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Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

The many canards surrounding currency swap

Economic commentators should be clear on the monetary economics of the policy. Unfortunately, there has been more obfuscation than enlightenment

In this space a fortnight ago (Fixing The Plumbing—Of Our Political Economy, 5 December), I had argued that the Narendra Modi-led government’s currency swap (popularly, but misleadingly, referred to as “demonetisation") constitutes a classic political economy trade-off: between the short-term costs of the policy and its medium- to long-term benefits. These putative gains and losses may be construed both economically and politically. Last time, I explored both of these, laying stress on the latter, arguing that Modi’s method may be understood as trying to “fix the plumbing" of the economy, the currency swap being but one element of this.

While political commentators may disagree on whether the currency swap will be a winner for Modi politically—my stated view is that I believe it likely will be—economic commentators, at a minimum, should be clear on the monetary economics of the policy. Unfortunately, as is often the case in politically contentious economic policy debates, there has been more obfuscation than enlightenment from many of the usual suspects.

Consider the canard that the currency swap must be considered a failure because a large quantum—of the order of 80% or so—of the old, denotified high-denomination notes have re-entered the formal monetary system either by being exchanged for new notes (a small proportion) or being deposited (a large proportion). The reasoning is that the government supposedly touted a “fiscal bonanza" to be realized by a bonfire of the old notes representing black money, which, therefore, presumably could not be converted or deposited without attracting the attention of the tax authorities, and that this has come a cropper.

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There are many fallacies here.

First, one would be hard-pressed to find an explicit, official assertion by the government that a fiscal gain could be realized by cancelling the liabilities associated with old notes that were not turned in by a certain date. This seems to be a claim propagated by the overzealous, that somehow become accepted as gospel truth.

Second, most sensible observers expected that only some fraction of the old notes, representing a portion of black money, would fail to make it into the system—most back-of-the-envelope estimates were around 20%. Well, that is about the percentage we are at now, so, by this metric, that portion of the stock of old notes has effectively been taxed at a 100% rate.

As a corollary, the current situation is one, thus, of a shortage of cash, not of money, and this may be a nudge for the behavioural change towards less cash and more digitization that Modi is seeking.

Third, let us assume that some chunk of the 80% of old notes that have entered the formal financial system represents black money that holders are attempting to launder into white money through one or more of many well-known mechanisms, such as using intermediaries. On the one hand, such holders of black money have paid an implicit tax—some anecdotal accounts suggest that the discount on old notes in the illegal, secondary conversation market is up to 50%. While it is true that the proceeds do not benefit the treasury, they certainly represent a tax on the holders.

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On the other hand, it is not correct to assume that black money deposited into bank accounts, and thus supposedly laundered into white, will escape scrutiny. Unusually large or suspicious deposits would be audited, and, if irregularities are found, be potentially subject to penalties or confiscation.

This process will not be perfect, to be sure, but the use of modern data analysis (“big data") could be put to use to sift through the many deposits that have been made since the currency swap went into effect to ferret out such suspicious transactions.

Fourth, those who have argued for, and against, a fiscal bonanza from note cancellation are making a fundamental conceptual error, by conflating the fiscal benefit from bringing black money under the tax net, as discussed above, with the putative fiscal gain to be reaped from part of the currency stock going up in smoke.

The reason is twofold. First, it is mistaken to assume that notes not turned in cease to be a liability on the books of the central bank, unless they are explicitly and legally demonetized—which has not been done thus far.

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Second, even if this happens, and as I argued about a month ago (“demonetisation: Fact And Fiction", 14 November), it is always possible for the Reserve Bank of India to “sterilize" the monetary effects of a portion of the currency stock being destroyed. The latter is a form of negative helicopter drop—call it a “vacuum cleaner"—in other words, a one-shot reduction in the stock of high-powered money.

This can always be reversed, in principle, by an equivalent and offsetting helicopter drop, through conventional open market operations, or even through unconventional monetary policy such as the purchase of non-traditional assets. Depending on the method employed, the composition of the stock of broad money may change, but any effect on its level can be fully offset.

Whether the Reserve Bank of India does so will depend on whether they expect more than merely a transitory deflationary impact. I think it unlikely, based on their rationale for keeping the repo rate unchanged on 7 December.

Every fortnight, In The Margins explores the intersection of economics, politics and public policy to help cast light on current affairs. Read Vivek’s Mint columns at

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