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.