I am appreciative of the work that the Modi government has done to tackle the menace of black money. The Nov ’16 Demonetization however, is this government’s poorest policy decision not just in this area, but in its tenure so far.
The title of this post is self-explanatory. I’ve listed below the key problems with this policy action.
1. Demonetization trapped just 2.5% (likely even less) of the stock of black money. The gains are rather modest.
In the post I wrote yesterday, Demonetization: What % of Black Money did the Indian Government actually Trap? , I estimated that the Demonetization of 500 and 1000 Rupee notes has trapped only ~2.5% of the total stock of black money held by Indians. Albeit a rough estimate, this one figure (likely conservative) sums up the flawed design of this exercise. For just 2.5% of the current stock of black money and no mechanism to prevent future generation of the same, the demonetization has caused chaos and dislocation, decelerated growth and disproportionately impacted the poor.
2. It’s a one-time “indirect” measure; does not prevent the ongoing/future generation of black money or its storage in cash in the future.
In their article High costs, meagre gains published in the Indian Express yesterday, Amartya Lahiri and Devashish Mishra invoke Jagdish Bhagwati’s 1963 paper on Trade Distortions to explain the sub-optimal nature of the demonetization. Mr. Bhagwati noted in this paper that the optimal intervention instrument attacks the source of distortion directly. Lahiri and Mishra explain how demonetization just attacks one of the ways of storing black money (one of the least popular ones), and that too only at this present moment in time. Demonetization does not prevent the accumulation of black money in the form of cash in the future, nor does it target directly any of the sources of black money generation like the implementation of GST would for example. Except for the fear that the government may demonetize again, this action provides no credible deterrent. Thus, it fails the “Bhagwati test”.
3. Demonetizing 87% of currency to capture counterfeits that comprise just ~0.0018% of currency in circulation defies common sense. Also, new notes do not have significantly enhanced security features.
The government’s narrative has been changing given that defending what Professor Matraik Ghatak of the London School of Economics has rightly described “perhaps the biggest policy-induced recessionary shock in post-Independence India” is difficult on the black money front alone. The demonetization has thus also been projected as the panacea for ridding the nation of counterfeit notes.
Per RBI data, counterfeit notes comprised just 0.0018% of the total currency in circulation in 2015-16. Demonetizing 87% of the country’s currency to destroy just 0.0018% of fake notes makes no sense. Even if demonetization were to be used as a tool to rid the country of counterfeit currency, it could have been done in a phased manner. It would still have achieved the same result, but in a markedly less destructive fashion.
Also, while the new notes do have more security features, these aren’t significant enough to prevent counterfeiting. There’s no reason to believe that in time fake notes wont resurface.
4. The Modi government has made credit-worthy strides in its endeavour to move India towards a cashless economy. That said, forcing the populace to do this overnight in a country where ~95% of all transactions are done in cash and close to 19 crore people are still “unbanked”, with those that are “effectively banked” limited mostly to urban areas, is unrealistic and callous.
Moving to a cashless economy is a patently worthy goal. The Modi government has done a lot in this area which it deserves credit for. Since its inception in August 2014, the Pradhan Mantri Jan-Dhan Yojna (PMJDY), the PM’s project for financial inclusion, has resulted in the opening of 26.7 crore bank accounts. The numbers are rather impressive.
That said, it is important to understand the limitations of such an exercise where focusing disproportionately on speed can compromise the spirit of the endeavour and ultimately its underlying objective.
While the government’s push to bank the unbanked through the PMJDY is laudable, the numbers alone do not tell the full story. Account duplication (~33%), account dormancy (~30%), corruption/ malpractices due to lack of oversight and pressure to achieve numbers, limitations of the “bank mitra” model etc. all point to the fact that while the number of people with bank accounts has increased substantially, many of these new entrants are not “effectively banked”. For those you interested in knowing more about the efficacy as well the ground realities of the PMJDY, I highly recommend this great article (link here) published by The Wire (3/5/2016).
I estimate that ~19 crore people in India are still unbanked i.e. do not have a bank account. Of those that are technically “banked”, only a small fraction are actually experiencing meaningful financial inclusion. Given this backdrop, forcing the populace to move to cashless transactions overnight, which is what the demonetization has effectively done, is unrealistic and cruel.
While for the urban middle class, demonetization has been an inconvenience, for the poor in urban and especially rural areas, the ultimatum to go “cashless” is callous and has caused a great deal of distress.
Delhi-based author, Monishankar Prasad (as quoted by the Tribune) sums it up aptly - “The poor were taken totally off guard and the banking infrastructure in the hinterland is rather limited. The tech class has poor exposure to critical social theory in order to understand the impact on the ground. There is an empathy deficit."
5. There are much more effective, sustainable, “direct” intervention instruments that tackle the problem of black money at its source, some of which the government is already in the process of implementing. However, these will take time, as any credible, lasting solution to the black money issue will.
There are much more “direct” ways of tacking the scourge of black money (vis-à-vis an extreme move such as demonetization), some of which the government is already in the process of implementing like the rollout of the GST, mandatory PAN for all transactions beyond a certain limit including jewellery (came into effect from Jan 1, 2016 for all jewellery transactions above Rs. 2 lakh), PAN requirement for opening an account with any bank, reduced stamp duties on real estate transactions (expected), income tax raids based on information/tips, move towards a cashless economy (read point 4 above), gaining information about Indians holding bank accounts in tax havens abroad (the Swiss will begin to share this information with the Indian government starting 2018), reform of campaign finance etc.
The Modi government has made genuine progress in many of these endeavours and needs to continue to do so for long-term, sustainable results to be achieved. Knee-jerk and ill-conceived measures (such as the demonetization) are not the way forward.
6. The disproportionate cost borne by the poor and marginalized who were never the target of this exercise, is inexcusable.
My biggest problem with the demonetization much more than the limited gains from the action, is the disproportionate, unforgivable impact on the poor and marginalized in our nation.
Here are some figures. The informal sector (untaxed, unlisted) of our economy employs around 85% of the national workforce. It includes small-scale businesses and enterprises, traders/merchants, small service establishments, home businesses, the self-employed, farmers, small vendors, street hawkers and others. The informal economy is almost exclusively dependent on cash for its transactions.
Daily wage workers for example comprise around 30% of the nation’s workforce or ~35% of those employed in the informal sector. They’re completely dependent on their daily cash wage for subsistence. Demonetization has grievously impacted these workers. Massive layoffs have been reported in the Small & Medium Scale Industries. Many workers have lost their livelihoods and suffered immense hardships (deaths have been reported). The impact on farmers has been brutal, as they’ve struggled to sell their kharif harvest and sow crops for the Rabi season.
While those with substantial untaxed incomes will survive relatively unscathed, the poor, who were not the target of this exercise, have suffered an unforgivable amount of distress and hardship.
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