The Indian Demonetization - Success or Failure?

The RBI disclosed in its Annual Report for 2016-17 released on 30th Aug, that of the Rs. 15.44 lakh crore of currency banned post demonetization (Rs 500 and Rs 1000 rupee notes), Rs 15.28 lakh crore or 99% was returned by the public to banks/RBI by June 30th 2017. 

This information has raised a storm of criticism from opposing parties in parliament as well as economists and policy gurus. They aren’t wrong in their argument. I’ll explain why in minute. 

1. The government had earlier estimated that ~3-4 lakh crore of black money was deposited post Demonetization. Only ~5% of this has been found to be black money so far. This is just 0.1% of the total stock of black money held by Indians. 

The government had earlier estimated that around 3-4 lakh crore of black money (or money on which tax had been evaded) had likely been deposited into bank accounts in the 50-day window (till Dec 30th 2016) post demonetization. The tax department has been scrutinizing accounts where large deposits/deposits inconsistent with historical patterns/income history were made. While admittedly this process is slow, so far from Nov’16 to May’17, only Rs 17,526 crore has been found to be undisclosed income. This is just 5% of the government’s initial estimate of 3-4 lakh crores. 

To put things further in perspective, this is just 0.1% of my conservative estimate of Rs 135 lakh crore for the total stock of black wealth held by Indians (read my post Demonetization: What % of Black Money did the Indian Government actually Trap? dated 10 Jan '17).

Going even further, if one believes that India’s black economy is 60-75% of GDP, which I believe is much closer to reality (read my post India's Black Economy 60-75% of GDP! dated 13 Feb ’17), then this number is less than even 0.1%!

2. Additionally, the government believed that some banned notes would not come back into the system, thus automatically extinguishing some black money. That has not happened - almost all the black money stock is now in the system, leaving the government with the complex and in many cases impossible task of finding its origin and owners. 

The government was expecting that some of the banned notes would not come back into the system, as the genesis of this tax evaded income would be hard to explain to the authorities. In this way, the government had thought that at least some amount of black money would be automatically extinguished, thus saving them the trouble of finding it through scrutinizing deposits made. 

However, the data finally presented by the RBI (many have questioned why it took the RBI so long to release these statistics) paints a different story. It confirms that practically all the black money held in the form of 500 and 100 notes (which is the overwhelming majority of black money) has found its way back to banks!

This underscores two things: 

(a) People with black money don’t hold it in the form of bundles of cash at home! Most of it has already been laundered/converted into white money and is being held in the form of assets such as real estate, gold/jewellery, stocks and shares, foreign currency, foreign assets etc. or has been invested in various businesses.

Infact, based on data with the IT department, it has been found that of the total black money held by tax evaders, only ~5-6% is usually held in cash. The rest is held in the form of assets mentioned above. This clearly means that if the government has to truly go after black money, it has to investigate individuals and firms whose assets are disproportionate vis-a-vis their known sources of income. Only then can these assets be seized and black money trapped. 

This was clear even before demonetization. Granted that the government now has a lot of deposit data to sift through and hopefully this leads them to the holders of at least some tax-evaded income. But even this will be hard given all the ingenious methods tax evaders have employed in order to deposit money into the banking system without leaving a clear trail back to themselves (I’ll talk about this in the next section).

Even if the government manages to uncover some of these trails leading to the holders of black money, uncovering all their ill-gotten assets will be a long-drawn-out process, which will have to be been seen through to its logical conclusion by tax authorities. Also, the IT department has to accomplish this while hopefully not harassing genuine income tax payers. Only time will tell how successful this exercise will be since there are no short cuts here.

(b) Like I mentioned above, holders of black money found several ingenious ways to deposit their tax-evaded income into banks using the accounts of other individuals/ businesses/ institutions post demonetization. 

For instance: a) They used “Money mules” - these are people who were hired or requested in case they were friends/relatives, to deposit black money in their accounts post demonetization and exchange it for new notes. The new currency was then to be withdrawn at a later date by these “money mules” and returned to the tax evaders. b) They utilized “Name lending” - refers to a person opening a new account in order to hold currency for someone else, this currency being tax-evaded income in the current context. c) They purchased gold - there was a surge in gold purchase in the days following the demonetization action. Some jewellers sold gold in back-dated transactions, so that they don’t come under the government’s scanner. d) They made "donations" to temples - these were deposited by the temple management in banks, exchanged for new notes and returned to the tax evaders after keeping a commission. They employed sundry other tactics - read this article from the Huffington post, 13 ways in which Indians will convert their black money into white even after Demonetization, to know more. 

Like I’ve discussed above, uncovering the trail leading from the deposits back to the real owner of funds will be a rather arduous, time consuming process. 

Conclusion

Of all the critiques I've read of the Demonetization action, Ex RBI Governor, Mr Raghuram Rajan's is the most balanced. He effectively says that while the demonetization action had the right intent, it cannot be labeled a success, at least not yet. He is absolutely on-point. 

Almost all the black money has come back to the system and it remains to be seen how much the government will be able to identify as black money and link to its owners. This process will be long and arduous and whatever the tax authorities are able to uncover will still be just a small portion of the entire stock.

While the government says that demonetization was intended to accelerate digitization (after an initial upward blip in digital transactions, their quantum has settled lower), reduce the amount of cash in the economy, curb terrorist activity etc., it is naïve to believe that making a big dent in the black money problem was not the key objective. And in meeting that objective, this action has not been much of a success so far, especially given the costs that it imposed on the public, in particular the weaker sections of society who work mostly in the unorganized sector. The devastating impact of this
action on such citizens is not really captured by GDP numbers, IIP numbers or other statistics released by the government that are derived mainly from the formal sectors of our economy. Read my post Sub-optimal and Inexcusably Expensive: All that’s Wrong with Demonetization dated 11 Jan '17 for more.

There are ways of going after black money and achieving higher tax compliance that do no impose this sort of cost, some of which the government is already employing for e.g. mandatory Aadhar for banking transactions over Rs. 50,000, linking of PAN and Aadhar, PAN requirement for jewellery purchases over 2 lakhs and various other transactions (different limits), the GST rollout etc. These are less dramatic than a one-time sweeping action, but ultimately more effective in the long-term.

At the very least, if the demonetization action had to be done, the government should have printed the new notes ahead of the action like Mr. Rajan suggests. Instead, it has been almost 10 months since the action and the remonetization is still not complete. 

The Recent Surge in Gold Imports from South Korea: the History, the ‘Why’ and the ‘How’ explained in detail.

There’s been a recent, much reported surge in gold imports into India from South Korea since July 1st, when the Indian GST tax regime came into effect. Newspaper reports assert that gold imports from South Korea jumped to $339M during July 1-August 3 this year vs. imports of $470M in all of 2016-17. 

In this post, I'll explain in detail how and why this has happened, while giving the reader some historical context as well. 

The Backdrop

The Free Trade Agreement (FTA)

India has an FTA (Free Trade Agreement) with South Korea and other ASEAN nations due to which there is no basic customs duty on the import of gold from these countries. Note: A 10% basic customs duty is levied on gold imports into India from countries with which we do not have an FTA. The Indian government started levying this 10% import duty on gold in Aug 2013 when our Current Account Deficit (CAD) had reached sky-high levels and gold imports were soaring. The duty has stayed ever since. 

While the duty and other measures taken in 2013/2014 helped bring down the CAD and stabilize our currency, a new unanticipated problem relating to the gold trade emerged. 

Unintended Consequences of the FTA: Surging gold Imports taking advantage of the duty differential

The FTA with ASEAN meant that even after the imposition of the 10% import duty, gold imports from these nations were not subject to this basic customs duty. As a result, import of gold jewellery from these countries into India spiked due to the favourable duty differential vs. other nations. 

For instance, gold jewellery imports form Indonesia suddenly spiked in Apr-June 2015 to Rs. 2,896 crore from Rs. 620 crore in all of 2014-15! Obviously something fishy was going on. Indonesia is a gold producer and gold jewellery from Indonesia accounted for ~50% of the overall unstudded gold jewellery imports into India 2014-15, but the sudden dramatic surge obviously meant that a third country was likely routing its jewellery shipment through Indonesia in order to take advantage of the low import duties on gold shipped to India. (link to source article in Business Standard)

This was obviously concerning for the Indian government since higher gold jewellery imports not only have ramifications for the Current Account Balance but also hurt domestic producers. 

This is just one instance of misuse of an FTA leading to a surge of gold imports into India. There are many such instances from the past. The government needed a solution to plug such loophole. 

The Government’s Solution: Imposition of Excise duty on domestic gold jewellers so that Countervailing duties could be imposed on gold Imports 

In his 2015-16 budget, the Finance Minister levied a 1% excise duty on domestic gold jewellers with turnover over Rs. 12 crores. Note: This 1% excise duty was with Central VAT credit; without Central VAT credit, the duty would be 12.5%. Since these large jewellers would get credit for the VAT already paid on inputs etc., the effective excise duty for them would be just 1%. 

However, since an excise duty was now being levied on domestic jewellers, this meant the government could now impose a 12.5% Countervailing Duty (same as the excise duty on gold sales without Central VAT credit) on imported gold jewellery. Countervailing duties are levied on imports in order to ensure a level playing field between domestic and foreign producers. 

While the key reason the Finance Minister gave publicly for levying the excise duty was that gold is a luxury good and thus should come under excise duty purview (he also argued that this was a precursor to the GST), using this levy to protect domestic industry and a put a clamp on gold imports that utilized loopholes in FTAs was a key motive for the move as well. Gold traders/jewellers went on strike to oppose the levy but the government didn’t budge. 

The Current Problem 

The beginning of the GST regime meant Countervailing duty was no longer applicable

When GST became applicable from July 1, 2017, the 12.5% Countervailing duty levied on imports got subsumed under the GST. Per GST rates, gold imports now attract only 3% IGST (IGST = integrated GST which is shared between the central and the state government). 

As a result, gold imports from South Korea (one of the countries with which India has an FTA) have surged because of this sudden fall in tax rate from 12.5% to 3%. As I mentioned above, gold imports from South Korea jumped to $339M during July 1-August 3 this year vs. imports of $470M in all of 2016-17. In July alone, ~10 tonnes of gold mainly in the form of coins and medallions was imported from South Korea as compared to 0 tonnes imported in July 2016. Per industry sources, these coins are then melted in India/converted into gold bars and used for the manufacture of gold jewellery. 

FTA Violations 

Besides the fact that this modus operandi takes advantage of a loophole, it is also in violation of FTA rules. Under the FTA, gold imported from South Korea has to be manufactured/refined in South Korea, in order for it to be eligible for the zero basic customs duty. According to bullionstar.com (link here), South Korea’s gold refining capacity is 60 tonnes/year. Of this capacity, for ~10 tonnes of gold to come to India in just one month (July), points clearly to violations. 

Obviously, refined gold is being routed through South Korea from a third country in order to take advantage of the duty differential. It has been widely reported that per industry sources this refined gold is coming from Dubai. It is imported into South Korea in the form of gold bars or coins. If it is in the form of gold bars, then it is converted into gold coins in South Korea. Then it is incorrectly shown that the gold itself was manufactured (i.e. refined) in South Korea, and these gold coins get exported to India. These coins are then melted and used by gold traders/jewellers. 

The other FTA violation involved in this modus operandi is that under the FTA, any gold coins imported into India have to be meant for sale to final consumers. They cannot be converted into gold bars and/or used to manufacture jewellery, in the way that traders/jewellers are doing right now. 

What will the Indian Government do?

Good question. I wont speculate right now because the government will have to do something soon. I’ll dissect their action in a subsequent post.

Increased Gold Imports lead to Rupee Depreciation & Current Account Deficit

So I wrote the post Round Tripping and the Ban on 23 & 24 Carat Gold Exports just yesterday. In this post, I talk about the practice of “Round Tripping” and how the Indian government hopes that its recent order banning gold jewellery exports of 23 and 24-carat purity will curb it to some extent.

For anyone who’s been reading recent news articles about this gold export ban and surging gold imports from South Korea (read about this in my next post The Recent Surge in Gold Imports from South Korea: the History, the ‘Why’ and the ‘How’ explained in detail) which have alarmed our government, it is only logical to ask “why all this fuss about gold?”

Here’s why.

India is amongst the top gold importers in the world. Roughly a quarter of the world’s gold demand comes from India thanks to our penchant for investment in gold. On an average (rough average over the years), India imports ~800-900 tonnes of gold annually. 

Gold imports comprised ~10% of our total merchandise imports for FY17 (note: gold imports were down 24% y-y in FY17). 

Since gold is paid for in dollars (USD), high gold imports tend to deteriorate our Current Account Balance. When this happens i.e. our imports become much greater than our exports, the demand for dollars rises as compared to that for the Rupee and the Rupee depreciates. 

Sustained Rupee depreciation is not a good thing for India. It makes imports expensive (each dollar costs more rupees now) and leads to inflation. Also since it tends to happen in concert with our Current Account Balance deteriorating (India always runs a Current Account Deficit since we are a net importer), it is accompanied by a fall in forex reserves with the RBI. This means a drop in our reserve of dollars, which we need to pay for our imports. This is always troubling for any net importer. 

Depreciation also worries foreign investors who’ve invested money in India since now their investment returns are lower when converted to their own currency. This may spook them and lead to an exodus of foreign money out of the country (called “capital flight”). This can crash our stock market and spike our bond yields, and lead to further depreciation of our currency. This would mean country-rating downgrades for India and basically a full-blown economic crisis. 

OK. So I described the absolute worst scenario there, but you get the idea.

Bottom-line

Gold imports form a significant portion of our import bill and hence have direct ramifications for our Current Account Deficit (CAD) and Rupee strength. Since gold is not a necessity for our economic growth in the way oil is, excessive import of gold, which deteriorates our CAD, is not desirable for our nation. This is why government bodies and market watchers keep a close watch on gold imports and this is also why you have been reading about them in the paper recently.

Round Tripping and the Ban on 23 & 24 Carat Gold Exports

A few days ago (14th Aug), the Directorate General of Foreign Trade (DGFT), Ministry of Commerce, GOI, banned the export of gold jewellery, coins and medallions with purity above 22 carats. This means that Indian exporters can now only export gold products of purity of 22 carats or below.

Why did the Government do this? 

While the order did not give any official reason, most believe it is to help curb what is called “Round tripping”. In the context of gold, “Round tripping” refers to the practice where traders import gold, usually at low import duties/taxes and then subsequently export this gold without any value-addition or with minimal value addition (change packaging etc.). This is done mainly to avail of benefits such as cheap financing from banks by inflating trading volumes, higher import entitlements (this happens when import entitlements are linked to export volumes) or to simply profit from differences in tax rates/ interest rates/ exchange rates. 

Why is Round tripping undesirable? 

Round tripping is undesirable for a variety of reasons. First, it is against the law. Second, while traders indulging in this practice end up profiting and garnering bank finance at favourable rates, genuine traders suffer as these benefits are not available to them to the same extent. Three, Round tripping artificially inflates gold import and export figures for the nation in question. Since gold imports (India is one of the largest importers of gold in the world) require payment in dollars, high import volumes put a drain on our Current Account Balance and contribute to the depreciation of the Rupee. This is why in times when the Rupee has depreciated strongly due to deterioration in our Current Account Balance (when imports > exports, we need more dollars than foreigners need rupees, so the rupee depreciates vs. the dollar), the government has usually taken steps to discourage the import of gold and curb Round tripping. 

How much are Rounding tripping volumes for India?

While there are no official estimates, industry sources estimate gold Round tripping volumes at ~150-200 tonnes/year. For context, India imports roughly 800-900 tonnes of gold annually. 

Why is it hard for the government to prevent Round tripping?

It is hard for the government to prevent Round tripping because while it wants to clamp down on this practice, it doesn’t want to penalize genuine traders in the process. For example, in early 2015 the government tightened value addition norms in order to prevent Round tripping. As part of this exercise, for plain gold jewellery articles, value addition norms were raised from the earlier 3% to 4%. This meant that traders would have to add at least 4% value to imported gold in order to export it in the form of plain gold jewellery. 

Such a measure adds to the cost of exporting. Thus in theory, you cannot keep exporting gold without any value addition and keep importing it back multiple times if each time you export this gold, it is priced at least 4% higher. This will make Round tripping unviable. 

But at the same time when the government does something like this, it wants to ensure that the value addition norms aren’t so high that they discourage genuine exporters of gold jewellery and make their products uncompetitive in the world market. 

Will the current order Banning 23 and 24 Carat Exports curb Round tripping? 

This is a good question. Per Surendra Mehta, National Secretary, India Bullion and Jewellers Association (IBJA), the leading industry body representing gold jewellers and dealers in India, there isn’t much scope for value addition in 23 and 24 carat purity gold when it is converted to gold jewellery and medallions (link to the article in Business Standard where he is quoted). 

Experts tend to agree that it is difficult to make high quality jewellery out of 23 and 24 carat gold. 

Hence, the government’s logic is that those claiming to ship gold jewellery and medallions of 23 and 24 carat purity are likely indulging in Round tripping. This is why the government believes that banning these shipments will plug at least one channel of Round tripping.

The logical next question is how much gold jewellery / medallions of 23 and 24 carat purity are exported out of India? The same Business Standard article (link here) that I referenced above states that per an industry estimate, India exports ~170 tonnes of jewellery and medallions made of/ studded with gold. Ornaments made of 24-carat gold apparently form ~15% of this volume or ~25 tonnes. 

If we assume that all of these 25 tonnes of export comprised Round tripped gold (extreme assumption), then it follows that of the 150-200 tonnes per year of Round tripping, 25/175 or ~15% has been plugged.

Remember, there are a lot of assumptions and rough estimates here. This is just a back-of-the-envelope exercise. 

What about the recent surge in Gold Imports from South Korea?

Read my post The Recent Surge in Gold Imports from South Korea: the History, the ‘Why’ and the ‘How’ explained in detail for this discussion.

Real Interest Rates in India Amongst the Highest in the World Right Now

In the wake of yesterday’s Monetary Policy Review meeting, it’s important to talk about real interest rates in India. 

What is Real Interest Rate? 

Real interest rate = Nominal interest rate - Inflation 

For example, if you earn 10% (this is the nominal interest rate) on a deposit with a bank and inflation is running at 8%, the real interest rate you earn = 10% - 8% = 2%. 

What does it mean? 

If your deposit is worth Rs 100, the interest you earn is 10% * 100 = Rs 10. But inflation is running at 8% which means that whatever goods you were buying earlier with the deposit mount (Rs 100), now cost Rs 108. So, of the interest income of Rs 10 (or 10%), Rs 8 (or 8%) goes just in preserving the purchasing power of your deposit. Your “real interest income” is Rs 10 - Rs 8 = Rs 2 or 2%. This is the income with which you can buy extra goods over and above what you could buy with Rs 100 earlier. 

So the “Real interest rate” gives you (the lender), the true purchasing power of the interest income you earn. For the borrower (the bank in this case), the “real interest rate” is the return it gives to the lender in terms of real purchasing power. Naturally, it follows that....

....High Real Interest Rates are good for lenders and bad for borrowers 

Even after yesterday’s Repo rate cut, Real interest rates in India are amongst the highest in the world right now 

Let’s compare current Real interest rates in India vs. those in the US. For this purpose, we will compare the Real interest rate on 10-year government bonds of both countries. Government bonds give us the “risk free” real interest rate for a country because theoretically, governments do not default on their debt. At least that is the expectation. 

Real interest rates on corporate bonds are higher because over and above the risk-free real interest rate that is associated with government bonds of the same maturity, lenders add a risk premium to compensate for risk of default by the corporate entity. 

The 10-year government security (gsec) yield in India yesterday (2nd Aug) was 6.46%. The most recently reported CPI inflation number (for June) was 1.54%. This means that real yield or the “real interest rate” for the 10 year gsec is 6.46% - 1.54% = 4.93%.

In the US, 10 year g-sec real yield (on 2nd Aug) was 0.47%. 

As you can see, the positive differential between the 10-year Real interest rate in India vs. the US is a whopping 4.45% or 445 bps! India currently has one of the highest real interest rates in the world, making it a rather lucrative destination for foreign funds looking to pick up this extra yield. 

This is the reason that FII/FPI funds have been pouring into the Indian debt market 

Year to date, FII/FPIs have ploughed Rs 1.71 lakh crore ($27 Bn*) into the Indian equity and debt markets. Of this total amount, Rs 1.15 lakh crore ($18 Bn*) or 67% has been invested in the debt market and Rs 56 lakh crore ($9 Bn*) or 33% has been invested in equities. 

As one would expect, Indian debt has absorbed the lion’s share of foreign fund inflows YTD.

* I’ve converted FII/FPI INR inflow figures into USD at the 2nd Aug exchange rate of INR 63.635/USD.

While these high Real interest rates are favourable for FIIs/FPIs (foreign lenders), they are bad for Indian industry (borrowers) as explained above. That said, simply lowering rates isn’t a magic bullet. 

Especially in the current environment where demand is muted, corporate earnings aren’t strong, corporate balance sheets are over-leveraged and the NPA problem is rampant, corporates aren’t borrowing much anyway. High real interest rates on top of that, aren’t helping. This is one of the key reasons why market players wanted a lower Repo rate and applauded RBI’s rate cut yesterday. 

It’s important to remember however, that simply lowering rates is not going to revitalize India Inc. For that to happen, demand has to pick up, the investment cycle has to start in earnest, over-leveraged balance sheets have to be stabilized and the NPA issue has to be fully dealt with. 

Finally, let’s look at some historical data. 

Another way of calculating Real interest rates is looking at the spread between the Repo rate (the rate at which the RBI lends to commercial banks overnight) and CPI inflation. This gives us the “real interest rate” for overnight funds. 

In the chart below, I have plotted CPI inflation, Repo rate and Real interest rate (Repo rate - CPI inflation). For July and Aug ’17, I’ve assumed CPI inflation of 1.07% and 1.45% (there’s a favourable base effect) respectively. This gives us estimated real interest rates of 5.18% for July and 4.55% for August.

As you can see from the chart below, besides Nov ’14 when the real interest rate rose to 4.73%, current real rates are the highest that we’ve seen since Jan ’12. 

Barring Nov ’14, current Real rates are the highest we’ve seen since Jan 2012.

Source: RBI, MOSPI data 

Why the RBI cut the Repo Rate Today

The Monetary Policy Committee (MPC) of the RBI cut the Repo rate today by 25 bps from 6.25% to 6%. A Repo rate cut was widely expected, and rightly so this time. 

Important to understand WHEN the RBI cuts rates

Sometimes market players/watchers predict rate cuts simply because growth slows, forgetting that RBI’s primary mandate is to keep CPI inflation within its target range of 4 +- 2% or 2-6% in the medium/long term. Simply because inflation is within this target range at the current moment doesn’t imply that the RBI will cut. The MPC usually looks at its projections for inflation 3-4 quarters out. If inflation looks close to its 4% (average) target or lower, without any significant risks to the upside, then it considers cutting rates. 

Market players always tend to advocate for a Rate cut

It’s important to remember that while the Central Bank will always tend to follow a cautious approach, market players (banks, research houses, financial institutions, corporates) will always tend to advocate for rate cuts. Why? Because lower interest rates are a positive driver for all of them. 

1) Banks can offer lower rates on deposits when the Repo rate falls and the RBI signals a low interest rate environment. This allows them to lend at lower rates to borrowers, which can help stimulate credit supply and expand banks’ loan books and profits.

2) Research houses are usually attached to the equities business. A Repo rate cut usually transmits through the banking/financial system and results in lower lending rates. This means that listed companies can borrow at lower interest rates, which is obviously a positive for them/equities in general. Also, for listed companies that have existing floating rate loans, a Repo rate cut usually translates into a fall in interest rate payments. Given this favourable impact on equities, research houses will usually tend to root for rate cuts.

3) Corporates (listed or unlisted) want rate cuts for the same reason listed in point no. 2 above.

CPI inflation has been consistently lower than RBI’s estimates over the last few months and some of the upside risks have receded. Hence the RBI felt comfortable cutting.

Even though CPI inflation has stayed below the mid-point of RBI’s target range (4%) since Nov ’16, RBI kept the Repo rate unchanged at 6.25% because it was unclear about the inflation trajectory going forward and there were risks to the upside - potentially weak monsoon, Fed rate hikes, GST implementation, global uncertainties (read Trump), oil price trajectory, fiscal slippages due to farm loan waivers, disbursement of allowances under the 7th pay commission etc. 

However, over the last few months, inflation has been consistently lower than the market’s and RBI’s estimates. Also, many of the upside risks to inflation have receded (monsoon has been normal, GST implementation has been smoother than expected, Fed hikes have been priced in, oil prices have been benign). 

The RBI now expects headline inflation (the total CPI inflation number reported by MOSPI) to be a little above 4% by Q4 excluding the impact of implementation of House Rent Allowance (HRA) recommendations under the 7th Pay Commission. This is lower than RBI’s June projections. As a result, the MPC felt comfortable lowering the Repo rate by 25 bps. 

Monetary policy stance is still neutral. Some disappointed, but this is in-line with RBI’s usual approach.

The RBI continued to keep its monetary policy stance as “neutral” since it believes that inflation is headed higher from current multi-year lows. It will watch how things shake out and look at more data before and if it makes any changes to its stance. This was disappointing for some market players who were hoping for the RBI to signal towards a more “accommodative” stance (i.e. intent to cut rates further). However, this was a naïve assumption in my view. Given RBI’s central mandate (keeping inflation in range) and its widely known (and appreciated) conservative approach, I expected the MPC to remain non-committal about future rate trajectory.

Second Advance Estimates for GDP are Confusing

The Second Advance Estimates (2nd AE) for FY17 GDP, released by the Central Statistical Organization (CSO) today, are confusing. 

These estimates, unlike the First Advance Estimates (1st AE) released on 6th January this year, include the impact of demonetization. Yet, the CSO still projects GDP to grow at 7.1% y-y in FY17, as it had estimated on Jan 6th when the impact of demonetization was admittedly not included. This effectively means that Demonetization has had no impact on GDP growth for this fiscal, which goes against all anecdotal evidence and estimates of almost all independent (non-governmental) organizations. 

What’s going on? 

Table 1: Here are the headline GDP numbers...

Table 2: Here are the Expenditure Components of GDP (2nd AE vs. 1st AE)

Table 3: Here is the Q-Q Movement in the Expenditure Components of GDP (2nd AE released today)

If you look at Table 2 (the expenditure components of GDP - 2nd AE vs. 1st AE), you’ll see that the CSO now expects Private Final Consumption Expenditure (PFCE) to actually be higher (+1.7%) than it did before the demonetization impact was taken into account. This doesn’t make much sense to me. 

The numbers are equally hard to digest when you look at Table 3, which shows PFCE up 11% q-q in FQ317. Such a big sequential jump in the demonetization (Nov 8) quarter is hard to understand even if one takes into account the fact that the festive season (up till Diwali) when most of the consumption/buying takes place, was already done before the note ban. 

Private consumption has undoubtedly been hit post the note ban. The 3rd quarter results of FMCG companies are testament to this fact. Infact, most consumer product companies have been affected. Sales of two wheelers, which are a proxy for rural demand, fell in Nov, Dec and January. In the unorganized sector, the impact is more pronounced, since this sector is even more dependent on cash. 

Having said all this, it’s important to note that most figures we read about in the papers (including the Q3 results of listed companies) are not representative of the huge informal/unorganized economy of India where the impact of demonetization is worse than in the organized sector. 

The CSO estimates suffer from this same problem. CSO’s early numbers do not have a good handle on the informal economy i.e. they are mostly based on data from organized players/businesses (I’m talking about the Value Added Approach to GDP here). While I’m analyzing the Expenditure components of GDP in this post (which are derived from the Expenditure approach to estimating GDP), the Value Added Approach is the most reliable and the one from which most of the early data for GDP is gathered. The Expenditure method is less precise. 

Keeping this preamble in mind, while CSO’s PFCE data could be presenting a rosy picture right now, this may not reflect the reality for most of the country. These numbers could very easily be revised later. 

Let’s also take a look at Gross Fixed Capital Formation (GFCF) or investment. Table 2 show that GFCF in the 2nd Advance Estimates is actually a bit higher (+0.6%) vs. GFCF in the 1st Advance Estimates. This again appears rather odd to me. In a quarter where for at least for half of the quarter, near-term consumption was severely impacted and sales were hit, companies would have been accumulating inventory and would have put the breaks on capital spending. How then can the Q3 GFCF estimate including the demonetization impact be higher than that excluding demonetization impact?

Separately, the sequential (q-q) numbers in Table 3 show GFCF up 2.3% q-q in Q3. This again looks rosy to me. 

Bottom-line: At first look, the 2nd Advance Estimates for GDP look optimistic. It’s possible that due to lack of data for the informal economy in these early estimates, the CSO is underestimating the impact of demonetization.

India's Black Economy 60-75% of GDP!

I did a post titled Demonetization: What % of Black Money did the Indian Government actually Trap? last month, where I estimated the size of the black economy (as a % of GDP) in India as well as the total stock of black wealth held by Indians (domestically and abroad). I’m pasting below the key tables from this post.

I assumed that the Black Economy was ~30% of GDP


I estimated that the Total Stock of Black Money was ~Rs 135 lakh crore or ~90% of GDP

The estimate of 30% (as a % of GDP) for the black economy in India seemed conservative to me at the time, but was still higher than dated estimates provided by the government (in a white paper released by the Ministry of Finance in 2012, the black economy in India was estimated at 19-21% of GDP for 1983-84). 

At the other end of the spectrum, independent scholar, Professor Arun Kumar (Retired JNU Professor and author the book “The Black Economy in India”) sizes the black economy at ~Rs 90 lakh crores or 60% of GDP and the total stock of black wealth at ~ Rs 300 lakh crore (200% of 2016-17E GDP). 

This appeared more realistic to me, but was so out of line with published government estimates, that I decided to mention it in my post, but go with my 30% assumption. 

The Finance Minister’s budget speech yesterday in which he characterized India as a “largely tax non-compliant society” along with the following pieces of information which have been bothering me ever since I wrote the above-mentioned post, now have me quite strongly inclined towards Mr. Arun Kumar’s estimate of the black economy at 60% of GDP. Infact, the black economy could to be larger: close to 75%.

1) I have been critical of the government’s demonetization action given its high costs and limited gains. Read my post Sub-optimal and Inexcusably Expensive: All that’s Wrong with Demonetization for details. While I still maintain this same view, the government’s demonetization misstep becomes easier to understand if they were privy to data that suggested that 60% or more of the Indian GDP was untaxed. While the FM did not go as far as providing an absolute estimate for the size of the black economy, characterizing India as “a largely tax non-compliant society” implies that the black economy must be at least 50% of GDP. Granted this inference is not scientific or based on hard data, but that’s what “largely non-compliant” means to me.

2) The UPA government during its term had asked the National Institute of Public Finance and Policy (NIPFP) to estimate the amount of black money in India and overseas. The NIPFP prepared a report on its findings, which was submitted to Mr. Chidambaram, the Finance Minister at the time, in later 2013. This report was never made public and/or placed in parliament by the UPA government or the succeeding NDA government, which has now access to it. Why? I believe it’s because both governments believed that the estimated size of the black economy and the stock of black wealth was so large that making its quantum public would invite a backlash from the opposition as well as the public.

3) “The Hindu” reported on August 4th, 2014 that it had accessed this NIPFP report, which stated that India's black economy could be close to 75% of GDP! (here is the link to this article)

4) Mr. Jaitley gave some interesting figures in his budget speech yesterday. Amongst these was the statistic that only 3.7 crore individuals filed Income tax returns in 2015-16. I will use this figure to do a rather simple, back-of-the-envelope calculation. Here goes... 

Per the 2011 census, India’s total population in 2011 was 121 crore. 50% of this population was within the age group of 20-60 (I will assume that this was our working age population). Using a growth rate of 1.5% per annum, let’s assume that our population grew to 128 crore in 2015, of which 50% or 64 crore was the working age population. Of this working age population, let’s assume 50% was below the poverty line and/or did not need to pay taxes (earned less than 2.5 lakh/year). This leaves us with 32 lakh crore individuals. Let’s assume 2 member families for this population of 32 lakh crore (remember, we have already excluded dependents below the age of 20 and above the age of 60). If only one person per family is working/earning (let’s make the assumption that the woman/spouse does not work or her income isn’t enough to be taxed), we get a base of 16 crore individuals whose income was eligible for tax. 

Only 3.7 crore of these individuals or ~23% of total individuals liable for paying taxes filed returns in 2015-16. This admittedly rough calculation suggests that ~77% of individuals liable to pay income tax, did not file returns/ pay taxes in 2015-16. 

Conclusion: All this suggests to me the black economy in India is likely 60-75% of GDP, dramatically larger than published government estimates as well as most estimates from  financial/business/academic circles (including the one I made last month).

Sub-optimal and Inexcusably Expensive: All that’s Wrong with Demonetization

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.

Demonetization: What % of Black Money did the Indian Government actually Trap?

I’ve waded into the Demonetization debate later than most. Mostly because I’ve been stunned by the sub-optimal, poorly executed and cavalier nature of this policy action. Despite the public service messages, the claims that this move will rid us of the scourge of black money and the rationalization that the pain caused is a necessary evil for the greater good, the facts of the matter paint a different reality.  

I’m going to do a series of posts on the Demonetization action and its impact. In this current post, I will estimate the % of the total stock of black money held by Indians that the government has been  able to trap through demonetization. 

I’ve been reading everywhere that 5-6% of black money in India is held in cash. Where is this figure coming from?

This statistic is based on data from recent tax raids and investigations. In tax probes conducted from April - Oct 2016, black money holders admitted to holding Rs. 7,700 crore worth of assets bought with black money. Black money held in cash was only Rs. 408 crore or 5% of total black money held. The remaining was invested in businesses, stocks, real estate, Benami bank accounts etc. 

This is consistent with data provided in the white paper on Black Money, published by the Ministry of Finance, GOI in 2012. The average % of cash in the total undisclosed income admitted for the period 2006-07 to 2011-12 was 5%. 

It’s important to note here that this statistic is based on the undisclosed income admitted by black money holders; the actual amount of black money (including what is not admitted) is much more. 

With that out the way, let's get some rough estimates and do some back-of-the-envelope calculations of our own. 

How much is the black economy as a % of GDP? 

It is very hard to estimate the amount of black money generated annually in India. As expected, there is a wide range of estimates. In the same white paper released by the Ministry of Finance in 2012 that we mentioned above, black money in India was estimated at 19-21% of GDP for 1983-84. The World Bank estimated that in 2007, the size of the black economy in India was 20% of GDP. Independent scholars however, have much higher estimates. For instance, Professor Arun Kumar (retired, JNU), who has authored the book “The Black Economy in India”, estimates the black economy at ~50% of GDP today! 

Since government figures tend to be conservative especially for subjects such as the shadow economy, let’s assume that the black economy in India is ~30% of GDP. 

The Business Standard and Economic Times reported today (10/1/17) that as the government analyses data on the bank deposits made post the demonetization (8th Nov 2016), it estimates that Rs. 3-4 lakh crore of tax evaded income (black money) could have been deposited during the 50-day window (till Dec 30th 2016) provided to deposit old 500 and 1000 rupee notes. 

Now let’s do some math. (Table below is self-explanatory)

Based on our assumption of the black economy being ~30% of GDP, and assuming that the Rs. 3-4 lakh crore that the government suspects is tax evaded income is indeed black money, demonetization has succeed in trapping 7-9% of the black money likely to be generated in FY17. 

That said, black money generation is a continuous process. Every year, citizens conceal income and avoid paying taxes. Most of the black money that is stored over the years (and not spent on consumption) is held in the form of gold, land, real estate, foreign currency deposits and assets abroad. Currency forms only a small proportion of the black money held. 

How to estimate the quantum of the entire stock of black money? 

This brings us to the next logical question. How much is the entire stock of black money held by Indians (this includes accumulation over the years through investment in gold, property, land, overseas deposits etc.)? This is almost impossible to estimate accurately. 

That said, we can make a rough estimate by adding together some broad categories: 1) the amount of black money held abroad (in tax havens such as Switzerland), 2) the amount of black money held in the form of gold, and 3) the amount of black money invested in real estate. 

How much black money is held abroad?

There is a wide array of estimates here. According to Washington-based think-tank, Global Financial Integrity (GFI), Indians stashed away $462 billion (Rs 32 lakh crore at current exchange rate) in overseas tax havens between 1948-2008. Former CBI director, AP Singh estimated that ~$500 Billion (Rs 34 lakh crore) in black money was lying abroad. These two estimates are broadly consistent. 

Assocham however, has estimated Indian black money stashed abroad at ~$2 Trillion (Rs 136 lakh crore)!

Let’s go with the CBI Director’s estimate and assume that $500 Billion or Rs 34 lakh crore (at the current exchange rate of 68.35 INR/USD) in black money is lying abroad in tax shelters. 

Note: We are assuming that this figure ($500 Bn) includes the entire stock of black money lying in tax havens abroad at the beginning for FY17, and excludes any black money transferred abroad during the current fiscal. We will make this same assumption for the amount of black money held in gold and in real estate. 

How much black money is held in gold? 

According to an estimate by the Gold Council a few years ago, around 22,000 tonnes of gold is held privately in India. At current gold prices (Rs 28,179 per 10 grams), this gold is worth Rs. 62 lakh crores. Let’s assume that a third of this gold was purchased with black money. I have no published research to rely on here; 1/3rd is just a guesstimate that seems reasonable. Based on this guesstimate, we assume that ~Rs 21 lakh crore of black money is held in gold. 

How much black money is tied up in real estate? 

This is rather difficult to size. I will make a very rough estimate here. Officials in the income tax department as well as real estate participants have often said that the amount of black money stashed away in real estate, is much more than the amount of money stashed away abroad. 

So, let's assume (to be conservative) that the quantum of black money invested in real estate is at least as much as the money stashed away abroad. I estimated earlier in this post that the black money held in foreign tax havens is around Rs 34 lakh crore. I’m going to assume that the same amount is tied up in real estate. 

Let’s add it all up, shall we?

Note: As I’ve mentioned above, I’ve assumed that estimates made for money held in tax havens abroad, in gold and in real estate represent the amount of black money held at the beginning of FY17. To their sum, I’ve added the amount of black money estimated to have been generated this fiscal. This gives us a figure of ~Rs. 135 lakh crore for the total stock of black money at the end of FY17 (March 2017). 

The cash trapped by demonetization (3.5 lakh crore - I’ve taken an average of the government’s estimate of 3-4 lakh crore) is just ~2.5% of this total stock of black money. 

Conclusion 

Per my admittedly rough estimate (likely generous), the government has been able to capture only ~2.5% of the stock of black money held by Indians through this historic demonetization that has stunned the world, decelerated domestic growth, disproportionally affected the poor and put the Indian masses through an incredible amount of distress. Its small gains do not justify the substantial costs.

More in my following posts.