Demonetisation: The good, the bad and the ugly

Demonetisation does not affect the continuous flow of black money and the corruption, tax evasion which generates it

Demonetisation can only be a part of a comprehensive strategy to tackle corruption and generation of black income. Photo: Indranil Bhoumik/Mint
Demonetisation can only be a part of a comprehensive strategy to tackle corruption and generation of black income. Photo: Indranil Bhoumik/Mint

Eliminating 86% of the value of the currency with the public was bound to be a shock. The government has called this “short-term pain for long-term gain” and many citizens on TV have said they are willing to endure short-term pain. But what gain and by when?

The long-term objective must be to cleanse the system of corruption, tax evasion and the generation of black income. demonetisation only targets that part of existing black wealth which is held in cash. It does not affect the continuous flow of black income and the corruption/tax evasion which generates it, which in many ways is the core of the corruption problem.

What effect has demonetisation had so far?

It has clearly caused considerable inconvenience as people with perfectly legitimate quantities of old notes of Rs500 and Rs1,000 have to queue up at banks to exchange them into new notes. Tragically, many deaths have also been reported. In addition to inconvenience, the shortage of cash has also disrupted business in the cash-based informal sector, which is where the majority of the population is employed.

Farmers, fishermen, vegetable sellers, small shopkeepers without card readers or Paytm, taxi drivers, truckers, etc., have all been affected with loss of livelihood which may be irretrievable in some cases, for example, loss of daily wages for casual labour, or lower sales for vegetable vendors. Real-estate development will be badly affected because it is heavily cash-dependent, having long been a favourite asset for holding black wealth. Sectors such as hotels, restaurants, catering, the fashion garments industry, etc., which were often paid for in cash from black income, will also be affected. Some of the disruption, as in the case of real estate, can be viewed as an unavoidable rebalancing. However, in the short run, it will disrupt downstream income flows in the form of wages to construction labour, purchases of cement and other construction materials, including steel, paint, glass, etc. This will have downstream effects on both employment and income.

Does demonetisation affect black wealth held in cash?

Much of the public enthusiasm about demonetisation comes from the expectation that those with hoards of cash will not be able to exchange it in the banks for new notes, and will therefore lose their ill-gotten money. This group includes businessmen, or politicians (either on their own behalf or on behalf of political parties), or bribe-taking bureaucrats. The public will certainly applaud their loss. However, much of this may be laundered.

Since the notes will be valueless after 30 December, holders of undeclarable cash will be willing to offer 30-40% commission, or even more as the deadline approaches to offload the cash. Intermediaries will organize large numbers of individuals who can take smaller “explainable” amounts of cash to the banks for deposit. Since farm income is free of tax, large numbers of people claiming to be farmers, could make deposits in banks, technically even exceeding Rs2.5 lakh with impunity.

Black wealth held in cash can also be laundered by purchase of gold and hawala transactions but that assumes that the suppliers of gold and the hawala dealers can launder the old notes received before 30 December. Some of this has already happened as evidenced by the sharp rise in gold prices and also the hawala rate for the dollar. Inevitably, higher gold prices will encourage smuggling and divert foreign exchange that would otherwise have flowed through legal channels to finance gold smuggling. This is bound to put pressure on the rupee.

How long before we get to normalcy?

It has been reported that given the capacity constraints at the two printing presses which can print the high-value notes (assuming three shift operation), it will take until May 2017 to replace all notes. It may not be necessary to replace all notes because (a) there will be some switching to digital payments, which is desirable, and (b) some of the cash hoards will be cancelled in any case on 30 December. Even so, the cash-availability situation is unlikely to ease very quickly. The 50-day horizon mentioned by the Prime Minister probably assumes that a substantial volume of outstanding notes will actually be cancelled on 30 December. If on the other hand, they are extensively laundered, the cash shortage and the disruption it causes in the informal sector may be prolonged.

Will GDP growth slow down?

The negative impact on the various sectors of the economy is bound to produce lower growth. Estimates for gross domestic product (GDP) growth in FY17 from financial analysts vary from a low of 3.5% to a range of 5.5-6.5%. My best guess is that GDP growth is likely to slow down to around 6% in 2016-17. More importantly, it will also remain subdued next year. Much depends on what happens to the investment climate.

Since the slowdown will be concentrated in sectors which are more employment-intensive, the impact on low-end employment will be greater than on overall GDP. This raises the issue whether the slowdown should be offset by counter-cyclical additional expenditure on road construction and railways. Such intervention will breach the fiscal-deficit target but a temporary deviation can be justified in the face of the negative-demand shock of the demonetisation.

Could things have been managed better?

Building up a larger stock of new notes in advance would certainly have avoided some of the inconvenience and the associated cash shortage. The belated provisions made for weddings and farmers, could have been anticipated. The ministry of agriculture’s request regarding an exemption for farmers purchasing seeds and other inputs during the sowing season, in order to avoid disruption in sowing, should also have been addressed promptly, rather than after several days.

The flexibility provided after problems surfaced is to be welcomed but it could be increased even further. For example, old notes are allowed to be used in public-sector hospitals but not private hospitals, and farmers are allowed to use them for purchase of seeds from public-sector agencies but not private agencies. There is a good case for allowing flexibility for purchases from the private sector also. The deadline that has been allowed for this flexibility could be extended. Perhaps the most important flexibility is to allow cooperative banks to accept old notes. Their presence in rural areas is much larger than that of commercial banks, and they are all regulated entities. If enough currency does not exist at present to supply cooperative banks, they should be allowed to accept the old notes and supply new currency later.

Will demonetisation control generation of black income?

This is the key question and demonetisation does not address this problem. There have been announcements that more steps will be taken, but these relate to benami properties and undeclared foreign holdings. What is needed are steps that will discourage fresh black income from being generated in future through continued corruption.

The following is a list of steps that can be taken, which will have a significant impact over time.

(i) Reducing discretion in both the Central and state governments and increasing transparency and accountability especially where the financial amounts involved are large. The biggest area of discretion relates to land and land use.

(ii) Reforming the system of tax administration, including reorganizing, strengthening and modernizing the Central Board of Excise and Customs/Central Board of Direct Taxes.

(iii) Lowering tax rates and simplifying the tax system to improve compliance. The goods and services tax (GST) to be introduced shortly was an ideal opportunity, but the proposal finally approved by the GST council has far too many rates and exemptions. Even if this cannot be changed at this stage, the council could at least announce a review of the multiplicity of rates with a view to converging on two rates plus a sin tax. It could also announce an intention to include alcohol—a major source of evasion and black money—and also real estate in the GST by 2020.

(iv) Lowering the corporate tax rate to 25% at one go with exemptions eliminated in the next budget. The present rate is much higher than in most other jurisdictions. Any negative effect on the fiscal deficit can be justified given the need for a fiscal stimulus.

(v) Persuading states to drastically lower the stamp duty for real estate sales as high rates of stamp duty are a major incentive to perpetuate real estate transactions in black money.

(vi) Pursuing some high-profile corruption cases to a successful conclusion to send a message to both business and the bureaucracy that corruption will not be tolerated. A selective approach based on scientific probabilistic analysis is much better than broad-based action which only creates fear in the business community.

(vii) Finally, it is absolutely essential to start making a serious effort at reforming the system of electoral funding, including introducing transparency in party finances. Businessmen routinely say that they are forced to generate black money to meet the demands of the political system and also the demands of the bureaucracy which has arbitrary powers which can bring business to a halt.

To sum up, demonetisation can only be a part of a comprehensive strategy to tackle corruption and generation of black income, and it is likely to impose substantial pain because of the adverse effect on GDP and low-end employment. The more important part of the fight against corruption involves the other set of measures listed above. Progress on these would make a real contribution to reducing the long- term gain of reducing the generation of black income over time.

Montek S. Ahluwalia was the deputy chairman of the erstwhile Planning Commission