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Shock Therapy vs. Gradualism: Approaches of India in 1990s and 2016.

By Sanjana Medipally

The issue of speed and sequencing of reforms has become prominent in the early 1990s while designing a reform strategies for former Soviet satellite countries. The sequencing of reforms refers to the order in which either macroeconomic policy actions or specific reforms are introduced. The debates regarding the appropriate speed of reforms have given rise to discussions on what can be described as ‘big bang’ versus ‘gradualism. From the political economy point of view, many policymakers favor gradualism, however, this approach requires a robust administrative capacity while some prefer that reforms should be undertaken quickly. The big bang strategy in the absence of time consuming adjustment processes and costs would result in long run efficiency gains immediately.
Given this case, a rational individual would choose to opt for adjusting slowly to credible reforms even if the government chooses to follow shock therapy. Choosing between gradualism and shock therapy has become a highly debated topic. Some of the countries have chosen both the approaches. Proponents of a gradualism point to the experiences of Hungary and China while advocates of shock therapy point to the cases of the Czech Republic and Poland. Though the concepts of gradualism and shock therapy have been mostly applied to transition economies in the Central and Eastern European countries after the disintegration of the Soviet Union, India has also followed gradualism approach in the same period. The reason for countries like Hungary and other CEE countries to follow gradualism or shock therapy is due to a prolonged crisis or because of a system collapse. But in case of India, the process of transition has many starting points and the reforms have taken place due to the urgency of the balance of payment crisis in 1990-91 along with the pressure from international organizations like IMF and World Bank (World Bank, 2005).
However, the reason to initiate the process of economic reforms is also connected to the early reforms initiated by the Congress in the 1980s, the effect of Gulf War on India’s inflation. The government has signaled a systemic shift towards a more open economy with more dependence on the market forces, the role of the private sector and restricting the role of government. Over the periods of two decades, the impact of these gradual reforms has been positively experienced. While experiencing these benefits, India has implemented a shock therapy reform – the demonetization – in November 2016 which has abruptly affected the poor and weaker sections in the economy. With this backdrop, the paper would analyze the gradualism (in the 1990s) and shock therapy (2016) reforms implemented in India.

Shock therapy Vs. Gradualism
With the end of Communism in Central and Eastern European (CEE) countries came another challenge – a suitable approach for these countries to transition from a Soviet planned economy to a Western based market economy. During the communist period, the state controlled all the attributes of the economy where no individual profit holding venture was possible. But with the fall of the Soviet Union and its influence in these nations, it was time to build a new economy based on the free and decentralized market.
During this phase, two different approaches to transitioning were evident: Shock Therapy and Gradualism. Both aimed at overhauling the economic architecture of the country, bringing in new policies and schemes. Though the major difference lied in the time frame, with shock therapy focusing on short-term and gradualism is concerned with the long term, the two approaches aimed to address the policies essential for a smooth transition. The Shock Therapy, as the name suggests, aimed at quick implementation of numerous policies simultaneously – privatizing the market overnight, ending price control regime and others. This virtually ‘shocks’ the economy and forces a jump start with a fresh set of customs and reforms. Whereas in the Gradualism approach, these reforms are carried out in phases. The masses and the market are given time to grasp and absorb the changes taking place. But does the difference in approach really help? Is one better than the other?
As mentioned in the earlier section, there was immense debate taking place on the merits of shock therapy versus gradual reforms. It has been observed that most of the transition governments have used what shock therapy is also called as ‘big bang’ approach in their transitional process. At times, shock therapy is referred to as ‘Type I’ reforms and ‘Type II’ reforms is used for a gradual approach. In order to carry out Type I and Type II reforms, the major differences lied in the ability of transition governments, which was based on two important factors: their ability to reduce corruption and their ability to collect taxes in order to finance public program (Svejnar, 2002).
Jeffery Sachs is a well-known advocate of shock therapy in Central and Eastern European Countries. For him, shock therapy is the suitable means of action because, ‘the existing structures are the problem’ (Sachs, 1994). Sachs also emphasizes that, with quick implementation of reforms, most of the public is benefitted. For shock therapy proponents, the transition to a market economy is the destruction of the current system and building a new system. It involves macro and microeconomic reforms for the quick transition to occur. As shock therapy is being employed on the economy, it leads to the release of price and currency controls along with rapid liberalization of trade and withdrawal of state subsidies. This can be illustrated by the J-curve – a sharp initial fall in economic activity, yet the recovery is followed rapidly. On the other hand, the J-curve of the gradualist approach has a moderate initial decline in recovery following at a slower pace.
Given the nature of gradualism, most of the citizens “do not know before the reform whether they will be winners or losers (Dehejia, 1996)”. This is an attractive feature of gradualism to individuals who are uncertain about the results reforms can impact their lives. Gradualism enables the public to accept or reject the reforms, which allows its government to decide whether there is a need to execute additional reforms.
When following the Shock Therapy, any opposition to the reforms is minimal, because, given its nature, it does not give time for individuals to plan a strategy. But at the same time, it does not give them time to assess the reform and verify whether it will be beneficial for them in the long run. Using Gradualism, there is scope for trial and error as the failure of one reform initially can be rectified in the next along with giving time to tailor a policy which would benefit everyone. But even this is not always unproblematic. Hungary, prior to applying the economic reforms, almost had a decade of experience in initiating soft reforms in the 1980s itself. That is the reason it is one of the most successful transition economies in direct sales.
One important feature of shock therapy is that it brings benefits quickly, but if the shock is too strong, i.e. if the economy is not able to jump start in time, then the repercussions are damaging. There can be widespread corruption, with no policy implementation, with the gap between rich and poor widening due to privatization. This can even give rise to oligarchic tendencies among a select group of people. On the other hand, if the Gradualism approach is too slow, then the effect of one reform could fade out before the next rolls in. And this is worse if the two are interdependent. Inflation can lead to a depreciation of the currency, in turn tilting the balance of payment in the negative with higher imports. This, in turn, would bring another policy, which will definitely upset some part of the business community. Hence, the key lies in applying the right policy at the right time.

India’s approaches – Gradualism or Big Bang?
India’s reforms have highlighted the process of gradualism instead of a rapid restricting of the economy or known as ‘big bang’ approach. Unlike other countries, especially the CEE, whose reforms were introduced due to an extended economic crisis or the collapse of the USSR which has generated a desire and willingness to accept big bang reforms to restructure the economy, the gradual reforms in India were undertaken due to the severe 1991 balance of payments economic crisis. This was not a prolonged crisis but rather an abruptly erupted one, before the crisis India was experiencing a healthy growth rate in the 1980s.
Given that the East Asian economies were performing well in this period, India (with a view to performing well) has introduced several initiates like reducing direct taxes, increasing the role of private sector and licensing liberalization – all which have proved to have a positive effect on the economy had have paved the way for gradualist reforms. Along with the balance of payment, a crisis was the problem of overvalued currency in the late 1970s in India because of its strict import tariff structure (Nayak,2007). These tariffs were reduced overtime to devalue the exchange rate and have acted as incentives for domestic producers. The 1990s reforms in India have foreseen a systematic change in a very gradual pace.
Most of what we see in India today can be traced back to the opening up of the economy in 1991. The old way of doing business has been disrupted by the end of license raj, opening up of the economy has welcomed global brands into the country (Kohli, 2006). This change took almost two decades while changing many aspects of independent India. The 1991 reforms did not yet end, indeed it is when they were started, though these reforms had disrupted the economy and affected the weaker players while paving way for stronger ones, it took time for the benefits to be seen and experienced. Considering the Indian history of reforms, we can conclude that there is encouraging evidence which favor reforms – we obtained the huge service sector which was unorganized or informal, reformed the stock market which was prone to scams and restored the telecom sector from incurring losses. The poor also have benefitted from the rise in their average incomes. The 1990s reforms can be categorized as gradual reforms in India, but the demonetization reform in 2016 was a big bang which severely affected the poor and the weakest the most – especially their incomes.
The decision to cease the legal tender of Rs 500 and Rs.1000 notes has come overnight and the reason to do so: black money. The black money in the country is used for corruption or illegal transactions in high denomination notes i.e Rs. 500 and Rs.1000 (Raj, 2016). Prime Minister Modi has specified that these high-value notes were being used to fund terrorism and finance corruption. Within hours of the announcement, the currency notes lost their legal tender. While at the same time new Rs.500 and Rs.2000 notes are introduced which would check the unaccounted money and also cleanse the Indian economy of the black money accumulated in the form of high denomination notes. But the government did not ensure a large enough supply of the new notes and has sent the economy into a scramble. The banks were unprepared and the new money was not produced or distributed beforehand and people could not obtain the new bills in the ATMs as the ATM vendors like the general public were ‘shocked’. As the cash extinguished from the economy without a viable alternative in place this move has disrupted and affected the different sectors of economy abruptly. Given that there was no widespread and effective mobile payment infrastructure in India, the government should have considered waiting until the mobile infrastructure gets stronger in the economy before taking the drastic step.
The demonetization shock was particularly disruptive to the nation as almost 86% of the money in circulation has been extinguished (Nag and Marlow, 2017). Given that the target of demonetization was black money and the ones who have accumulated it via tax evaded income, hold it in real-estate, gold and tax haven abroad – these holdings of black money would not be affected by the demonetization move. It is complicated to estimate how much amount of money in India is black or white and the attempt to curb it has sent shock waves through the nation which had its consequences felt across the economy.
Out of the socio-economic strata the working class has been adversely affected along with casual workers in the hierarchy. Daily wage workers had lost days’ wage while queuing up at the banks to convert their money. The working class though do not hold any tax-evaded income as their annual incomes would be mostly below the threshold of income tax exemption have suffered from large magnitude adjustments. Small and medium enterprises are another group which was severely affected as the integral part of their daily operations is ‘cash transactions’(Raman,2016). Self-employed professions like lawyers, doctors who tend to hold huge amounts of tax evaded income were also affected with their monetary income being extinguished as demonetization will unload the black money, but their large ‘non-monetary’ income were unaffected with this move. The real estate sector where there are huge proportions of black money has been affected to an extent that all transactions were frozen for a long time and have experienced painful chaoses and restricting. The informal economy comprising of street vendors and small manufacturing units etc which are neither taxed nor monitored by the government have been severely affected than the formal economy (Das, 2017).
This process of demonetization has also cost the lives of people as hospitals (in some parts of the country) have refused to treat patients from the lower strata, in exchange for old notes. Many senior citizens have also lost their lives while standing in queues in front of banks in exchange for old notes. Given that almost 50% of them do not hold bank accounts the collective punishment to India’s poor and informal sectors had severe effects on all categories of households. India’s growth has been slowed down to 6.1 percent from January to March 2017 and has undergone adverse effects of demonetization on output and employment (Nag and Marlow,2017). The government should have implemented a transparent system to discuss the merits of such policies which was done while opening up of the economy in the 1990s and the easing of inward and outward foreign exchange flows (Panchal,2017).
The banking sector was the only one to welcome the move would bring back a lot of undeclared cash back into the formal economy. On another note, though demonetization has resulted in a cash crunch, it has pushed for digital payments promoting less cash/cashless economy. India’s cash to GDP ratio stands at 12% and is one of the highest amongst the developing countries (Wilson, 2017). Although there was a negative monetary shock sent through the country with 86% of currency being extinguished, there has been an increase in bank deposits which has enhanced the flow of bank credit.
Though India is coming out of its twin shock of demonetisation a gradual approach would have given time to businesses, tax department and professionals to learn and adapt while the word of mouth spreads on the ‘need to change and on modalities of change’ and this would have avoided disruption in the economy (Raj,2016).

India’s experiment with the demonetization phenomena has impressive objectives nevertheless, the implementation process has caused undeniable hardship to the common citizens of India, especially its huge informal economy. This underlines that the need for basic financial literacy to be given priority rather than using instruments which would force people into banking activities. Instead of a big bang move for demonetization, a more gradual transition would have avoided from the sufferings of the common people. The unearthing of black money objective of demonetization has failed because most of the black money was in the form of wealth. The capacity of ATMs to dispense the new notes was incomplete and there were instances of ATMs dispensing counterfeit currency of the new Rs.500 and Rs. 2000 notes (Raj,2016).
On the other hand, there is an increase in awareness of the banking system and digitization amongst the common public along with unearthing the black money which is held in cash. Furthermore speculative and rampant terror activities seemed to have been tamed.
It is according to the situation if gradualism or shock therapy is a better fit in a situation. If Shock therapy (like demonetization in India) was to be implemented there should be supplementary plans which would reduce its immediate effects. Though the action plan of implementing shock therapy is strong there are always immediate effects and risks to a certain extent and could have negative effects on the economy. Whilst gradualism may not include a shock element, its benefits are spread over the years to deliver. Therefore it can be assumed that the shock therapy reforms are short term reform mechanism which is more volatile but immediate and gradualism is a long term strategy which is not immediate but is better over time and is less volatile with low risk of failure.



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Sanjana Medipally is a final year student at Jindal School of International Affairs.

Featured Image Source: The Online Citizen

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