Success and failures of demonetisation

The Reserve Bank of India (RBI) has released numbers that show how most of the currency notes that were cancelled were deposited in banks. Now that we know that 99% of demonetised money has come back, the government’s estimates of how much black money would be extinguished have been proven wrong.

As the RBI’s latest annual report has confirmed, Rs 15.28 lakh crore or 99 per cent of the Rs 15.44 lakh crore worth of the notes withdrawn overnight onNovember 8 was turned in. Thus, almost all demonetised notes have been returned to the central bank, including the stock of black money held as cash.

2016 Indian banknote demonetisation

On 8 November 2016, the Government of India announced the demonetisation of all Rs.500 and Rs.1,000 banknotesof the Mahatma Gandhi Series. The government claimed that the action would curtail the shadow economy and crack down on the use of illicit and counterfeit cash to fund illegal activity and terrorism. The sudden nature of the announcement—and the prolonged cash shortages in the weeks that followed—created significant disruption throughout the economy, threatening economic output.

The Specified Bank Notes (Cessation of Liabilities) Ordinance, 2016 was issued by the Government of India on 28 December 2016 ceasing the liability of the government for the banned bank notes.

Demonetization technically is a liquidity shock; a sudden stop in terms of currency availability. It created a situation where lack of currencies jams consumption, investment, production, employment etc. The intensity of demonetization effects clearly depends upon the duration of the liquidity shocks. Following are the main impacts.

  • Currency crunch in our economy
  • Welfare loss for the currency using population.
  • Consumption was adversely affected
  • Consumption
  • Production
  • Employment
  • Growth
  • Tax revenue
  • Loss of Growth momentum
  • Increase in bank deposits and reduced interest rate
  • Countering of black money
  • Check on counterfeit currency

How money laundering took place?

The total reduction in black money was much smaller than what might have been envisaged. To the extent that it was possible to exchange money legally, individuals did so. After that it was done illegally.

Those who could not exchange money legally found money changers. When the government announced that old notes could no longer be exchanged, but only deposited, new ways of changing the stock of unaccounted cash emerged. Individuals with bank accounts, including Jan Dhan accounts, and companies showing cash accrual from sales came into business.

Large amounts could be laundered through this route as it did not involve immediate cash payouts by banks, since cash shortages still persisted with the RBI and banks scrambling to remonetise the economy.

Even when people have to pay tax on their hoarded cash, and a change fee they preferred to do that rather than lose the whole amount.

Data from Prowess, a database of companies in India, shows that in the quarter of demonetisation, when purchasing power had fallen sharply, net sales by companies rose significantly.

At the same time, the number of tax payers and tax collections rose. The tax department is said to have found thousands of shell companies which were possibly engaging in the activity of depositing money in their accounts during the demonetisation period, claiming that it was cash from sales. This provided a means for laundering money.

There is no doubt that those with holdings of unaccounted cash lost some of their wealth in the process of laundering it. To some extent, taxes were paid on it in the process of legitimising it. But in addition to that, illicit wealth was redistributed from black money holders to money launderers. Whether the money launderer was a company owner, a bank employee or a Jan Dhan account holder, there was now a need breed of criminals with wealth obtained from illegal means.

Objective seems unachieved:

The objective of reducing counterfeit currency seems unachieved.

In 2015, the National Investigation Agency established that at any point only Rs. 400 crore of counterfeit currency is in circulation. That’s 0.028% of total currency. Now, CNBC has calculated only 0.0007% of the returned Rs. 1,000 notes as being fake and only 0.002% of the Rs. 500 notes. In value terms the total is just Rs. 41 crore. So either a lot of fake currency hasn’t been detected or didn’t exist.

In terms of tackling terror funding, the Finance Ministry has said: “As a result of demonetisation of specified bank notes, terrorist and Naxalite financing stopped almost entirely.” But no proof has been provided.

Reduced dependence on cash: Both in number and value, digital transactions increased sharply after November but also dipped sizeably thereafter. There were 671.49 million transactions in November, rising to 957.50 million in December before shrinking to 862.38 million in July. So, the use of cash initially diminished but has been steadily increasing thereafter.

Criticism against demonetisation

Critics say, the Demonetisation as a means of tackling the black economy, carried out on the incorrect premise that black money means cash. It was thought that if cash was squeezed out, the black economy would be eliminated. But cash is only one component of black wealth: about 1% of it.

Black money is a result of black income generation. This is produced by various means which are not affected by the one-shot squeezing out of cash.

Any black cash squeezed out by demonetisation would then quickly get regenerated.

So, there is little impact of demonetisation on the black economy, on either wealth or incomes.

Negative economic consequence of demonetisation:

The disruption of unorganized supply chains that are dependent on cash transactions; it is still not clear how smoothly they were being rebuilt as the economy was remonetized.

No less has been the damage to institutional credibility. The RBI is yet to convincingly demonstrate that the demonetisation decision was not forced on it. At any rate, it was ill-prepared to deal with the aftermath, in terms of making available adequate quantity of replacement notes in the right denominations.

That remonetised notes are mostly of the illiquid Rs 2,000 denomination — constituting over 50 per cent of the total value of currency in circulation even as late as March 31 — didn’t help matters.

The economic costs— whether manifested in a crash in farm produce prices or a wide swathe of cash-dependent informal enterprises going bust, not to mention the sheer time wasted waiting in lines — are incalculable.

In the period immediately after demonetisation, there was expectation that it would bring a windfall for the Centre. To the extent that the scrapped Rs 500 and Rs 1,000 denomination notes were not deposited or exchanged at banks — especially by those who had hoarded their ill-gotten wealth significantly in cash — the resultant reduction in the Reserve Bank of India’s (RBI) currency liabilities would generate a “profit”, which it could then distribute as dividend to the government. But this did not happen.

Potential advantages of demonetisation:

  • Attack on the scourge of black money, tackling corruption, counterfeit currency, terror funding and reducing dependence on cash.
  • Changed narrative from Black money to cashless economy
  • The original intent of demonetisation was to address the issue of black money. There is enough work that suggests that people with black money hold a very small proportion of it in cash. Most of it is usually invested in gold, or real estate, or in the stock market, or abroad, and the share of black cash is 6% of the total black economy.
  •  The primary pitch and narrative of the demonetisation drive by Prime Minister seems to have taken a major shift to cashless economy from the initial key highlights of war against black money, corruption and counterfeit currency.
  • Now Government says that idle money has come into the system, the cash-to-GDP ratio will decline; the tax base will expand. But none of these required demonetisation and could have been implemented independently.
  • The government now also said that demonetisation is only one of the many steps to tackle the black economy.
  • The government’s argument that cash coming back to the banks will enable it to catch the generators of black income, and there will be formalisation of the economy, may not hold.
  • Then the goalposts started shifting when it became apparent that the main reason was not justified by what was happening. First it was cashless, then less cash economy, then formalisation of the economy. The final step was in saying this would give IT authorities the information to go after people who had deposited black money.

Who mostly have borne the brunt?

Large deposits by businesses do not automatically become black. The Income Tax department has to prove that the sums deposited resulted from generation of black income. According to the Finance Minister, big data analytics would track black money holders who have deposited cash in their bank accounts.

The negative effect of demonetisation can be seen in terms of big losses to the unorganised sector, farmers and traders.

The start-up world has seen a drop in investment activity

The brunt of this move actually has been borne by those who never had any black money. The note shortage is slowly waning and the long-term economic and social effects are becoming evident.

Critics overlook the significant gains of demonetization which have begun to accrue and will gather momentum
For India to achieve prosperity for all, three ingredients are essential: a transparent, effective government, flourishing of competitive free markets, and huge investment in the poor.

Corruption had made the government dysfunctional, crony capitalists flourished at the expensive of honest entrepreneurs, and rampant tax evasion that hindered state’s capacity to invest in uplifting the most vulnerable citizens. Note ban was announced to overcome these issues to some extent.

Short-term costs inevitable

There were always going to be costs in the short run — people would be short of currency, businesses would be disrupted, consumption would fall, and GDP growth would take a hit.

S  The government announced the Pradhan Mantri Garib Kalyan Yojana where cash could be declared, deposited, and a hefty penalty paid. For those determined to deposit their illicit wealth without disclosure, the cash has not become white. It will be scrutinised by the tax authorities and penalties levied.

The gains may accrue in the coming year once tax authorities have scrutinized through accounts with suspiciously large deposits.

According to Finance Minister, between November 8 and December 31, 2016, deposits between Rs.2 lakh and Rs.80 lakh, and deposits of more than ₹80 lakh amount to some two-thirds of the value of the demonetised currency. The holders of these suspicious accounts will now be in the tax net for perpetuity.

However, not all of that money deposited is black. Perfectly white cash holdings were common. To able to distinguish the black from the non-black would be the responsibility of the IT authorities. They have to analyse the deposits and correlate them with the tax payment records, which is relatively easy to do.

Move to a less cash economy

The significant gain which has begun to accrue, and will gather momentum, is the move to a cashless economy.
In the long run, a move away from the use of cash is the surest way of curbing the black economy.

Less cash economy can happen with shift in payment patterns. There was certainly evidence that the number of electronic transactions went up. But after the money supply started coming back, those dropped. Whether Indians have changed the way they make payments is questionable.

Other significant gains from demonetization

Nobel laureate Kailash Satyarthiand others working to fight human trafficking said that the note ban had led to a huge fall in sex trafficking.

The Demonetisation has badly hit Maoist and Naxalites as well. The surrender rate has reached its highest since the demonetisation is announced. It is said that the money these organisations have collected over the years have left with no value and it has caused them to reach to this decision.

Mumbai Police reported a setback to Hawala operations. Hawala dealers in Kerala were also affected. The Jammu and Kashmir Police reported the effect of demonetisation on hawala transactions of separatists.

Several e-commerce companies hailed the demonetisation decision as an impetus to an increase in digital payments, hoping that it would lead to a decline in COD returns which could cut down their costs.

The demand for point of sales (POS) or card swipe machines increased. E-payment options like PayTM and Instamojo Payment Gateway, PayUMoney also saw a rise.

The number of I-T returns filed for 2016-17 grew by 25 per cent and the advance tax collections during that period rose 41.8% over the 1-year period, as increased number of individuals filed their tax returns post demonetization

Salient lessons learnt

The government did not seek the advice of experts before going ahead. The strategic decision to surprise holders of illegal wealth would anyway have restricted the circle of those who could be informed, but it seems that the idea didn’t come from experienced policy advisers.

Good policy design should take into account how people will respond to any change in the rules of the game. In other words, incentives matter. Most rational human beings will adjust their behaviour to further their self-interest. Those who had illegal wealth held in cash obviously gamed the cash exchange process. Good incentive-compatible policy design is thus as important as good policy intent.

Political dynamics can be quite different from economic dynamics. That voters have continued to back the Bharatiya Janata Party (BJP) despite the pain imposed by demonetisation shows that the ruling party has gradually redefined its typical voter from the traditional trading base that supported the Bharatiya Jana Sangh to the aspirational middle class that has a lower tolerance for corruption.

International evidence suggests that few countries address the problem of black money by demonetising their currencies. If the problem is large-scale crime, corruption, bribery, bureaucrat-politician nexus, rent seeking, tax evasion etc. the answer lies in reforming the criminal justice system, law and order, administrative reforms, bringing transparency in the functioning of the state and rationalisation and simplification of the tax system.

In this context, the GST will be a far more effective mechanism to bring down tax evasion in indirect taxes considering the greater incentive for compliance that its design holds.

This episode in India’s policy-making highlights an essential tenet of policy-making — the need for a cost benefit analysis. For any objective that is to be achieved, we need to examine various policy options and analyse their costs and efficacy. For an economy on the path of reform, with many more reforms still to come, long-term sustainable impact can be achieved only when we strengthen the policy-making process as well.

Why Demonetisation alone is not responsible for slow GDP growth?

Reading the signals from the growth numbers is proving a tricky affair — especially as answers have to be shifted from multiple, intertwined narratives: the political, the economic as well as the purely business. There are multiple villains to blame, though, the most immediate being the damper of demonetisation of November 2016 and the implementation of the goods and services tax (GST) in July this year.  Following may also be the reasons for slow GDP growth.

There has been a sign of distrust in financial investments.

While GST pushed up gold buying, it pushed down manufacturing. Manufacturing companies sent out their old stocks to market, holding back on production. It brought down manufacturing sector growth from 5.3% in January-March to 1.2% in April-June.

In the post-rabi-season quarter we expected strong agricultural growth but it was pulled down by the animal husbandry sector. In fact, animal husbandry, specifically buffalo meat exports, has been the leading contributor to growth among all the areas that are clubbed under agriculture.

Uttar Pradesh, India’s largest meat processing state faced huge shutdowns from end-March. Livestock contributes a little over 4% to GDP and roughly a quarter of total agricultural GDP. Agri-sector growth dropped to 2.3% in April-June quarter against 2.5% in the same quarter of 2016.

Robust government expenditure rose 27% in the April-June quarter, to 6.5 lakh crore. The not so good news: fiscal deficit touched 92% of its budget estimates by July. At the same time, some of the government’s revenue-generating plans have not being implemented. While disinvestment and spectrum sales have yet to make significant headway.

Lack of PPP projects is clearly our biggest problem. Implementing the Kelkar Committee report and tackling the institutional bottlenecks that constrain PPP in India are the need of the hour. There is an institutional capacity issue. With an NPA overhang, corporates are wary and lack appetite to take risks.

Savings from physical assets were being moved from gold and real estate to financial assets. Gold (valuable) imports go up sharply. Household savings moving away from physical assets, especially real estate may not be a good thing for the economy. The second largest job creator after agriculture is real estate and construction growth has already tapered.

Way forward

Government should focus on ensuring growth, job creation and investment. The urgent need is to get the private sector to start investing. One way to avoid winds of deflation is to kick-start private investments.

Reviving the investment cycle and tackling bad loans will be the key challenges to be tackled on a priority basis in the current fiscal.

Government has launched a multipronged attack on corruption and black money. Government discretion has been reduced particularly in the allocation of natural resources.

There is a concerted attempt to improve ease of doing business, and technology is being used to deliver public services without leakages.

It is far too early to write-off any of these efforts, and demonetisation. There is a future beyond the present.

Conclusion

It is still quite possible that demonetisation will have positive consequences over a longer period— the growth in the direct tax base, the switch in the financial holdings of households from cash to bank deposits, and the increased use of digital payments. The question to be asked is whether the potential long-term benefits will be greater than the short-term costs that the Indian economy had to bear.

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