Economic Rationale of ‘Demonetisation’

 

On 8 November 2016, Prime Minister Narendra Modi announced the “demonetisation” of `500 and `1,000 notes with effect from the next day. Through the 50 days after 8 November, the government has made a set of claims with regard to the objectives and outcomes of the demonetisation scheme. In this note, we wish to examine the economic rationale and logic behind a few of these claims.

The first claim is that demonetisation would plug terror financing. The Prime Minister asked:

“have you ever thought about how these terrorists get their money? Enemies from across the border run their operations using fake currency notes…Many times, those using fake five hundred and thousand rupee notes have been caught and many such notes have been seized” (PMO 2016).

 

The second claim is that demonetisation would help unearth “black money.” Clearly, the Prime Minister was referring to black money hoarded in cash; he asked: “which honest citizen would not be pained by reports of crore worth of currency notes stashed under the beds of government officers? Or by reports of cash found in gunny bags?” (PMO 2016). There are two ways in which this is supposed to happen: one, unaccounted cash is not returned to the banking system due to fear of detection; and two, when unaccounted cash that enters the banking system is either detected by tax authorities or voluntarily disclosed by the depositors.

 

The third claim is that the unearthed black money would expand the fiscal space of the government. One, when unaccounted cash is not returned to the banking system, the Reserve Bank of India (RBI) can use the savings to pay the government a dividend. Two, unaccounted cash that is voluntarily disclosed would be subjected to a 50% tax as per the Taxation Laws (Second Amendment) Bill, 2016. Unaccounted cash not voluntarily disclosed but detected by tax authorities would be subjected to a 75% tax. Further, the declarant would have to deposit 25% of the undisclosed income into the Pradhan Mantri Garib Kalyan Deposit Scheme (PMGKDS) 2016, which would be used to finance “programmes of irrigation, housing, toilets, infrastructure, primary education, primary health, livelihood, etc.”[i]

 

The fourth claim is that demonetisation would help reduce interest rates in the banking system. According to Arun Jaitley, Minister of Finance and Corporate Affairs, “banks are now flushed with funds … and … these low-cost funds are going to be lent at a much lower rate.”[ii] In his address to the nation on 31 December 2016, the Prime Minister further claimed that demonetisation would reduce inflation in the economy.

 

The fifth claim is that demonetisation would help formalise India’s informal economy, reduce the extent of transactions in cash and help create a “less-cash economy.” In fact, between November 2016 and December 2016, the slogan of demonetisation has shifted from being an attack on black money into a facilitator of transformation into digital transactions. A number of incentives have been offered to induce people to use digital transactions.

 

Counterfeit Currency

 

The circulation of counterfeit currency in the economy is a fact. However, there is no accurate estimate of the quantum of circulation of counterfeit notes. There are two major sources of data on Fake Indian Currency Notes (FICN): one, the data released by the RBI on FICN “detected by the banking system;” and two, the data released by the National Crime Records Bureau (NCRB) on FICN “seized” by the police.

 

• The share of FICN “detected” by banks in the total number of `500 notes in circulation was 0.000022% in 2013–14, 0.00002% in 2014–15 and 0.000016% in 2015–16. The share of FICN in the total number of `1,000 notes in circulation was 0.000021% in 2013–14, 0.00002% in 2014–15 and 0.00002% in 2015–16 (RBI 2016: ch 8).[iii]

 

• The share of FICN seized by police in the total number of `500 notes in circulation was 0.0037% in 2013, 0.0025% in 2014 and 0.0019% in 2015. The share of FICN seized in the total number of `1,000 notes in circulation was 0.0038% in 2013, 0.0031% in 2014 and 0.0028% in 2015.[iv]

 

In 2012, the government had entrusted the Indian Statistical Institute (ISI), Kolkata with a study on counterfeit notes. The results of the study were reported in the written answer to a question in the Rajya Sabha in August 2015.[v] According to the answer, “the face value of FICN in circulation was found to be about `400 crore” and “the value remained constant for the last 4 years.” Media reports also quoted the ISI study as concluding that “the existing systems of seizure and detection are enough to flush out the quantum of FICN being infused.”[vi]

 

Thus, it is unclear if the quantum of FICN is significant to warrant overarching measures like demonetisation.

 

Black Money

 

A crucial assumption in the demonetisation exercise is that “black money” is hoarded as cash. Such a view is not just narrow, but also serves to defeat the larger purpose of preventing illegal creation and storage of unaccounted money. To begin with, it is necessary to distinguish between three concepts: “black economy,” “black money,” and what we may refer to as “black cash.”

 

The term “black economy” may simply refer to a broad set of economic activities that generate production and income flows that are under-reported or unreported or result from economic illegality. A portion of incomes generated in the black economy, when saved, adds to the stock of black wealth or, what we may call, “black money.” Because savings that financed the acquisition of black money were themselves undisclosed, black money has been defined officially as “assets or resources that have neither been reported to the public authorities at the time of their generation nor disclosed at any point of time during their possession” (GoI 2012a).

 

A part of the black money is held as “black cash.” According to estimates in the National Institute of Public Finance and Policy (NIPFP) (1985), cash was a “very significant” form of holding black money in only less than 7% of the cases. The prominent forms of holding black money were: (a) under-valued commercial and residential real estate; (b) under-valued stocks in business; (c) benami financial investment; (d) gold, silver, diamonds and other precious metals; and (e) undisclosed holdings of foreign assets. More recently, open economy policies, free-trade arrangements and financial liberalisation policies have expanded the scope for holding black money in newer forms.

 

However, the very concept of black money is nebulous (NIPFP 1985). This is because the same person who earns black income also typically generates income in white. He may choose to declare his savings by claiming them to be a portion of his legitimate income. There may, in other words, be black incomes but little or no black savings! No wonder then that economists are not very fond of estimating the size of black money. In fact, we are not sure if there could be any realistic estimate of black money in India. A commonly cited estimate puts the size of the “black economy” between 19% and 21% of the gross domestic product (GDP) (NIPFP 1985). Some other estimates note higher shares. According to Kumar (2016), the size of the black economy amounted to about 62% of GDP in 2012.

 

In fact, the idea that only illegal holdings of cash lubricate the black economy is itself misplaced. This presumption has not only infiltrated the public discourse but has also seeped into some of the academic work on the subject. In his much-quoted work on the “subterranean economy” of the United States (US), Gutmann (1977) chose a base period in which he considered the size of the black economy to be negligible. The currency-to-deposit ratio of the base period was then applied to the deposits in 1976. Such a method gave him an estimate of the legitimate currency requirement in 1976. The ratio of GDP-to-legitimate money (legitimate currency plus deposits) multiplied by the currency stock in excess of its legitimate requirement, then, gave Gutmann his measure of black income in the US.

 

The problem, however, is that transaction balances used for generating black income need not be undeclared or illegal. For example, a firm can declare cash in its balance sheet and then use it to procure inputs at inflated prices from an associated firm that operates from a low tax jurisdiction. The profits can then be ploughed back into the firm, say, via the foreign investment route. The expansion of liabilities that results may, at least temporarily, cause the firm to hold even larger amounts of cash. In this case, there is nothing illegal about the original holdings of cash or their subsequent augmentation. In fact, since transaction balances are held legally as cash, they could well be held as deposits. The example, therefore, shows that bank deposits can also finance black activities. This, of course, goes against the very grain of what Gutmann suggests and what the current Indian government would have us believe.

 

In the example we constructed above, black incomes are generated in the country but received in a foreign land. But are not incomes from corruption (and many other forms of illegalities) received as cash within the country. Would not demonetisation reduce these to worthless pieces of paper? It would, but only to the extent that the recipients of such incomes were foolish enough to continue to hold them as illicit cash. They could, in the first place, choose to consume these incomes. But even when such incomes are saved, they need not be held as cash. The savings can take the form of land, gold/bullions or financial shares. Besides, there are ways to launder illicit cash. For example, “bill masters” may be engaged to sell fake bills to those firms that wish to inflate their expenses (GoI 2012b). Illicit cash can then be shown as a receipt for sales that never took place and, in this manner, made perfectly legitimate.

 

Thus, only a small section, which stores cash in large amounts either for future use or as revolving cash in business/trade transactions, is adversely affected by demonetisation. As we explained above, even here, a big portion of cash might actually be legal or made legal through myriad innovative ways. The assessment by I G Patel, the then Governor of the RBI, of the demonetisation scheme of 1978 is as true for 2016 as it was for 1978:

 

such an exercise seldom produces striking results. Most people who accept illegal gratification or are otherwise the recipients of black money do not keep their ill-gotten earnings in the form of currency for long. The idea that black money or wealth is held in the form of notes tucked away in suit cases or pillow cases is naïve. And in any case, even those who are caught napping – or waiting – will have the chance to convert the notes through paid agents as some provision has to be made to convert at par notes tendered in small amounts for which explanations cannot be reasonably sought (Patel 2002: 159).

 

In sum, no significant unearthing of illegal cash may be expected by demonetisation, even if it might halt or slow down illegal cash-based operations for a while.

 

Fiscal Space

 

In the days soon after 8 November, the buzz in policy circles was that demonetisation would extinguish close to `3 lakh crore of RBI’s currency liabilities. The enlarged net worth of the RBI, it was hoped, could then be transferred to the government in the form of a special dividend. The legal permissibility of such a transfer was a matter of speculation for almost a month after the announcement. However, two points may be noted in this context. First, the transfer of extinguished currency as dividend to the government was ruled out by the RBI itself. Urjit Patel, the RBI Governor, clarified on 7 December that “the withdrawal of legal tender characteristic status does not extinguish any of the RBI balance sheets ... They are still the liability of the RBI.” Secondly, as on 10 December, an amount of `12.44 lakh crore in the old series of notes had already entered the banking system. The public had time till 30 December to deposit old notes with banks, and they could continue to submit old notes to the RBI until around March 2017. In other words, there is likely to be very little money left with the RBI to extinguish.

 

Given that the dividend route is closed, the government would bank on the second version of the Income Disclosure Scheme (IDS) to improve tax collections and enlarge the kitty of the PMGKDS 2016. However, one wonders why such a scheme could not have been announced without demonetisation. Perhaps, demonetisation has armed the government with evidence on big ticket deposits that it can use to confront tax evaders. Yet, why would anyone deposit a large sum into a bank after 8 November and invite scrutiny from tax authorities? According to news reports, people may have split their large hoard of cash into smaller parcels before converting them into deposits. The tax authorities now have the unenviable task of establishing the trail from the original hoard of cash to multiple small-ticket deposits in the millions of accounts spread across tens of thousands of bank branches.

 

What is likely to be the net revenue gain from demonetisation? As an illustration, let us assume that `1.6 lakh crore are voluntarily disclosed (which is more than two and a half times the amount disclosed in the first income disclosure scheme). A 50% tax on this amount would result in an addition of `80,000 crore to government’s tax kitty. Besides, declarants are supposed to provide an interest-free loan equal to one-fourth of the disclosed amount to the government for a period of four years. Assuming a 6% interest rate on borrowings, the government would then save `2,400 crore in each of the next four years. The present discounted value of this income stream comes to `8,430 crore. The total revenue gain is then `88,430 crore.

 

However, the government would also lose money. It will end up spending about `17,000 crore on printing and distributing currency, and conservatively, another `6,000 crore as the interest cost (explained later) of managing the excess liquidity with banks. Let us assume that 2% of the nominal GDP is shaved off due to demand contraction; instead of growing at, say, 11.5% per annum, the nominal GDP would grow at 9.5% per annum. Taking the nominal GDP (at market prices) of `135 lakh crore in 2015–16 and a tax-to-GDP ratio of 17%, the combined loss of tax revenue to the centre and the states due to economic contraction would amount to `45,900 crore.[vii] The total loss of revenues due to demonetisation would then be about `68,900 crore. This does not include the compensation that government may have to provide for toll operators (about `922 crore, as per estimates in the media) and the loss of revenue from the sops announced on digital payments. The net revenue gain to the government would then be `19,530 crore. Even if we are generous and assume that the government actually gains `40,000 crore from the entire exercise, it would still work out to just 1.3% of the combined revenue receipts of central and state governments in 2015–16.

 

In other words, it is hard to think of demonetisation as a game changer for government finances.

 

Interest Rates and Inflation

 

According to Arun Jaitley, and a few media commentators, demonetisation would expand credit supply and reduce interest rates in the economy. Such a claim betrays an incorrect understanding, not only of India’s credit markets, but even more worryingly, of the process of demonetisation itself.

 

Before dealing with this issue in detail, we need to, right at the outset, dispel a claim made by the Prime Minister in his 31 December 2016 address. He had said: “the excess of cash was fuelling inflation and black-marketing. It was denying the poor, their due. Lack of cash causes difficulty, but excess of cash is even more troublesome.”[viii] What may drive inflation, besides a sustained escalation of costs, is an excess of demand over supply. Demand, of course, is backed by access to a means of payment, which may be held as cash or deposits. It is thus conceptually erroneous to claim that a mere conversion of cash into deposits will deprive economic agents of the means of payments to demand commodities. As a matter of fact, after 8 November 2016, the poor, who are underserved by banks and mostly receive and make payments in cash, were forced to spend less due to the denial of their rightful cash. The “success” in controlling prices, in other words, was achieved by squeezing the consumption budget of the poor.[ix]

 

The claim that demonetisation would result in lower interest rates can be rationalised through a simple money multiplier process. Suppose `10 of cash in the hands of the public is converted into deposits. Let us further assume that out of every `10 that banks issue as deposits, they are required to hold `1 as cash reserve. As a result, banks will now have `9 worth of “excess cash,” which they lend to public and, which, assuming that the public is discouraged from holding cash, returns as deposits. The cycle would then start afresh: deposits will increase by `9, cash reserves by `0.90 and loans by `8.10. When all is said and done, deposits, reserves and loans would have increased by `100, `10 and `90 respectively. Another way to understand this process is to simply assume that the banks hold no more than their required reserves by crediting `90 to the deposit account of their borrowers. Of course, such an expansion of credit cannot come without a reduction in its price and demonetisation has raised hopes that the interest rate on loans may fall in the near future.

 

There is, however, a fly in the ointment. What we are witnessing in India today is not a permanent conversion of currency into deposits but a temporary measure that would last only till the limits on withdrawals exist. Once the convertibility of deposits into cash is restored, the multiplier process sketched above would start working in the reverse direction. As deposits worth `10 are converted into cash, the banks, now holding less cash than they are required to, would be compelled to extinguish loans worth `90 (and the corresponding sums in the deposit accounts of their borrowers) from their balance sheets. Any increase in credit on account of demonetisation would therefore be completely temporary.

 

There is more. The textbook money multiplier mechanism assumes that banks fix the overall quantity of credit and its price is determined in the marketplace. In the real world, just the opposite happens: banks fix the price of credit and its quantity is determined in the marketplace by the activities of borrowers. To borrow terminology developed by Polish economist Michal Kalecki, the quantity of bank credit is demand-determined whereas its price is cost-determined. Commercial banks can always expand their lendable resources by borrowing funds from the RBI at the repo rate fixed by the latter. The repo rate, in turn, sets the floor for lending rates to various bank borrowers.[x] It is only when the stock of eligible securities with banks, which the RBI requires as collateral in repo transactions, begins to run thin that one can realistically talk in terms of a quantity constraint on their credit-creating capacity.

 

Surely, there was no quantity constraint for Indian banks before demonetisation. As on 28 October 2016, the stock of government and other approved securities with banks stood at `28,956 billion; this was about 29% of the demand and time liabilities issued to the non-bank public, a figure well in excess of the 20.75% Statutory Liquidity Ratio (SLR) that the banks are required to maintain.[xi] There was no constraint on the credit-creating capacity of banks to begin with, and the finance minister’s claim that demonetisation would result in an expansion of credit appears grossly exaggerated.

 

Since the RBI acts as a price fixer in money markets, it seeks to mop up the enlarged cash reserves of banks either by activating its reverse repo window or through the outright sale of government securities.[xii] Between 30 November 2016 and 6 December 2016 alone, the RBI had mopped up more than `4 lakh crore from the commercial banking system.[xiii] The impact of expanded deposit base would, therefore, be not so much to enlarge credit to private borrowers as to shift the ownership of Government securities (G-Secs) and Tresury bills (T-Bills) from the RBI’s balance sheet to that of the banks.

 

It is hard, then, to see how interest rates in the banking system would fall due to demonetisation; any decline in interest rates would only be transient.

 

On the other hand, excess liquidity situation, while doing little to improve credit supply, will actually have adverse fiscal implications. This is because the RBI, a public institution whose profits are transferred to the central government budget, will lose its income earning assets to commercial banks. Moreover, to the extent that market stabilisation bonds are used to mop up excess reserves from the banking system, interest payments will have to be made directly from the central government budget. The exact magnitude of these costs is anybody’s guess at the moment. But if `12 lakh crore is mopped up by the RBI for a period of just one month, assuming an annual interest rate of 6% paid over 12 equal monthly instalments, the total interest outgo of the central government would be about `6,000 crore.[xiv]

 

Less-cash Economy

 

Given the inordinate delay in the printing of new currency, the government has begun a campaign for less-cash banking. It is argued that less-cash banking would formalise a large share of India’s informal economy by bringing more firms into the tax net.

 

To begin with, there is no clear relationship between the currency-to-GDP ratio and what we call as the “shadow economy,” which is a more appropriate concept to use than informal economy.[xv] India had a currency-to-GDP ratio of 12.5% in 2015 (Rogoff 2016). The size of India’s shadow economy—using one definition—is estimated at about 21% of its GDP (Schneider et al 2010). Let us take three countries where the currency-to-GDP ratio was either higher or comparable to India’s: Japan at 18.6%, Hong Kong at 14.7% and Switzerland at 11.1%. The size of the shadow economy relative to GDP in 2012 was only 8.8% in Japan, 15% in Hong Kong and 7.6% in Switzerland (Schneider et al 2010; Schneider 2011). Now, let us take five countries that had lower currency-to-GDP ratios than India in 2015: South Africa and Brazil at 3.4%, Chile at 3.6%, Indonesia at 4.1% and Mexico at 5.7%. All these countries had a large-sized shadow economy relative to GDP in the second half of the 2000s: 26.8% in South Africa, 38.5% in Brazil, 18.5% in Chile, 19.1% in Indonesia and 28.5% in Mexico.

 

A higher share of cash in total payments does not necessarily indicate a larger shadow economy. According to a Deutsche Bank’s study in 2016,

 

surveys and estimations for different countries show that a high share of cash in total payments does not always indicate a large shadow sector: Germany and Austria are cash-intensive countries with relatively small shadow economies. In Sweden, cash payments have become rare but the country still has a mid-sized shadow economy. However, in many cases the degree of cash usage and the size of the shadow economy do seem to be related: Spain, Italy and Greece are characterized by intense cash usage and large shadow economies while countries with relatively low cash usage tend to show low levels of shadow activity (Anglo-Saxon countries as well as Switzerland, the Netherlands or France). Given these diverse findings, it becomes clear that cash is scarcely the reason for conducting shadow activities (Mai 2016:  7–8, emphasis added).

 

Similar, again, is the relationship between corruption and cash. There are cash-intensive countries with lower perceived corruption and less cash-intensive countries with higher perceived corruption. The “corruption perception index” of Transparency International represents the perceived level of public sector corruption on a scale of 0 (highly corrupt) to 100 (very clean). In 2015, the index was higher for many economies with higher currency–GDP ratios (75 for Japan and Hong Kong; 86 for Switzerland; 81 for Germany; 76 for Austria) and lower for many economies with lower currency–GDP ratios (44 for South Africa; 38 for Brazil; 35 for Mexico; 36 for Indonesia).[xvi]

 

There are also many reasons why cash is preferred by firms, particularly small and micro-enterprises. Transaction costs in cash transactions are low; in particular, costs of book-keeping are minimised by relying on cash. The use of digital transactions is expensive as each transaction invites a 2%–3% tax. Cash transactions may also be convenient because of the immediacy of realisation without delays of bank transfers. In many cases, informal credit is available to small and microenterprises only as cash, and needs to be repaid too as cash. In other words, forcefully formalising a fragile informal sector may actually end up eliminating the minuscule margins on which these firms survive.[xvii]

 

Finally, cash leaves no trail, while digital payments leave a trail. For this reason, the potential for state surveillance, violation of privacy and abuse of civil liberties rise significantly with the replacement of cash payments with digital payments. New sources of metadata on everyday transactions of citizens are emerging; big data analytics is increasingly becoming big business. Such personal data of citizens turn into commodities in the grey markets, resulting in a breakdown of trust between the state and its citizens. While strong laws on privacy and cyber-security exist in many Western economies, Indian legal system is marked by the absence of such legal safeguards. The introduction of Aadhaar, and its expansion into the Orwellian idea of India Stack and the JAM (Jan Dhan–Aadhaar–Mobile) trinity, present new threats to the freedoms of Indian people that have not been adequately appreciated in the public discourse on cashless transactions.

 

Conclusions

 

In this brief note, we tried to examine the government’s claims on the benefits of demonetisation. We argued that (i) the extent of circulation of counterfeit notes in the Indian economy is exaggerated;
(ii) the claims of unearthing large amounts of black money is unfounded and based on a poorly informed view of what constitutes black money; (iii) no improvement in government finances may be expected due to demonetisation; (iv) it is unlikely that interest rates in the economy may fall as a consequence of demonetisation; and (v) the movement into a less-cash economy may neither lead to the shrinkage of the shadow economy nor reduce corruption, and, instead, may open up new spaces of surveillance and assaults on the personal freedoms of citizens.

 

Thus, one finds it extremely difficult to locate any economic logic in the conception and implementation of the demonetisation scheme.

 

REFERENCES

 

GoI (2012a): “Black Money: White Paper,” Ministry of Finance, Government of India, New Dehi, May.

 

— (2012b): “Measures to Tackle Black Money in India and Abroad,” Report of the Committee headed by Chairman, Central Board of Direct Taxes (CBDT), Ministry of Finance, Government of India, New Dehi.

 

GoK (2016): “Interim Report of the Committee to Study the Impact of Demonetisation on the State Economy of Kerala”, Kerala State Planning Board, Government of Kerala, Thiruvananthapuram, December.

 

Gutmann, P (1977): “The Subterranean Economy,” Financial Analysts Journal, Vol 33, No 6, pp 26–34.

 

Kumar, Arun (2016): “Estimation of the Size of the Black Economy in India, 1996–2012,” Economic & Political Weekly, Vol 51, No 48, pp 36–42.

 

Mai, Heike (2016): “Cash, Freedom and Crime,” EU Monitor, Deutsche Bank AG, Deutsche Bank Research, Frankfurt, November.

 

NIPFP (1985): “Aspects of the Black Economy in India,” Report submitted to the Ministry of Finance, Government of India, National Institute of Public Finance and Policy, New Delhi.

 

Patel, I G (2002): Glimpses of Indian Economic Policy: An Insider's View, Delhi: Oxford University Press.

 

PMO (2016): “PM’s Address to the Nation,” viewed on 17 December 2016, http://www.pmindia.gov.in/en/news_updates/prime-ministers-address-to-the-nation.

 

RBI (2016): Annual  Report 2015–16, Reserve Bank of India, Mumbai.

 

Rogoff, Kenneth S (2016): The Curse of Cash, Princeton and Oxford: Princeton University Press.

 

Schneider, F, A Buehn and C E Montenegro (2010): “Shadow Economies All Over the World: New Estimates for 162 Countries from 1999 to 2007,” Policy Research Working Paper 5356, Development Research Group, World Bank, Washington.

 

Schneider, F (2011): “Size and Development of the Shadow Economy of 31 European and 5 Other OECD Countries from 2003 to 2012: Some New Facts,” unpublished Note, http://www.econ.jku.at/members/Schneider/files/publications/2012/ShadEcEurope31.pdf.