There is avoidable confusion about the objectives of the recent demonetisation programme which at one stroke invalidated 86% of the currency in circulation, causing widespread disruption in economic activity and the life of the common man. The opposition has trained its guns squarely on its political objectives. The government has shifted ground, from national security to targeting black money to a cashless economy, and finally to ethical or moral cleansing. How does the silver bullet of demonetisation measure up to its three stated economic objectives, namely counterfeiting, black money and cashless economy?

Governments the world over replace old currency with new to neutralize counterfeiting. If there are pressing national security concerns, the new currency can have added security features and suspected denominations can be withdrawn. The latter can also be declared illegal tender after a critical mass of new currency is in circulation. It is, however, only a matter of time before the new currency is counterfeited. Counterfeited new currency surfaced within days of demonetisation. Government data shows that counterfeit notes comprise less than 1% of the currency in circulation. Demonetisation on this scale is a blunt instrument for this purpose.

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Targeting black money through demonetisation of high-currency notes is recommended by Kenneth Rogoff, a noted Harvard economist, in a recent book, The Curse of Cash. A substantial chunk of America’s illicit economy is conducted, and its assets parked, in $100 bills. According to Rogoff, demonetisation would have a similar impact in India, although long-term gains would be offset by the reintroduction of new high-denomination notes.

The US dollar is the de facto global reserve currency. It is a riskless, universal store of permanent value, a safe haven like gold. It makes eminent sense to stock illicit wealth in $100 bills within the US and outside. The Indian rupee on the other hand is a risky asset exposed to high rates of inflation, exchange fluctuation, loss of value beyond borders and political risk of the kind that has just fructified. High-value currency notes are therefore mostly used in black economy flows, the profits from which are ultimately converted into black money. The greater proportion of Indian black wealth is parked in assets like real estate, gold, stock markets, foreign accounts and $100 bills. Demonetising only Rs1,000 notes would have caused less disruption, as data from the Reserve Bank of India shows that their share of the total currency in circulation grew spectacularly over the last decade. The small portion of black wealth stocked in currency is likely to be recouped over time, especially since high-denomination notes are being re-introduced.

The third objective of demonetisation is to move towards a cashless economy by sharply contracting the currency in circulation. The disruption of economic activity, the payments and exchange systems, the wheels of commerce, the long queues outside banks and ATMs, and consequential loss of employment/productivity are only partly the result of ham-handed implementation. They are also the outcome of a deliberate attempt to formalize economic activity and push it towards electronic payments, and ultimately, taxation system by fiat. Electronic transfers are freely permitted, but withdrawal in cash is being rationed.

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It is difficult to see how India can leapfrog to cashless transactions without difficult structural reforms in the ease of doing business, tax administration and lower rates, greater financial and digital literacy, and a better infrastructure. There is a close correlation between the cash intensity of economies, and their level of development and per capita incomes. Like all developing countries, India has a large, unbanked informal sector, much of which escapes the tax net to generate black money flows. Much of the daily income of the poor—including a third of the world’s poorest that, as per World Bank data, resides in India—is dependent on this sector, which is seamlessly entwined with the formal economy. Since the poorest by definition have no savings or assets, the informal economy is their only means of exchanging labour for essential goods and services.

If this dynamic sector is unable to make a rapid transition to the formal economy, India’s potential growth rate could be permanently lowered through hysteresis and poverty decline halted. At best, it will find new mechanisms to return to the status quo ante with the new currency, with people more circumspect about how they launder money, as new grey markets take root. All the pain would have amounted to little. Financial deepening is achieved by nudging people towards reducing their demand for cash through market-based incentives, rather than by reducing its supply. Until this demand-supply imbalance is bridged the queues will not abate.

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Some long-term damage has also been done through loss of confidence in the economic policy skills of India’s leadership. There is a growing sense of a return to a kind of licence Raj where proximity to the executive matters more than robust institutions, which are being systematically undermined. The political risk arising out of potential expropriation is unlikely to fire the animal spirits so critical for robust growth in a free market economy. Lawrence Summers, who headed the council of economic advisers of the US president, feels that most free societies would rather let several criminals go free than convict an innocent man who, for one reason or another, does not manage to convert his money. Rogoff recommends gradual withdrawal of high-denomination notes for this very reason. Even the left-leaning Nobel laureate Paul Krugman sees few significant gains from India’s highly disruptive demonetisation.

In conclusion, however laudable the objectives, a single blunt instrument—demonetisation—has been used to achieve multiple targets. As per mainstream economics, the Tinbergen rule, each objective needed a separate dedicated instrument. Some short-term gains such as neutralizing the extant currency dump with part of the political class and corrupt government employees, and destruction of a small portion of black money stocks have accrued, but the long-term impact is debatable at best and potentially disastrous at worst, especially on the poorest. The same objectives could have been targeted through other sharper instruments without disrupting economic activity, the monetary system and the life of the common man.

Alok Sheel is a retired civil servant.

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