Demonetization: Can Pandora’s Box Contain Goodies?

The scheme for demonetization of Rs 500 and 1000 notes announced on 8th November, 2016 and aimed at curbing black money (BM) in India has opened the proverbial Pandora’s Box. Apart from stiff opposition from most, if not all, political parties the scheme is also facing tremendous logistical issues. While the level of preparedness of the government leaves a lot to be desired, ultimately the course from here will be determined by ratio of outcome, and inconvenience for the common man.

Here it is important to recognize that large cash in hand, or cash transaction, may not always be black (or bad). The term black money ( BM)refers to money that has been accumulated by corruption or by tax evasion. There is a sizeable proportion of India’s economy that is clean-cash based due to logistical and legacy reasons and that is perfectly legal. Now, before forming views on the scheme and its feasibility it is important to understand what does it intend to do, what does it not target, and what are its limitations.

What does this scheme intend to do

  1. Dampen the purchasing power of people with unaccounted wealth
  2. Cleanse the system of fake currencies
  3. Demolish a key financing element of terrorists and Maoists.

What it is not aimed at

  1. Turn India into a cashless economy

People who can explain the source and trail of their cash should be able to get their cash exchanged from banks in next 4-6 weeks. In fact people who deposit less than Rs 250,000 won’t face any questions. After some inconvenience over next 3-4 months clean-cash based economy too should be able to reach required levels. As an unintended but favorable consequence there will definitely be some move towards increase in cashless transactions in future.

What it may not be able to achieve

  1. Wipe out black money altogether
  2. Eradicate the plague of fake currency forever

What can it achieve

  1. Restore faith of honest citizens that the welfare state has not abandoned its duty to be fair to all its citizens. Here the key is that black money must be made to lose its value.As per this scheme people with large chunk of unaccounted cash have to pay applicable taxes and a hefty penalty. Government will be able to raise a sizeable amount as tax.
  2. Provoke fear of law amongst the dishonest – This event will for a long time weigh in their minds possibly as a deterrent to corrupt activity and tax evasion.
  3. Reduce inflation which can give ammunition to RBI to cut interest rates that in turn may help economic growth by spurring an uptick in credit demand.
  4. Improve liquidity and credit availability in the economy. The hoarded money that had been lying idle so far can now be deployed more productively by banks, or by the people themselves after withdrawing from banks.
  5. Induce trust in the system –As many cash transactions are replaced by cheques, online payment gateways and other modes of non-instantaneous payment, economic agents will need to trust each other more which can over the long term augur well for all economic activities. Perhaps this can turn out to be the biggest advantage to emerge from this exercise.

What are the factors that are prompting opposition to the scheme

  1. This scheme won’t be able to prevent generation of fresh black money – i) True since here the focus is on penalizing those who have been enjoying undue benefits – so far. It is naïve to expect generation of black money to be annihilated in one shot. Had there been a magic wand, governments in the past would have definitely used it. At the same time it is not illogical to demand from the government equally stern measures to control the black money menace in future too. ii) Black money generated in next 2-3 years may only be a fraction of what is being sought to be unearthed by demonetization. iii) In future tax evaders and the corrupt will need to devise new ways to cheat. However the fear induced after this action may provide some deterrence.
  2. Not all notes will be tendered – Yes – A large chunk of the cash may be destroyed by the hoarders but it does not change the outcomes. Either way the dishonest will lose their ill gotten wealth while relative buying power of the honest Indian will be boosted.

Destruction of notes is a sort of poetic justice and at the same time helps in redistribution of wealth away from the corrupt. Notes that are not tendered may add to one time profit of the RBI in practical terms which in turn can be passed on to the government as dividends. Even if RBI does not book this as profit and keeps this amount under the head of other liabilities in its balance sheet it will be owing to conservative accounting. RBI can use it as a large buffer to fight currency fluctuations and liquidity issues later.

  1. This is causing inconvenience to general public – This is the most potent and relevant argument against the scheme. In the first week of the scheme the government has been caught on the wrong foot. Now, the long queues at bank and ATM’s can perhaps be entirely explained by lack of new notes. When almost 85% by value of currency in circulation, ie about Rs 14.5 lakh crore, is sought to be demonetized the level of preparedness should have been much higher to say the least. The government should have been ready with fresh stock of at least 25-30% of the demonetized amount on 8th November. If secrecy was the concern, and rightly so, then a war chest of Rs 100 denomination could have been kept ready.

So far the lure of the outcome (blow to black money) is what has kept emotions of the man on the street from spilling over but situation may worsen if bank queues do not shorten and if cash availability does not improve in next two weeks.

  1. Barking up the wrong tree; Cash as a vehicle to store black money is peanuts as compared to gold and real estate – Even if Rs 2 lakh crore (equivalent to about 35%of India’s fiscal deficit, or about 80% of defense expenditure, or 3 x of India’s education budget) black money is unearthed in this exercise it will be worth the effort.BM in gold and RE can be tackled by other measures in near future.
  2. This did not work in the past – Demonetization schemes in the past were very different from what is being done now since i) In 1978 the quantum of high denomination notes was just about 1.5%of total currency in circulation. In 2016 it is 85%, ii) In 1978 the notes that were demonetized were Rs 1000, 5000 and 10000.Thus demonetization exercise of 1978 was much narrower in its targeting and hence passed off without even a whimper from hoarders of black money.
  3. Reintroduction of Rs 500, 2000 will negate the potential gains –The idea is not to kill the cash economy – even though some shift towards cashless system may happen as collateral gain.Where ever commerce/trade etc are done in cash due to some honest constraints, denominations of Rs 500 and Rs 2000 will be required.
  4. Cost of the exercise is too high – Cost of printing new notes to replace the existing ones can be about Rs 10,000 crore. If seen in proper context (about Rs 80 per Indian, or just about 0.7% of demonetized notes, or equal to fake money stock in circulation) this seems quite reasonable especially in the backdrop of the targeted gains.
  5. People with black money will game the system – Manipulators are trying their best to bypass the government’s dragnet even as the latter remains in hot pursuit. However as of now it does not seem that more than a small proportion of black money can escape detection.
  6. Bad for economy – It is true for short run but in 2-3 quarters the economy should bounce back. Once the gains start kicking in, trade, commerce, agriculture and industrial activities will look much stronger starting 4-5 quarters from now.

In any case, sizeable long term improvements often need disruptive, instead of incremental, initiatives and this is one of the few disruptive efforts seen in India for a long time. It must be given a fair chance.

Perhaps Janet Yellen, US Federal reserve chair, had some such event in mind when she said “Productivity growth, however it occurs, has a disruptive side to it. In the short term most things that contribute to productivity growth are very painful”.

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One thought on “Demonetization: Can Pandora’s Box Contain Goodies?

  1. Very informative article explained in simple language.
    • The real work of the govt. to start post 30th December (last date to exchange). I also hope that RBI gains as much as possible i.e. at least 2 to 3 lakh cr out of 14.5 lakhs cr
    • Many are /were trying to find escape route. Like buying high value train/fight tickets, buying gold, misuse of jan-dhan accounts, getting cash exchanged from others in big numbers, getting FD opened as back dated to mention few. I just want govt. to
    take note of all these and have a comprehensive scrutiny. Probably 0.5 lakh cr extra could be earned and will boost the confidence of honest Indians even more. There is a perception that most of black money will illegally be converted to white by 30th December. Which is not good.
    • Why can’t we have a special Ministry (for short term) exclusively for the above purpose? If they achieve 0.5 lakh cr also extra it would have served its purpose.
    • Though there is no scrutiny up to 2.5 lakhs deposit all the suspicious jan-dhan a/c /other a/c even under this amount should be thoroughly scrutinised. How can a zero balance /low balance a/c can have huge amounts post the demonetisation scheme. It raises suspicion.
    • As most black money (cash can’t sit idle !!!) is in real estate, benami properties, gold etc. there should be a even bigger crackdown on this.
    • There is a high possibility that gold is likely to replace high currency black money (it even can’t be demonetised) why can’t we have a new system that Gold CAN’T be bought by cash for next 2 years. Gold to be bought only through cheque/DD/online/debit/credit cards and high value purchase (Rs 1 lakh and above) to be immediately informed to central govt.
    • Last but not the least all high value NPAs by big corporate/industrial houses of India be given 6 months’ time to repay substantial amount. If it tantamount to selling their assets/properties be it so. Why should only a person/farmer with less than lakh or so be forced to suicide in this country.

    Liked by 1 person

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