A Year After Demonetisation, It’s Safe To Say That Modi's Ambitious Gamble Did Not Pay Off

A decision which was supposed to destroy black money, helped people launder it.

07/11/2017 4:39 PM IST | Updated 07/11/2017 4:42 PM IST
Jayanta Dey / Reuters
Demonstrators try to cross a police barricade during a protest organized by India's main opposition Congress party against demonetisation, in Agartala, India, February 17, 2017. REUTERS/Jayanta Dey

What do you say about a man who invalidates 86.4 percent of a country's currency overnight, and then keeps coming up with explanations over the next one year to tell the citizens that it was a success?

You don't need to be an economist to realize that if the bulk of currency in a country where transactions are largely carried out in cash (80 to 98 percent, depending on which estimate one takes), is suddenly invalidated, the results will largely be disastrous, a few benefits here and there, notwithstanding.

It has almost been a year since Prime Minister Narendra Modi, in a late evening broadcast to the nation, invalidated Rs 500 and Rs 1,000 notes. The idea was to attack black money and fake currency which were used to finance terrorism.

As the press release accompanying the demonetisation decision put it: "Use of high denomination notes for storage of unaccounted wealth has been evident from cash recoveries made by law enforcement agencies from time to time."

Modi invalidated Rs 500 and Rs 1,000 notes, which he said were used to store black money, and then decided to introduce a Rs 2,000 note, making it even more easier for those who have black money, to store some of it, in the form of cash.

Let's look at a few points one by one.

1) The total value of the Rs 500 and Rs 1,000 notes that were invalidated stood at Rs 15.44 lakh crore. On November 15, 2016, a week after Modi announced the demonetisation decision, the Attorney General, Mukul Rohatgi told the Supreme Court that the government expected that around Rs 4-5 lakh crore of the invalidated notes won't make it back into the banking system.

The hope was that those who have black money in the form of cash will not deposit it in the banks because they would end up creating an audit trail. This would end up destroying black money. Of course, nothing of that sort happened.

Around 99 per cent of the invalidated currency made it back into banks. This basically meant that what was supposed to be an attack on black money became a big money laundering scheme.

2) Why did this happen? This happened primarily because no basic research was carried out to check if demonetisation could really attack black money. In May 2012, the ministry of finance had published a White Paper on black money. As per data offered in this White Paper, it can be calculated that on an average around 4.9 percent of the black money is held in the form of cash. A bulk of the black money is held in the form of real estate and gold. Hence, by attacking cash/currency, Modi ended up sending the entire country on a merry-go-round. This is what happens when you make a decision that goes against the data that is on offer.

3) In August 2014, Raghuram Rajan, the then governor of the Reserve Bank of India, whom the Modi government let go by not offering a second term, said: "In the past, demonetisation has been thought of as a way of getting black money out of circulation. Because people then have to come and say 'how do I have this 10 crores in cash sitting in my safe and they have to explain where they got the money from. It is often cited as a solution. Unfortunately, my sense is, the clever find ways around it."

Rajan further said: "Black money hoarders find ways to divide their hoard into many smaller pieces...I think there are ways around demonetisation. It is not that easy to flush out the black money."

Thus, a decision which was supposed to destroy black money, helped people launder it.

This is precisely what happened. Those with black money found various ingenious ways to divide their black money into smaller amounts and exchange it. Thus, a decision which was supposed to destroy black money, helped people launder it.

This was before any such proposal for demonetisation was on the table. As Rajan writes in his recently released book I Do What I Do: "I was asked by the government in February 2016 for my views on demonetization, which I gave orally. Although there might be long-term benefits, I felt the likely short-term economic costs would outweigh them, and felt there were potentially better alternatives to achieve the main goals. I made these views known in no uncertain terms."

Of course, PM Modi decided not to listen to the best economist he had at his disposal.

4) No country in a reasonably good economic position has demonetised currency in the past, at the same level that India did. This is primarily because the economics of demonetisation is very complex. This was also overlooked. In short, there was enough evidence available which said that demonetisation as a tool to weed out black money, would not work.

5) Demonetisation was also supposed to "to curb financing of terrorism through the proceeds of Fake Indian Currency Notes (FICN)." Take a look at Table 1, which basically lists out the number of fake currency notes that were detected in the banking system.

Table 1: Denomination-wise Counterfeit Notes Detected in the Banking System

Annual report of the Reserve Bank of India.

(April to March)

(Source: Annual report of the Reserve Bank of India)

The number of fake Rs 500 (old) and Rs 1,000 notes that were detected during the financial year stood at around 5.74 lakh. The total number of demonetised notes stood at around 2,400 crore. This basically means that as a proportion, the fake notes identified between April 2016 to March 2017 stands close to 0 percent of the demonetised notes.

Demonetisation failed to achieve its second big objective. In fact, if you look at Table 1 carefully, fake notes of the new Rs 500 and Rs 2,000 hit the market, soon after demonetisation.

6) In a matter of few weeks it was clear that demonetisation would not achieve its two main objectives. Hence, a third objective was introduced. This was to move towards a cashless society through digital transactions.

As Modi said in the November 2016 edition of the Mann Ki Baat radio programme: "The great task that the country wants to accomplish today is the realisation of our dream of a 'Cashless Society'. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a 'less-cash society'? Once we embark on our journey to create a 'less-cash society', the goal of 'cashless society' will not remain very far."

Indeed, a very noble motive, but at what cost?

How are things looking on this front? Let's first look at the total value of digital transactions. Data for total digital transactions is available up to August 2017 and has been adjusted for real time gross settlement, which can only be used for transactions of Rs 2 lakh or more. Take a look at Figure 1.

Reserve Bank of India

(Source: Reserve Bank of India)

The total value of digital transactions in August 2017 was more or less similar to the total value of digital transactions before demonetisation. As Figure 1 tells us, digital transactions by value kept increasing between January and August 2016. After that they have gone up and down. This also reflects the overall slowdown of the economy post demonetisation.

How do things look, when it comes to volume of digital transactions? Take a look at Figure 2.

Figure 2:

Reserve Bank of India

(Source: Reserve Bank of India)

While, there was a huge one time jump when it comes to the volume of digital transactions post demonetisation, things have remained flattish since then. The initial jump wasn't surprising given that there was barely any cash going around in the financial system. But that growth hasn't sustained.

Hence, the digital goal has not been achieved either. Such a fundamental behavioral change cannot be made overnight. People have to be nudged towards it and not forced, as was the case.

7) In the game of changing goal posts, an increase in the income tax base, has been highlighted as another benefit of demonetisation. The question is, has this increase translated into higher direct tax collections? For the period, April to September 2017, "Net Direct Tax collections represent 39.4% of the total Budget Estimates of Direct Taxes". For the same period last year, "38.65% of the Budget Estimates of direct taxes for FY 2016-17 has been achieved."

Yes, there has been a marginal improvement in direct tax collection. But this still does not justify the destructive effect that demonetisation had on the economy.

Another point made in the game of changing goal posts is that income tax notices have been sent to many people. So, what? People with black money have access to the best CAs and the best lawyers, and know how the system functions. They aren't exactly sitting there waiting to pay fines and hand over their money to the government.

Also, take a look at Table 2. This tells us very clearly, the limited processing capacity of the Income Tax department.

Table 2:

Annual Report, Ministry of Finance

(Source: Annual Report, Ministry of Finance)

8) There is enough evidence going around by now to say that the informal part of the economy, which dealt in cash, received a huge blow, from which it is yet to come out. The tragedy is that much of this is not reflected in the GDP numbers, given that the GDP numbers tend to measure the formal part of the economy, and not the informal one.

Also, there is a huge contradiction here. The Modi government has been saying that self-employment is the way forward when it comes to jobs. If self-employment is the way forward, then the informal sector needs to be handled with care.

In fact, as former prime minister Manmohan Singh, put it in an interview to Bloomberg Quint: "The value created by the informal sector will be captured in the form of income, wealth or consumption effects. Hence, we must be cautious about sweeping generalisations about the informal economy and passing moral judgments about the entire sector."

9) One of the claimed successes of demonetisation has been that the cash to gross domestic product (GDP) ratio has come down. In a speech made on October 4, 2017, Modi said: "Demontisation के बाद Cash to GDP Ratio अब 9 प्रतिशत पर आ गया है। (after demonetisation, the cash to GDP ratio has come down to 9 per cent."

This fall in cash to GDP ratio is being passed off as an achievement and the fact that nation as a whole has become more honest. As Modi said in the speech referred to earlier in the piece: "भाइयों और बहनों, इस सरकार ने देश में संस्थागत ईमानदारी को मजबूत करने का काम किया है। ये सरकार के अथक परिश्रम का ही परिणाम है कि आज देश की अर्थव्यवस्था कम Cash के साथ चल रही है। (Brothers and sisters, this government has worked to strengthen the institutional honesty of the country. It is due to the tireless hard-work of this government that today the country's economy is running on less cash.)"

For the period of three months ending March 2017 and June 2017, the non-government part of the GDP (which forms around 90 per cent of the GDP) has grown by a little over 4 per cent. When growth in economic activity slows down, the growth in currency in circulation is bound to be impacted as well.

So, yes, the hard work of the government has led to a lower cash to GDP ratio, but at the cost of slowing down economic activity. Hence, claiming this as success, is more of trying to build a narrative around demonetisation being successful, rather than being an actual success of any sort.

10) Another point that is being made is that a lower cash to GDP ratio means that the country has become more honest. Take a look Figure 3. It basically plots the cash to GDP ratio of different countries.

Figure 3:


Japan has the highest cash to GDP ratio at 19.4 per cent. India is nearly half of that at around a little over 10 per cent. Is India a more honest nation than Japan? As per the Transparency International's Corruption Perception Index for 2016, Japan is the twentieth least corrupt country in the world. India stands at the 79th position, despite having a much lower cash to GDP ratio.

To conclude, one year after demonetisation, all the destruction that was unleashed in its aftermath, could have been avoided, if PM Modi had heard the best economist he had at his disposal, and not an accountant masquerading as one.

Or take the case of Brazil, which has a cash to GDP ratio of 3.31 per cent. Like India, it is the 79th least corrupt country in the world. Then there is the Eurozone (country's which basically use euro as their currency). Their cash to GDP ratio is higher than that of India. Is the Eurozone more corrupt than India?

Hence, the link between a low cash to GDP ratio and low corruption is basically very weak. It is basically something that the Modi government has invented in order to build a positive narrative around demonetisation.

To conclude, one year after demonetisation, all the destruction that was unleashed in its aftermath, could have been avoided, if PM Modi had heard the best economist he had at his disposal, and not an accountant masquerading as one.

(Vivek Kaul is the author of India's Big Government—The Intrusive State and How It is Hurting Us.)