No one quite knows which Narendra Modi will turn up to fight for reelection in 2019: the reformist technocrat pledging to create jobs or the tub-thumping populist armed with giveaways. For most of his first term, the Indian prime minister has struck a fair balance between the two, and last month he passed his third anniversary in power with a good growth record and strong poll numbers. But his calculations appeared to change last November, when he tilted toward populism by launching demonetization, a surprise move to scrap two high-denomination banknotes. This has proved to be one of the most disruptive experiments in recent economic history, and one from which Modi’s administration now risks learning all the wrong lessons.

The fact that demonetization has been bad for short-term growth is no longer in doubt. Last week, India released GDP figures for the first quarter of 2017, the period when Modi's demonetization had its largest impact. Over those three months, hundreds of millions of Indians were forced to line up at cash machines and bank counters to replace their old 500-rupee (about $7) and 1000-rupee (about $15) notes, which made up about nine-tenths of the value of all currency in circulation. The crunch hit the poor particularly hard, and brought swaths of commercial activity in India’s cash-dependent economy—and especially in its large semi-legal gray market—to a standstill.

Sure enough, the new data bear this out. From January to March of this year, Indian growth sank to six percent, down from seven percent in the previous quarter. Although high by Western standards, these figures lost India its title as the world’s fastest-growing major economy, pushing China back into first place. They also brought growth over the last twelve months down to its lowest point for three years. Modi’s Bharatiya Janata Party (BJP) government, eager to defend demonetization, blamed other factors, such as weaker global trade performance, for the slowdown. It also pointed to the policy’s potential longer-term benefits, such as higher rates of tax collection. But demonetization’s impact was especially clear in the collapse of spending on construction, which is heavily dependent on informal cash transactions. 

Demonetization has proved to be one of the most disruptive experiments in recent economic history.
 The problem is that although a drop of a percentage point or so in growth is large, it is not that large. Many economists feared a drop many magnitudes bigger. Now that the worst has worn off, demonetization remains popular. At least at first, Modi justified the measure on anticorruption grounds—by scrapping notes, so the argument went, the government was taking a swipe at black money, or the illicit cash piles thought to be held by everyone from criminals and terrorists to corrupt bureaucrats—and the public appears to have believed him. Yet there is little evidence that any of the criminals suffered more than temporary inconvenience. As their eyes turn toward reelection, the risk is that BJP leaders will have learned to dismiss expert warnings about the cost of populism and press ahead with more of it. 

Understanding why demonetization has been less harmful than feared is therefore important. The World Bank’s most recent India Development Update, published in late May, provides some clues. It shows that the impact of the cash crunch was cushioned by other factors, including a third year of good monsoon rains, which are crucial to agriculture. A recent uptick in global growth helped too, as did higher public spending unrelated to demonetization. And when the demonetization crunch did hit, India’s economy proved more resilient than expected: the remaining cash in the economy circulated more quickly, informal credit was provided to consumers and farmers, and some wealthier people switched to digital payments. 

Put another way, Modi got lucky. But now there is a real risk that he will take more populist measures in the same vein. When his party won a resounding post-demonetization victory in crucial elections in the bellwether state of Uttar Pradesh this spring, Modi went on to install the firebrand Hindu cleric Yogi Adityanath as chief minister. Adityanath responded by canceling nearly six billion dollars’ worth of bank loans to farmers. This cancellation started off a chain of events in other states, which some estimate is likely to result in tens of billions of further debt forgiveness, raising pressure on public finances. 

Meanwhile, for the long-term benefits of demonetization to be felt, Modi needs to push what the World Bank report calls “complementary reforms,” including improvements to tax administration and the reduction of complex business barriers, to encourage more of India’s vast informal economy to move into the formal sector. There is a good chance that no such reforms will emerge. So far Modi’s economic achievements are real, but his record on delivering growth-enhancing reforms, especially those that risk upsetting the public, is mixed. Although his grand gesture of demonetization made little sense economically, it has proved enduringly popular, and it appears to have made only a minor dent in the GDP. As he approaches 2019, it is not hard to see the lesson that he might learn.  

An earlier version of this article referred to India's "surprise move to scrap two low-denomination banknotes." The notes in question were high-denomination.

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  • JAMES CRABTREE is Senior Visiting Research Fellow at the Lee Kuan Yew School of Public Policy NUS in Singapore, on sabbatical from his previous position at the Financial Times, where he was Mumbai Bureau Chief. 
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