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Is Demonetisation Enough To Curb Black Money In India?

15/12/2016 10:19 PM IST | Updated 19/12/2016 1:05 PM IST

Will the 8th of November 2016 go down in the annals of history as the day when the fortunes of India turned for the better or worse? Only time can tell.

With an aim to take strict action against corruption, counterfeiting, and tax evasion, the Modi government decided to make ₹500 and ₹1000 notes invalid. The initial reaction was positive—the move was seen as bold and decisive and BJP leader Subramanian Swamy went as far as to proclaim that demonetisation had achieved 50% of its objective to curb black money.

According to Kaushik Basu, ex-chief economist for the World Bank, the "collateral damage" is likely to outshine its paybacks.

Now, demonetisation is not new. High denomination notes of ₹500, 1000 and even 10,000 were introduced and then taken of circulation in the years 1946 and 1978. Will the third time be the charm for the common citizen of India? A month into demonetisation, people are still grappling with the cash shortage, and while this doesn't inspire confidence many are still hopeful that the move will bring about the change they were promised.

What we know so far

  • India is a cash economy and according to the RBI, as of March 2016 we had about ₹16, 415 billion in circulation. The ₹ 500 and ₹ 1000 denomination notes together accounted for nearly 86% of the value of notes in circulation.
  • Other independent estimates indicate that nearly 20% of black money in the country is parked in cash while the rest is invested in gold and land.
  • Currently, 200% penalty is limited to those with black money in the form of cash. What about gold and land? How does the government plan to tackle those?
  • When compared to other economies of the world, India's cash-GDP ratio is 11.8%, while Germany's is 8.7% and France's is 9.4%. Japan has the highest ratio of 20%.
  • The RBI measures and maintains records of every currency note printed, every three months, so its data on notes circulated in the economy is identical to the cash available in the market.

Ground realities since demonetisation

The first two days after ₹500 and ₹1000 notes became invalid, there was chaos everywhere. People panicked, and some managed to convert their invalid cash to gold overnight. People thronged to ATMs to withdraw cash, only to be told limit was ₹2000 a day. Small-time traders and ordinary citizens who rely on cash transactions for their needs every day were badly hit, with many queuing up for hours together to exchange their cash.

A few villages in India fell back on the age-old barter system to compensate for the low cash in circulation. With no money, some people are unable to get treated at hospitals. Scheduled marriages have been in jeopardy as people have no money to make purchases. Those selling wares in markets for cash have lost most of their customers.

De-validation of currency may curb illegal transactions temporarily, but only until some figure out a few ways to circumvent the law again.

Though the exchange limit was increased to ₹4500 initially, it was reduced to ₹2000 again for currency exchange at banks. As of 24 November, the exchange of notes across the counters was stopped by the government, going back on their word to allow it till the 30th of December 2016.

On a high note

  • The move put paid to a lot of dreams for people who illegally dealt in large cash transactions.
  • The government has claimed that demonetisation has reduced the unrest in Kashmir because militants no longer have usable counterfeit currency in hand.
  • The influx of cash into bank accounts will reduce interest rates, which could stimulate economic growth. This will also help us reduce budget deficits, as some of that black money gets taxed, thereby reducing inflation in the country.

The downsides

  • India holds the dubious distinction of being the fastest economy to race towards a slowdown. According to Kaushik Basu, ex-chief economist for the World Bank, the "collateral damage" is likely to outshine its paybacks. This could mean the cost of this flush-out will be huge, with the government forking out ₹11,000 crore to print new currency with the hope of bringing back ₹3 lakh crore in black money into the legal fold.
  • Trade in India has come to a standstill due to cash crunch, while the rupee is on a downward spiral due to shortage in liquidity. With a "validation effect" on more than half the non-tax paying businesses in the unorganised sector (that accounts for 40% of the GDP) will become unfeasible and give up their market share to the organised sector businesses.
  • Financial markets believe India will face a recession for the next 6-8 months, and recover slowly by the end of the year 2017. The GDP is expected to fall by 0.5% by the second quarter of 2017 while contracting further in the third quarter, which could also mean a shrinking of the economy in India.
  • According to official data, 2013, India's household expenditure on groceries, fuel, consumer electronics, and core services is ₹2, 97,455 a month. Lack of cash will force people to buy only to sustain their lives. In the last few years, household expenses have accounted for nearly 60% of the GDP. With demonetisation, any consumption using cash has come to a standstill.
  • The state governments expect to collect lower taxes, as new land registrations and VAT collections have been reduced drastically. Central service tax and excise duty collections stand to fall because of frozen production and sales.

Is demonetisation enough to curb black money in India?

Professor and executive vice dean of the Jindal Global Business School Rajesh Chakraborty believes black money is not tantamount to corruption; rather, it is one of the signs of corruption. He believes, unless the root causes of corruption are eradicated, corruption will continue. Demonetisation will become a short -term solution to a lifelong issue in India.

According to a report, "Drivers and Dynamics of Illicit Financial Flows from India: 1948-2008", the total value of illegal assets held outside the country is 72% the size of India's domestic black market, which was an estimated 50% of the GDP or $640 billion by the year 2008.

An absence of other steps to curb black money would make demonetisation a pointless exercise just like the 1978 attempt.

De-validation of currency may curb illegal transactions temporarily, but only until some figure out a few ways to circumvent the law again. This can be witnessed in the money discounting scheme that many traders resorted to when black money exchange was not possible. This may also increase the demand of other currencies in the black market, which may cause the official rate of currencies to depreciate.

The government announced ₹2000 notes, as people may need higher denominations to overcome future inflations. Smaller denominations may lose value and buying essential commodities may become difficult. Just demonetisation will not be enough— it needs to be supported by an efficient and better tax system in the country.

The government would need to implement other steps like the GST as a part of their reforms. An absence of other steps to curb black money would make demonetisation a pointless exercise just like the 1978 attempt.

The jury is still out today. The only way we would know is in March, when this exercise will show us how much of the black money has been accounted for over the period.

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