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.