Demonetization in India : Good or Bad?

PM Modi - who has an uncanny knack of managing the media narrative - announced on 8/11 that the 500 & 1000 rupee currency notes are being demonetised at the stroke of midnight; the media which was till then closely following the US elections was forced to immediately shift to a domestic capsule. Defense Minister, Manohar Parrikar, said later that this move would impact the opposition parties in the impending state elections; clearly, this action was not bereft of political motives. The spin on terror financing from across the border, though true,appealed to the patriotic sentiments of the people.

As per Ambit Capital about 1/5^th of the $2 trillion dollar Indian economy is “black” while others have pegged it at a more ambitious $1 trillion dollar (50%) parallel economy; safe to assume 25% ($500 billion). India’s cash economy is about 17 lakh crore rupees ($250 billion) & 86% of that – 14.5 lakh crore rupees ($217 billion)  – is in the form of 500 ($120 billion in value & 15.7 billion in no’s) & 1000 ($97 billion in value & 6.3 billion in no) rupee notes. As per the finance ministry, during the period 2011-16, while currency notes circulation increased by 40%, 500 rupee notes increased by 76% & 1000 rupee notes by 109%, suggesting that higher value currency notes might have an important role in India’s black economy. Since all the 500/1000 rupee notes are not “black” money & if we assume about $100 billion (about 50% of the 500/1000 notes in value) of such notes as “Black” this is only 25% of the $500 billion black economy. Clearly, more of the “black” money is not in a cash form.

With interest rates low, internationally, Indian black money is not hoarded in Swiss Banks but has “round tripped” to India vide the Mauritius & Singapore routes.  Participatory notes (PNs) – the opaque financial instrument – that helps people invest in the stock market without revealing their identity, is the other culprit. As per a Credit Suisse report the top 1% of Indian population hold 53% of wealth & the top 10% hold 76%; surely, if the black money has been invested in real estate, housing, gold, precious stones & securities, would it not make more sense to target the top 10% rather than inconveniencing the entire population?.

The cost of production of Rs 1000 note is about Rs 3.2/-, Rs 500 is RS 2.5/-, Rs 100/50 note is Rs 1.8/- & for Rs 10/- is Rs 0.96/-. Thus reprinting the same of of 500/1000 notes withdrawn would cost about Rs 6000/- crores. If all the 500/1000 notes are replaced with Rs 100 notes it would cost Rs 25400 crores; however the same is unlikely since some of the money would is re-issued in the Rs 2000 note form. Chidambaram has pegged the cost of transition at anywhere between 15-20000 crores & has argued that the action undertaken by the govt. should achieve at least the breakeven value.

Positives of the move:

Indian savings rate which about 37% of GDP in 2007-08 has dropped to 29% now while China is around 50%; a high savings rate can spur investment creating more jobs in the bargain. Since agriculture is a political hot potato that is not taxed, India has the dubious distinction of only about 5.5 crores(4%) filing income tax returns of which only 1.25 crores (1%) actually pay income taxes & another 1.25 crores pay TDS (Tax deduction at source); demonetization is a route to force those outside the banking net to come to the banks for conversion, thereby leaving a financial trail; if in the bargain savings rate increases it would be a double whammy. Bank account seeded with Aadhar could be used by data analysts later to spot rich farmers & track them.

Indians are experts at “Jugaad” & it was not surprising to read in The Hindu that some politicians of Kolar have distributed 3 Lakhs each to commoners as an interest free lean for 6 months with the directive to get the same exchanges at the banking networks; India Today carried a report where touts offered to exchange the notes at a 40-60% discount.  The govt. seems to have moved in quickly to stem the same by introducing a 200% penalty which implies that a person in the 30% bracket shall pay another 60% as penalty, leaving only 10% as white money. Penalties have the potential of increasing taxes for a govt. 

The most positive aspect of a shrinking cash economy is less cash chasing goods & services which translates into reduced inflation & hence interest rates, a key demand from the corporate sector.

Negatives of the move:

P Chidambaram has argued that fake notes account for 0.07% of the entire cash economy & hence using a sledgehammer approach is unhelpful.  For those who have attributed this as a step to tackle terror, data suggests that fake currency from Pak flowing into India vide the Nepal & Bangladesh routes is about 400 crores per annum only – a pittance.  

As per the National Institute of Public finance & Policy report released in 2012, when the Janta govt. in 1978 withdrew the 1000, 5000 & 10000 rupee notes only 15% of such notes were exchanged for fear of penal action. Burma implemented it badly in 1987 leading to riots & a coup followed in 1988. While a coup is unlikely in India the social situation should be closely monitored.

As per the former chief statistician of India, Pronab Sen, with 86% of value of money in circulation withdrawn, the economy will have to make do with only 14% of money in circulation at least for two weeks, until when there are restrictions on withdrawing money would ease, effecting a chain reaction that could drop GDP growth by 1% this year

Conclusion

Modi had promised in his election rallies that he would tackle black money struck abroad & usher in 15 lakh into every bank account which Amit Shah later attributed to as an “chunavi jumla”; this statement had been attacked by the opposition & has effected the image of the BJP & the PM. Non action in the HSBC accounts case has convinced some that the govt. is not serious in bringing the issue to its logical conclusion. The spin doctors of the govt. would argue that the income disclosure scheme announced by the govt. in the last two years has netted about 75000 crores & the current move is an extension of the same resolve to tackle the parallel economy.

If the PM is indeed serious he should immediately announce that the BJP shall declare every paise collected as electoral funding on its website unlike the current practice where parties hide behind the clause in the Representation of peoples act that mandates declaration of only amounts above Rs 20000/-, ensuring that about 80-85% of collections remain undeclared. That would not only lead to an image boost but usher in genuine electoral reforms.

The reintroduction of the 500 & 1000 notes is questionable & the introduction of 2000 notes surprising. If indeed black money is stored in the form of high denomination notes, making it easier by launching a 2000 rupee note is perplexing.  

Cash to GDP ratio in India, as per a MINT report, is 10.86%, much higher than other major economies at 4%. If the intention of the government’s move is to transition to a cashless economy, creating infra should have been the first step.  The POS terminals, mobile wallets & ATMs per million of population is much less in India as compared to other economies. NSDL was inaugurated in 1996 & it rolled out infra before SEBI pushed for dematerialisation. Incidentally, UPI (unified payment interface) system is likely to be fully operationalized only by January 2017.

Clearly, the measure is meant to send across a signal to the population that the govt. is indeed serious in its intentions. It is also a political strategy to hurt the treasury of other political parties in the impending elections. Surely, the PM proves again that he is politically astute even though he is a self-confessed economic illiterate.