Saturday, November 12, 2016

Demonetisation: Ineffective, Inadequate and Premature

R. Ramakumar

(A shorter version appeared in the Business World: read here)

The demonetization of Rs 500 and Rs 1000 notes by the NDA government has three claims: to end the circulation of “counterfeit notes” from Pakistan; to eliminate and stop the use of “black money”; and to create a “cashless economy”. Let us examine each claim separately.

First, while counterfeit currency is in circulation, there is no accurate estimate of its quantum. Over-the-top claims of counterfeit currency amounting to tens of thousands of crores of rupees are wrong. In 2015-16, the share of Fake Indian Currency Notes (FICN), “detected” by banks and police, in the total notes in circulation was 0.002 per cent for Rs 1000 notes and 0.009 per cent for Rs 500 notes. The results of a study, conducted by the Indian Statistical Institute (ISI) Kolkata, reported in the press and quoted by Arjun Ram Meghwal (the Minister of State for Finance) in the Parliament in August 2015, estimated that only about Rs 400 crore worth FICN was in circulation at any given point. Moreover, only a part of FICN arrived from other countries as part of terror networks. Rest was indigenous. 

Thus, the claim that demonetization would significantly hit terror financing appears overstretched. Moreover, the media reports have quoted the ISI study as concluding: “the existing systems of seizure and detection are enough to flush out the quantum of FICN being infused” (Times of India, 11 May 2016). 

Secondly, demonetization is premised on the crucial assumption that “black money” is stored in cash by hoarders. This is wrong. For instance, the white paper on black money prepared by the Ministry of Finance in 2012 defined black money as “assets or resources that have neither been reported to the public authorities at the time of their generation nor disclosed at any point of time during their possession”. Thus, black money originates from (a) manipulating account books through multiple means, and (b) through various transactions outside the account books. The former includes manipulation of sales, receipts, expenses, production, value of capital, closing stock and so on. The latter includes transactions without bills, use of parallel account books and unaccounted assets, and investments in shares through dummy entities. If “black money” is the target of attack, it then requires a multi-pronged approach towards a more efficient and effective tax administration that would help unearth such illegal activities. 

Demonetization, on the other hand, is a one-time measure that addresses only those cases where proceeds from the above illegalities are hoarded in cash. In other words, we are referring only to a part of the “cash economy” portion of the larger “black economy” here. There are no estimates of the quantum of illegal cash hoardings in India (storing cash is legal in India with no limits specified). However, tax authorities have documented that the most important form of holding illegal earnings is not cash, but physical assets like land/bullion and financial assets like shares. Another part of the illegal earnings is seamlessly transferred as capital invested in productive activities – much like in Marx’s writings related to the transformation of “idle money” into capital – in a rather continuous fashion. It hence “disappears” as soon as it is generated. Yet another part of illegal earnings is shifted out of the country, through the hawala route, and is either stored as offshore deposits/assets or ploughed back to India through the “Mauritius route”. 

Thus, only a section, which stores cash in large amounts either for future use or as revolving cash in business/trade transactions, is adversely affected by demonetization. Even here, a portion of cash might actually be legal and convertible into legal paper through official channels. Another portion of cash, even if illegally earned, is made convertible into legal paper through myriad innovative methods. Newspapers have been reporting many such methods of conversion after the announcement of the Prime Minister (for an example, read this).

Hence, no significant unearthing of illegal cash may be expected by demonetization, even if it might halt or slow down illegal cash-based operations for a while. This was also what was clearly laid out by the committee on “Measures to Tackle Black Money in India and Abroad”, headed by the Chairman, Central Board of Direct Taxes (CBDT), and submitted to the Ministry of Finance, Government of India in 2012:
“One common demand from the public is that high denomination currency notes, particularly `1,000 and `500, should be demonetized. In this connection, it is observed that demonetization may not be a solution for tackling black money or economy, which is largely held in the form benami properties, bullion and jewellery, etc. Further, demonetization will only increase the cost, as more currency notes may have to be printed for disbursing the same amount. It may also have an adverse impact on the banking system, mainly logistic issues, i.e. handling and cash transportation may become difficult and may also cause inconvenience to the general public as the disbursal or payments of wages/salaries to the workers will become difficult. Besides, it may also adversely impact the environment as more natural resources would be depleted for printing more currency notes. Demonetization undertaken twice in the past (1946 and 1978) miserably failed, with less than 15% of high currency notes being exchanged while more than 85% of the currency notes never surfaced as the owners suspected penal action by the government agencies.”
Thirdly, much of economic transactions in India are cash-based due to the presence of agriculture as a major source of livelihood, prevalence of a large informal sector and the poor penetration of banking infrastructure in rural areas. The persistence of cash is, then, a structural feature of the Indian economy. Opening bank accounts for every household (as under the Jan Dhan Yojana) alters nothing vis-à-vis the structural basis of this cash-nexus. For example, even after the opening of crores of bank accounts, a large share of bank accounts is dormant; even after appointing lakhs of banking correspondents in villages, about half of them are “untraceable” (as was recently officially admitted), and many others are financially “unviable”. 

A cashless economy, in other words, is not created by diktat. It requires, as a pre-requisite, a structural transformation of the rural economy into a modern and productive sphere, which would facilitate more and more cashless transactions. 

As an ideal state, moving into a cashless economy is not necessarily a bad idea. Developed countries have, over time, eliminated notes of larger denomination and moved to card/bank-based transactions. Such a shift indeed aids in controlling corruption and crime. The problem in India is that any move in haste towards a cashless economy would be premature and self-defeating. How many shops have credit/debit card machines, or even mobile-based transaction facilities? How many people have credit/debit cards? How many people have, or know about, Internet banking? Even after the recent progress made in opening new bank accounts, crores of households remain without bank accounts. These are indications of total lack of readiness. In such a context, any drastic push towards a cashless economy would be harsh on the unbanked households and those poorly connected to the banking system.

No economy can ever be cashless. The point, then, is to induce people to use the formal channels where cash is currently used for high value transactions. The tax department has, for some time, been taking steps towards this direction. If this is the trajectory the government wants to adopt, it is unclear why the government would want to introduce new notes of Rs 2000 denomination. In fact, once the current dust settles, legal and illegal cash-based transactions are likely to resume with the new Rs 2000 notes. On its side, the government has given no logical justification for this baffling step, which raises deep suspicions on the real intent behind demonetisation.