Demonetisation, a mixed bag

Alok Ray | Updated on January 15, 2018 Published on November 29, 2016


Its focus is based on treating black money as a stock, whereas it is actually a flow. Therefore, other steps to deal with the latter would be required

Now that the shock and the euphoria over the sudden demonetisation (of 86 per cent of currency notes) have subsided to some extent, let us have a balanced look at the possible costs, benefits and consequences of the exercise.

The costs are evident in terms of the physical hardships (particularly for the old and infirm), lost man hours and lost potential output as people have to stand in queues for hours. In addition, because of the acute liquidity shortage, the third quarter GDP will take a hit as people will be forced to buy less and economic activities would go down.

By how much the annual growth of GDP would be affected would depend on how much time it would take for the situation to normalise and to what extent the sowing of rabi crops and informal rural lending would be adversely affected. Though everybody is feeling the pinch, the cost would be proportionately more for people in rural areas, petty traders, daily wage earners, migrant workers and the destitute who do not have bank accounts and identity cards (or banks are too far away) and who depend exclusively on cash transactions for their livelihood.

The supposed objectives behind the massive exercise are threefold: it would severely dent creation of ‘black money’, eliminate counterfeit currency and cut the flow of funds to terrorists.

Stock and flow

The so-called ‘black money’ (which does not pay tax) is both a stock of accumulated wealth and a flow which is generated all the time from certain activities. Most of this enormous stock of ‘black’ wealth is held in the form of real estate, gold, foreign exchange and assets held abroad. Hence, even under the best case scenario, the current demonetisation exercise would not touch the bulk of this wealth. At best, it can have an effect on the black money held in the form of domestic currency which is a small fraction of the total stock.

Further, as it is becoming increasingly clear, people with lots of black money are finding numerous ways to convert old money into new money. These include using hundreds of other people to exchange cash and/or deposit money in their bank accounts (including zero-balance Jan Dhan accounts), paying salaries to employees in cash for many months in advance and booking flats for employees with back dated transaction records, and taking help of temple trusts and companies which show cash in their books but actually have very little of their own.

The black money thus converted into white would be eventually returned to the original owners after keeping a ‘cut’. In the process, the black money owners would suffer some loss (some 20-30 per cent) which, in their reckoning, is better than paying 33 per cent tax plus hefty penalty and even more importantly, getting permanently into the tax net with recorded high incomes. But clearly it would have no effect on the huge stock of black wealth held in other forms. It would not stop generation of further black money in future either. The holders of black cash, at most suffering a hit of some 20-30 per cent would go on doing the same operations as before with new money.

Some professionals like doctors, lawyers, private tutors may not be able to use these conversion techniques that effectively and hence may be forced to show a higher income in the current year’s tax return by including their cash holdings. In future, they may also be more willing to accept fees in cheque and may hike their fees to offset the tax liability. With less availability of black funds in the immediate future, the demand for real estate is likely to fall, causing a drop in real estate prices.

But it is doubtful whether this effect would be permanent. Unless some additional steps are taken (like going after benami property, reducing stamp duty, and prosecution of some high profile offenders to create fear) soon it would be business as usual with cash payment (of some 30-60 per cent of the value of property, as is now).

Thus, at best, the first objective of controlling black money would be satisfied in a limited manner.

Mistakes in implementation

However, a much bigger success may well be attained regarding the second and the third objectives. The holders of counterfeit currency cannot come to the bank for conversion without being detected. Hence, they would be forced to abandon their stock.

But, then again, it would be a temporary respite till the makers of counterfeit currency (which happen to be the government agencies of some of our neighbouring countries) are again able to produce fake equivalents of the new currencies, despite additional security features. Many terrorist organisations have a big stock of currency (built up through extortions, loot and foreign funding) which is used to buy arms and finance various anti-national activities. Overnight, their cash holdings have become useless. Since most of these people stay underground, it is far more difficult for them to convert this cash into legal tender.

Granting the need for secrecy, the prolonged adjustment cost of the demonetization experiment would have been less if the government was better prepared. For example, the biggest mistake has been that the RBI has not printed new ₹500 notes from the outset and has released only new ₹2000 notes which have become largely useless for purchasing goods and services in the absence of a sufficient quantity of lower denomination notes (₹500 notes, in particular) as change. Similarly, changing the size of notes has created additional problems for recalibrating the ATMs which is taking weeks instead of a few days, as earlier announced.

Finally, can one blame the people for being enraged when they are being forced to stand in line for hours to withdraw ₹2,000 from their legitimate bank accounts, while some of our politicians face no difficulty to spend hundreds of crores of rupees on their daughter’s wedding?

The author is a former Professor of Economics, IIM, Calcutta.

Published on November 29, 2016
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