Needlessly demonising demonetisation

Much has been said and written about demonetisation. Distanced from the din and dust of the debate, one is perhaps in a better position to do an objective and dispassionate analysis of the effects of this measure.

The objectives, even minutes before its announcement on November 8, would have seemed unthinkable to most: making a dent on corruption, black money, terrorism and counterfeit currency. These were subsequently expanded to include digitisation of payments and enlarging the number of taxpayers.

The most important expectation was that about a third of the demonetised notes valued at ₹15.4 trillion and constituting 86.9 per cent of the value of notes in circulation wouldn’t be deposited. This seemed to be based on heuristic assumptions that about a quarter to a third of high denomination notes in circulation represented undisclosed income and that funding of terrorism and illicit activities was almost entirely done in those notes.

Judged by this yardstick alone, demonetisation was not a success, as 99 per cent of the demonetised notes were returned and there was no fiscal windfall to be showcased. But this by itself does not invalidate the underlying assumptions, although it will leave open the question whether demonetisation was the best way to deal with black money and corruption. Persons with previously undisclosed incomes who chose to deposit their cash in banks instead of destroying them were behaving perfectly rationally as they expected to salvage something from the tax net if caught.

On the issue of short-term cost, the most obvious pointer has been the observed fall in the overall growth performance of the economy from the third quarter of 2016 onwards. Even one year later, there is a near-term loss of growth momentum as also a drop in consumer confidence. But the quintessential issue here is: To what extent can this be attributed to demonetisation in a cause-and-effect sense? (see table)

Agriculture is a cash-intensive activity and it’s obvious that the rabi season sowing and harvesting in 2016-17 was not affected. In fact, rabi foodgrain production grew 8.5 per cent — the highest in the last 13 years. The fall in 2017-18 Q1 agriculture growth rate has been due to a slowdown in allied activities. The signs of a slide in industry in 2016-17 and in Q1 of 2017-18 were evident at the beginning of 2016-17 itself with low and falling appetite for new investment “as entrepreneurial energies flagged”. This was more likely because of the leveraged balance sheets of a good section of corporates and rising NPAs of banks than due to demonetisation. The effect of demonetisation was strong on the cash-intensive construction, financial, real estate and professional services sectors in Q3 and Q4 of 2016-17, although their rebound in Q1 of 2017-18 was strong.

Overall, one can surmise that the fall in growth performance of the Indian economy in 2016-17 and thereafter cannot be attributed to demonetisation alone. We need good quality research to reveal the facts. However, this conclusion is not to belittle the disproportionate hardship that low-income families, particularly those in the informal sector, had to go through at least for a few weeks because of the dislocation caused to their lives and livelihoods.

Among the several possible long-term benefits of demonetisation, the following three are worth mentioning, since there are incipient signs that they are gaining hold: (a) a culture of better tax compliance; (b) expansion of the formal financial sector; and (c) a payment system less reliant on cash transactions.

A narrow direct-tax base, a retrograde direct-indirect tax structure, widespread tax evasion, complex tax rules, and an inefficient and rent-seeking tax administration have been the hallmark of the Indian taxation system since Independence. Its dysfunctional nature has shaped the incentives of politicians, bureaucrats, businessmen and taxpayers in a way that engendered corruption and black money. A recent survey conducted by Transparency International in 16 Asia-Pacific countries revealed that India had the highest bribery rate. This comes as no surprise, but what is encouraging is that over a half of the respondents from India were positive about the Government’s efforts to combat corruption.

It hardly matters if the Government’s post-demonetisation drive on tax evasion is an after-thought, since it seems to be yielding results never seen before: the number of income-tax filings increased significantly this year, the use of cash in real estate deals has come down, and tax officials are now making diligent efforts to uncover cases of tax evasion based on the information of large cash deposits made during demonetisation. For the first time, the age-old practice of forming shell companies for tax evasion and other unlawful activities now faces a serious challenge. Overall, there is anecdotal evidence to infer that the environment for tax compliance is improving.

Demonetisation led to a notable increase in financial intermediation with a 48 per cent increase in deposits in Jan Dhan bank accounts. Further, 38.2 million new accounts were opened post-demonetisation till end-July this year. This is certainly a big boost for financial inclusion.

For India, where more than 95 per cent of retail transactions were in cash before demonetisation, any policy goal and action to reduce the use of cash and aggregate holding of cash are welcome. A year after demonetisation, the currency in circulation is about 10 per cent less than its pre-demonetisation level and 19 per cent lower vis-à-vis what would have been the level now without demonetisation.

Digital transactions — both P2P and merchant varieties — are on the rise. October 2017 saw the highest-ever transaction volume at 965 million, exceeding the previous high of 957.5 million in December 2016. The RBI may be just right in observing in its last annual report that “there appears to be a structural break in the volume and value of retail electronic payments, coinciding with...demonetisation”. This augurs well for the country.

The writer is a former central banker and consultant to the IMF. Via The Billion Press

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