Demonetization – The Economics Of The Move Amidst All The Noise

“GST was good economics; the demonetization is not. Its economics is complex and the collateral damage is likely to far outstrip the benefits,” Basu (World Bank Chief Economist) tweeted.

There has been a lot of banter about the surgical strike by PM. No doubt this is a brave move on behalf of the PM. There have been numerous reports of the hardships faced by common people, while many are hailing it as a landmark move that shall demolish black money. The answer, like many things in life, is somewhere in between.

What is black money? Basically, it is unaccounted money to evade tax/scrutinity. Illegal, fake currency can also be under the ambit. Say, for instance, X sells his apartment to Y at 40Lakh. To reduce capital gains tax, there is a transfer of cash via a trusted middleman, while officially the transaction is recorded to have happened for 20Lakh. Another way how black money is generated is when officials accept bribes.  

Of course, demonetization has pinched into the hoardings of illegal black money holders. It has also reduced funding by separatists according to many reports. Another noteworthy benefit of this move is that it is a significant step towards a cashless economy, that shall benefit India a lot – which the PM is constantly working on, but few theatric politicians blinded by smog, try to gain mileage out of. According to a report, Rs60,000 crore has been deposited into accounts after this move. This invariably means higher lending and boost to the economy (assuming good lending). Hence, interest rates may come down. More loans that are given out increases the broad money supply and creates inflation. But, less cash in hand would mean lower spending. So prices of goods and services will fall in the absence of demand. So, it is not really clear regarding the movement of inflation.

The flip side of this move has hit hard to the poor, especially in rural areas which thrive on informal means of exchange. Only 28%-32% of Indians have access to financial institutions, including post offices and banks. They do not have the privilege of buying, selling things online. There is going to be a huge blow to the purchasing power. One could argue that this move could act as an impetus on them to adopt these new technologies, but come on, whom are we kidding? Many small shopkeepers and laborers have seen a significant fall in their earnings. Many families have curbed their spending and this in turn affects the growth of the economy as has been iterated by Credit Suisse recently. Another criticism emerging is the sheer amount of time (opportunity cost) and money spent on the logistics of this whole mammoth exercise of replacing 80% of currency. Who can forget the cost of printing as well as the labor cost to exercise the whole scheme. The common people have faced the brunt of this move as they scramble to take out cash from ATMs which are constantly running out of cash. Many detractors say the whole logistics could have been planned better, but this was unavoidable to maintain the secrecy of this initiative.

Another criticism is the lack of rationale for introducing a higher denomination – 2000rs note. Would not this just make storing and transferring black money generated in future, easier. It is understandable that with rising inflation, there is a need for higher denomination currencies. This move may send a strong signal to corrupt people, but then, people being carried by the euphoria must realize that demonetization shall do very little to curb black money in the future.

It is also worth noting that all this was just a piece in a series of moves by Modi to tackle the black money menace. Jan Dhan Yojna, Voluntary Disclosure Scheme, India’s treaty with Tax Havens such as Mauritius have been fruitful. Without financial inclusion and digital India, this would not have been justified.

But, the essential question is how effective is the move? Many experts seem to have a skeptical opinion on the same. Demonetisation has been tried in many countries. It has produced very little results. People with large black income do not store cash (imagine the amount of space required). They invest in Benami properties using their relatives or fake names. Cash recovery has been less than 6% of the undisclosed income seized from tax evaders.

Moreover, there are means to convert some black money into white, especially if you also have a legal business in parallel or have good contacts with industrialists, gold makers. You could transfer the unaccounted 500rs notes to the legal business and get back the same amount of 100 rs notes. Obviously, there is a ceiling to the amount of conversion via this means. Another way is by transferring to big businesses which shall be expended as expenses (or overshoot expenses). For instance, gold makers could account 10% making wastage when in reality it would be, say, 5%. This extra gold is then sold to black money holders. Gold is the preferred investment since unlike other assets it is not easily under the public scanner. The government had anticipated this and had jewelers as well as foreign exchange portals under scrutinity. But how can they monitor everyone closely? An increase in demand for gold is bad for the economy. This was the same issue Modi tried to tackle by introducing Gold Bonds, which was a failure. There have also been reports where Jan Dhan accounts with zero balance have now seen deposits around 2 Lakhs. Corrupt people are taking advantage of a 2.5 Lakh limit by asking poor people to deposit cash on their behalf.

We need to avoid being blinded by ideology and affiliation and take positive criticism of such initiatives. It is easy to be swayed by a lot of misinformation, especially on Facebook and Whatsapp. As informed citizens, we need to understand things better. India has a moderate tax policy and it is upto us citizens to avoid under citing transactions to avoid paying taxes.

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 About the Author:


Niteen Bali is a graduate of NIT Karnataka, Surathkal. Post which he got into IIM Calcutta. He does not like to take a firm stand on any spectrum of political nor economic scale, since independent criticism is curtailed in that case. Right now in search of Ithaka and reading ‘Love in the time of Cholera’. If given a wish, he would want to become Chandler Bing. Or maybe Donald Trump.

Niteen Bali

Student at Indian Institute of Management, Calcutta