THE BLOG

10 Reasons Why BJP's Demonetization Move Is An Unmitigated — And Politically Motivated — Disaster

14/11/2016 12:01 AM IST | Updated 14/11/2016 9:36 AM IST
NEW! HIGHLIGHT AND SHARE
Highlight text to share via Facebook and Twitter
LightRocket via Getty Images

The Prime Minister's announcement of the withdrawal of ₹1000 and ₹500 notes ranks amongst the most significant economic measures taken by his government. The audacious move has given birth to wild hopes of a decisive blow to the black economy and counterfeit currency. It is also being lauded for its potential to convert India into a cashless economy. However, the disruptive impact of this decision is only now becoming clearer and dampening the celebratory mood that followed the announcement.

The government has rushed into a decision that is poor economics and may ultimately prove to be poor politics too.

While many are still hopeful that this "landmark initiative" will reap dividends eventually, upon deeper analysis I have come to the conclusion that it is nothing less than an unmitigated disaster. Here are 10 of the most prominent reasons why I say so.

1. Cash is an insignificant component of black assets

The effect of this move on the black economy will be limited because cash comprises only a tiny part of black assets. This is borne out both by facts and reasoning.

Cash recovery has been only 6% of the undisclosed income seized from income tax evaders, according to data from tax raids from 2012-13 onwards.

This fact only affirms what is already apparent upon the application of reasoning. Opening foreign accounts anonymously is child's play today and given the anonymity it provides, it is a widely preferred option for those holding black money. Investments in gold and property are also preferred for a variety of reasons. Firstly, wealth stored as cash decreases in value with inflation while other types of assets appreciate with inflation. Secondly, storing large sums of cash is much more problematic (occupies more space, vulnerable to hazards) than storing the same value in gold. Finally, security problems with cash are much greater.

Thus, illegitimate cash is just the tip of the iceberg and dealing with it does not mean taking down the mammoth black economy.

2. Counterfeit currency is more molehill than mountain

Much has been made of the "fact" that taking out higher denomination notes will render worthless the bulk of counterfeit currency in circulation today. But contrary to popular perception, the value of counterfeit currency is quite insignificant.

According to a study done by the Indian Statistical Institute, Kolkata, in 2015, the only reliable and comprehensive exploration of the subject, at any given point of time ₹400 crore worth of fake notes were in circulation in the economy. This is merely 0.025% o f the total budget outlay of ₹19.7 lakh crore as announced this fiscal.

In comparison, just the printing cost of notes being taken out of circulation is approximately ₹12,000 crore. Is it sensible public policy to flush ₹12,000 crore down the drain to purportedly remove about ₹400 crore of fake currency?

3. Information may have leaked—rise in bank deposits

While the news of the withdrawal of notes caught most people by surprise, leading many to hail the government's success in keeping it a closely guarded secret, it is now emerging the information—or at least a rumour of what was to come—had already reached several ears. Firstly, in April this year, SBI had said that people were withdrawing cash in large amounts in smaller denominations due to rumours of demonetization of ₹1000 and ₹500 notes. Secondly, in the past few weeks, local dailies in Gujarat and elsewhere had also reported that such a move might be in the offing. Thirdly, the BJP's West Bengal unit deposited an unusually large cash amount of Rs 1 crore just before the move's announcement. All these factors indicate that information of the action may well have leaked.

Is it sensible public policy to flush 12,000 crore down the drain to purportedly remove about 400 crore of fake currency?

While those who don't have black money may not have paid attention to rumours and speculations, those that did have something to hide probably took action right away to protect their spoils, thereby reducing the efficacy of the eventual demonetization.

What most strengthens the suspicion that many with black money were warned in advance is the sudden spike in bank deposits in the last quarter. Data from different banks shows that last quarter most of them reversed the trend of declining deposits and witnessed healthy growth. This rise in bank deposits happened despite the decline in industrial production and in the absence of any facilitating factors in the economy. In the absence of an upturn in economic parameters, the sudden rise in deposits just before demonetization decision is definitely fishy.

4. Whitewashing of whatever little black cash there is

Even the insignificant black assets in cash that remain with people (even after prior information) are likely being whitewashed through various loopholes. Backdated buying of gold and exchanging through the new black market for exchange of notes are prominent ways in which those with black cash are getting it laundered or changed to smaller notes.

5. The root problem of black money generation is untouched

The move is also questionable as it does little to address the root problem of black money generation. The annual black economy is conservatively over 20% of our GDP. This means that the annual generation of black money is over ₹30 lakh crore which is greater than the entire amount of ₹17.77 lakh crore of cash in circulation (86% of this cash is in the form of withdrawn ₹500 and ₹1000 notes). So, even if half the value of the withdrawn notes was black wealth and none of it was whitewashed, the black money destroyed would still be much less than the amount of black wealth generated yearly. It's clear from this that demonetization cannot do any long-lasting damage to the black economy since the roots of it remain untouched.

6. The government's politically motivated sensationalism has spread panic

In a bid to derive maximum political mileage out of the move, BJP sensationalized the move and announced with great drama for maximum impact. Many myths were spun around it, which made people panic. This panic is leading to untold miseries with ATMs reporting long lines and various establishments refusing to offer change; some hospitals are even denying treatment. Had the BJP been more sombre and pragmatic in its narrative and execution, rumour mongers would not have had such a field day and the move's implementation would have been less painful for the people.

7. In poll-dictated hurry, government was woefully underprepared

The government is visibly unprepared for the move.

Firstly, the RBI didn't have enough supply of smaller denomination notes and is supplying soiled 100 notes to meet the demand. Secondly, the new ₹2000 notes being released are smaller in size than the old notes and ATMs have not been modified to dispense them. Thus, ATMs are storing less cash and thus running out faster as they can only dispense ₹100 notes.

The annual generation of black money is over 30 lakh crore which is greater than the entire amount of ₹​​​​​​​17.77 lakh crore of cash in circulation...

Thirdly, the new ₹2000 notes are being released without any additional security features as the hurried decision by the government didn't allow for the provision of such features. It is reported that the government pushed through the action in six months, although over three years or so are usually needed to introduce new notes. Perhaps as a result of such haste, many errors are being reported in these notes. Because of the absence of additional security features (and presence of mistakes), the task of counterfeiting will become easier. Also since now there is a higher denomination, it is more profitable to counterfeit. Thus despite spending so much of public wealth, the hasty manner of the move will deprive us of any benefit in reducing counterfeit currency which would have occurred if the new currency had additional features.

So, why did the government act in such a rush despite knowing the associated downsides? My theory is that as the Uttar Pradesh elections and the model code of conduct are round the corner, the government decided to implement the move so as to milk the issue before the polls.

8. Reintroducing higher denominations facilitates future hoarding of black cash

Another pitfall of rushing through the decision is that it left government with no choice other than to reintroduce higher denominations as today India doesn't have the infrastructure for a primarily cashless economy. Doesn't it make more sense to first focus on transitioning to a cashless economy and then completely withdrawing these larger denominations?

By introducing ₹2000 notes, the government has made it easier for those who want to hoard black money in cash as they will need only roughly half the space they needed earlier for their ₹1000 notes. Thus, in this sense this move will give a boost to black economy.

9. Where is the infrastructure for a cashless economy?

The argument that the move will spur a cashless economy is flawed . First, how does replacing ₹1000 notes with ₹2000 ones help make the economy cashless?

How does replacing ₹1000 notes with ₹2000 ones help make the economy cashless?

Secondly, merely depriving people of cash doesn't make an economy cashless. With only 46% banking penetration, only 22% internet connectivity, 19% of population without electricity connection (and others with unreliable connection) and only 1.2 million of 14 million merchants having point of sale devices, India simply doesn't have the infrastructure for a cashless economy. Another problem is the low level of digital literacy in India. Unless these real challenges are addressed, withdrawing the bulk of cash only creates chaos as we can now see.

10. Economic activity is taking a beating

The gross under-preparedness of the government, the sensationalism of the move and it being inherently economically imprudent, have all lead to the move creating extreme chaos.

Firstly, the people are desperate for cash, so much of the workforce that should be productively working is wasting long hours in unending queues at the banks and ATMs .

Secondly, the abrupt call-back of 86% of cash, has brought the informal economy to a standstill—this sector is the worst affected, with the most marginalized suffering the most.

Thirdly, the wide speculation on property and gold pricing will also undermine economic stability and reduce investors' confidence in India.

***

Thus for the variety of reason discussed above, I have no hesitation in calling the move an unmitigated disaster. It's simply a case of headline management trumping sound economics. The government in its attempt to win brownie points on the black money issue has rushed into a decision that is poor economics and may ultimately prove to be poor politics too.

Endangered Animals

More On This Topic