exchange services, and accept up to Rs100,000 ($1,500) in customer deposits. But they cannot lend, must locate at least 25% of their branches in unbanked rural areas and must invest at least 75% of any newly earned deposits in short-term government bonds. 

A government obsessed with financial inclusion is offering typically unbanked and poorer Indians a new and cheaper way to pay bills, buy insurance and savings products, and transfer cash to their relatives. And they can do it all using brands they know and trust and which, in the case of Airtel and India’s postal system, have vast networks of branches and kiosks already in place around the country. 

“Two things are going on here simultaneously,” says Rashesh Shah, chair and CEO of Edelweiss Group. “The government is trying to democratize payment systems and democratize access to credit. Over the last 20 years, bank credit has been largely wholesale – 50% of bank credit has been extended to the largest 50 groups. Payment banks allow credit to be spread across the country fairly and evenly, particularly for retail customers and small and medium-sized enterprises.”

Every new licensee has a different reason to covet a limited-service bank. Telecom operators view it is a chance to lock in customers and reduce turnover. In February, Airtel announced plans to roll out insurance and credit facilities. For Paytm, a payments bank would allow the country’s largest digital wallet provider to broaden its reach. “We can leverage what we know about our 200 million users to offer them new financial products, starting with wealth management services,” says Paytm senior vice-president Deepak Abbot. 

Then there’s IPPB, which in many ways is the key to everything. As part of the postal system, it can in theory extend basic financial services to billions of customers via India Post’s 155,000 branches, 90% of which are in rural areas. IPPB plans to extend its reach to 650 branches nationwide by September.

Finally there is Reliance Industries, which is set to launch its own payments bank in the second quarter, in alliance with State Bank of India. Many are keen to see if Reliance owner Mukesh Ambani, India’s richest man, wants to build a finance-to-telecommunications powerhouse that combines the new payments bank with his fast-growing telco, Jio. 

It hasn’t all been smooth sailing. Of the 11 licences handed out in 2015, three have already been returned, including by IT provider Tech Mahindra and generic drugs maker Sun Pharmaceutical. Rumours abound that Vodafone will abandon plans for a payments bank once it completes a planned merger of its Indian operations with Idea Cellular, a telco whose parent, Aditya Birla Group, is another licence holder. 

“You’ll find more companies handing back their licences later this year,” says a Mumbai banker. “Some of these firms, notably those that aren’t allied with a mainstream lender, don’t realize how difficult a payments bank will be to run, and how elusive the profits are likely to be.”

Amit Shah, Yes Bank’s president, adds: “In the long term, we see ourselves becoming a technology firm, not a bank.” 

Even staid old State Bank of India is embracing the modern world. In January, it announced plans to launch its own digital lender, SBI Digi Bank. “We are currently in the process of digitizing all our products and placing them all on our expanding digital platforms,” says SBI chairwoman Bhattacharya. 

The impact of demonetization is being felt far and wide, cleaving India’s financial landscape and upending old certainties. Some of the most profound changes have occurred in the remotest and poorest parts of the country, far from the halls of political and financial power. 

Bhattacharya spent much of the past few months in outlying parts of India, sitting with customers and explaining what was happening. 

“I went to the deepest reaches of northeast India, where we held classes about demonetization,” she says. “Many of the people we met refused to believe these strange bits of paper really were new bank notes issued by the government. In [the state of] Assam, demonetization has led to tea-pickers being paid digitally rather than in cash. For 200 years, they’ve been vulnerable to the advances of moneylenders, who locked them into very high interest-bearing loans. Having a formal bank account gave them their financial freedom.”

Demonetization is set to have an enduring impact on India’s economy and identity. Since coming to power, Modi has worked hard to boost financial inclusion, get consumers to pay their taxes online and force government departments to invoice digitally. 

So far, it’s working. In the 30 months to the end of 2016 – roughly spanning the period since Modi has been in office – 270 million new bank accounts were opened, according to the finance ministry. Government tax revenues jumped 22% year on year in the April to December 2016 period. 

Harishanker Subramanian, indirect tax leader at EY, reckons that jump was helped by a sharp rise in sales tax and excise duty collections, stemming directly from demonetization. 

To SBI’s Bhattacharya, demonetization “will result in a far faster pace of digitization than we could ever have expected”. 

Adds HDFC Bank CEO Puri: “It has opened up new markets, boosted financial inclusion, and brought a huge new section of the population into the formal economy. And it has probably accelerated the digitization of the economy and the banking sector by anything up to five years. It was a very good thing that happened here.” 

Kapronasia’s Jaswal agrees, noting that demonetization has “forced the Indian population to embrace digitization in a way that has never been seen before globally”. 

In his book Cloud Atlas, David Mitchell writes that all revolutions are sheer fantasy until they happen – whereupon they become historical inevitabilities. Before November 8, it would have been ludicrous to imagine a sitting Indian premier deciding to de-cash a cash-based economy, and pure fantasy to imagine him pulling it off with something to spare. 

Yet that is what has happened. By taking a risk, India’s political leader has transformed the banking sector, boosted digitization and tax revenues, and brought millions of citizens who had been excluded from the banking system into the formal economy.