Opinion | What the RBI data on demonetization tells us
The entrepreneurial talent is unfortunately trapped navigating regulatory roadblocks. This unproductive entrepreneurship has helped India survive demonetization and also shackled growth
Last week, the Reserve Bank of India’s (RBI’s) annual report confirmed that ₹15.3 trillion of the demonetized currency in November 2016, i.e. 99.3%, is back in the banking system. What does it mean when only ₹107 billion, or 0.7% worth of the old notes, were not returned?
The assumption was that a significant share of the old notes were held by tax evaders and criminals who, in the interest of avoiding legal scrutiny, would eat their losses and not exchange their currency for the new notes in circulation. The RBI would reduce its liabilities because of the unreturned notes and the Indian government would receive a revenue windfall. This one-time dividend to all Indians would be paid for by participants in the underground economy, who would be effectively taxed at a 100% rate on their illicit wealth. In November 2016, experts and government officials made wildly optimistic predictions that 10-30% of the notes would remain unreturned.
What is surprising is that Indians managed to return virtually all the old notes in such a small window. Financial writer and blogger J.P. Koning points out this peculiarity by contrasting Indian demonetization to the euro. When the euro was introduced in January 2002, there were long fixed windows to redeem existing national banknotes before their money status was revoked. At the end of the 10-year period, 99.15% of Italian lira and 98.77% of French francs had been returned. Remarkably, Indians managed to return 99.3% of the value demonetized in a 60-day period. The return rate is even more incredible when one considers that, unlike the European demonetizations, which allowed unlimited redemption, the Indian demonetization imposed per-person ceilings on exchanging old notes for new notes with the rest having to be deposited into a bank account.
That 99.3% of the currency came back could mean one of three things. First, while there really was 10-40% black money in the economy, tax evaders and criminals never held this wealth in cash holdings; they were adept at laundering before demonetization through shell companies, tax havens abroad, and Swiss bank accounts. As they never held black money in cash, there was no problem in returning their old notes to the RBI through deposits. A second possibility is that Indians did hold large amount of black money in cash, but they are so adept at reacting to draconian state policies that in a mere 60 days, they displayed extraordinary entrepreneurship and managed to launder their money and deposit it in banks. This could have been done through shell companies, foreign accounts, deposits in Jan Dhan accounts, sending the money to Nepal to launder and return to India, or paying temple trusts/cooperative banks/political parties/middlemen a small premium to launder the money. A third, highly unlikely, scenario is that there really isn’t much black money in India, in cash or even otherwise, and the law-abiding, punctual citizens returned the old notes in time.
It is probably a combination of the first two possibilities that has led to this outcome. Indians are experts at circumventing laws and regulation. We even have our own term for it—jugaad. Jugaad has many meanings—finding a makeshift, low-cost, or creative solution to a problem; being entrepreneurial and innovative; removing obstacles; or troubleshooting. This curious Indian talent has made its way into academic journals and financial papers and is discussed in conferences at Ivy League schools. Jugaadu is used to describe someone adept at jugaad, and is almost always a compliment. Through 70 years of draconian regulations under socialism, Indians have honed this skill. There is a fix for everything, all rules can be managed. It’s only a question of cost. As entire cottage industries at varying levels of sophistication survive on providing these services, the cost of circumvention decreases. This ability makes Indians robust to shocks and adapt very quickly to unforeseen events. Even a 60-day window to exchange banned notes will lead to a higher yield than windows 60 times longer in non-jugaadu developed countries.
While this makes Indians flexible and adaptable, and helps them grow and prosper in a hostile environment, it also means that unless rules are very well designed and enforced, very few policy measures will have the intended outcome. There is so little trust in the state among Indians and there is so much adeptness at bypassing state enforcement that even well-designed schemes are hard to execute and demonetization was a highly flawed idea to begin with.
Everyone is aware of and has borne the enormous costs imposed by demonetization. Over 1% loss of gross domestic product (GDP), loss of entire small-scale industries, supply chain disruptions, drop in employment, and the multi-seasonal effect on the agricultural sector, not to mention the loss of lives and livelihood during the transition period that was botched by the government in its changeover to new notes. However, there is another long-term effect one needs to think about—some of the new tricks Indians learnt to launder money as a result of demonetization.
A huge cost borne because of the way India functions is that this kind of unproductive entrepreneurship, which spends so much resource in simply circumventing the state, could have been used productively to unleash more innovation and growth. The entrepreneurial talent is unfortunately trapped navigating regulatory roadblocks. This unproductive entrepreneurship has helped India survive demonetization and also shackled growth.
Shruti Rajagopalan is an assistant professor of economics at Purchase College, State University of New York, and a fellow at the Classical Liberal Institute, New York University School of Law.
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