DEMONETISATION - Will It Work?

 

by Don Aguiar

 

India is in the middle of an extraordinary economic experiment.

 

On 8 November, Prime Minister Narendra Modi gave only four hours' notice that virtually all the cash in the world’s seventh-largest economy in the world be effectively worthless.

 

The Indian government likes to use the technical term "demonetisation" to describe the move, which makes it sound rather dull. It isn't. This is the economic equivalent of "shock and awe".

 

Do not believe reports that this is primarily about bribery or terror financing, the real target is tax evasion and the policy is very daring indeed. You can see the effects outside every bank in the country. Queues of people clutching wads of currency notes stretch halfway down the street.

 

Mr Modi's "shock and awe" declaration meant that 1,000 and 500 rupee notes would no longer be valid. These may be the largest denomination Indian notes but they are not high value by international standards - 1,000 rupees is only £12. But together the two notes represent 86% of the currency in circulation.

 

Think of that, at a stroke 86% of the cash in India now cannot be used.

 

What is more, India is overwhelmingly a cash economy, with 90% of all transactions taking place that way. And that is the target of Mr Modi's dramatic move. Because so much business is done in cash, very few people pay tax on the money they earn.

 

According to figures published by the government earlier this year in 2013 only 1% of the population paid any income tax at all. As a result huge numbers of Indians have stashes of tax-free cash hidden away - known here as "black money".

 

Even the very poorest Indians have some cash savings - maybe just a few thousand rupees stored away for a daughter's wedding, the kids' school fees or - heaven forbid - an illness in the family. But lots of Indians have much more than that. It is not unusual for half the value of a property transaction to be paid in cash with buyers turning up with suitcases full of 1,000 rupee notes.

 

The size of this shadow economy is reckoned to be as much as 20% of India's entire GDP. Mr Modi's demonetisation is designed to drive black money out of the shadows.

 

At the moment you can exchange up to 4,500 (£48) of the old rupees in cash for new 500 (£6) and 2,000 (£24) rupee notes.

 

There is no limit to the amount that can be deposited in bank accounts until the end of December, but the government has warned that the tax authorities will be investigating any deposits above 250,000 rupees (£2,962).

 

Breach that limit and you will be asked to prove that you have paid tax. If you cannot, you will be charged the full amount owed, plus a fine of 200% of the tax owed. For many people that could amount to be pretty much the full value of their hidden cash.

 

This is brave politics. Some of the hardest hit will be the small business people and traders who are Mr Modi's core constituency. They voted for him because they believed he was the best bet to grow the economy and improve their lot. They will not be happy if he destroys their savings.

 

Mr Modi says he is simply delivering on his pre-election promise to tackle corruption and tax evasion. He says he warned that he would squeeze black money out of the system and had already offered amnesties to those who declare their black money holdings. And, so far at least, the policy seems to be popular, in spite of the long queues and the fact that much day-to-day business in India has ground to a juddering halt.

 

Most Indians resent the fact that many of the richest among them have used black money to evade paying their fair share of tax and are happy to suffer a few weeks of what Mr Modi called "temporary hardships" to see them face justice. They also recognize the benefits of drawing more people into the income tax net.

India has very low rates of tax compared to many other countries. The tax-to-GDP ratio - how much tax is raised as a proportion of the output of the economy - was 17% in 2013. The average across the economies of the Organization for Economic Co-operation and Development - a club of mostly rich nations - was over 34%.

 

Demonetisation is part of a wider project to draw Indians into the formal economy and to get them to start paying the tax they owe.

 

Curbing tax evasion is part of the agenda for the "aadhaar" scheme, (a giant digital database designed to give hundreds of millions of Indians a unique ID) and of the new Goods and Services tax.

 

And reducing tax evasion can only be good for India. The more money it raises in tax, the more it has to spend on useful stuff like roads, hospitals and schools. The more the country spends on public goods like that, the faster the Indian economy is likely to grow - or so the argument goes.

So the big question is: will it work?

 

Some economists have questioned the decision to introduce the 2,000 rupee note. They say if the policy is designed to force people into the banking system why issue a higher denomination note - presumably an even more convenient vehicle for black money transactions?

 

But the headlines about chaos and confusion are a bit misleading. There have been virtually no reports of violence despite the huge disruption this policy has caused. The new 500 and 2,000 rupee notes are in short supply and banks regularly run out of them. The queues are orderly and the worst you hear are the irritated mutterings of those whose days have been wasted standing in line.

 

But Mr Modi needs to be careful. The new notes are in short supply and there are not enough smaller denomination notes to go around, so the banks regularly run out of cash. That cannot go on for long without irritation turning to anger.

 

But some queuing may be excusable, because in one regard the policy has already been a complete success: it came as a surprise to the entire country.

 

Think what that means. The government managed to plan this audacious policy, printing billions of new notes without anyone letting slip what was happening.

 

Reportedly, even senior members of the cabinet were not told what was being planned, for fear that if word got out the entire policy would be undermined. The hoarders would have time to empty their mattresses and launder their stashes into gold or other assets.

 

Keeping a secret of this magnitude in India, a country that thrives on rumor and gossip, is nothing short of a triumph and surely a reasonable justification for a few hiccups along the way.

 

Mr Modi’s dramatic move to scrap 500 ($7.60) and 1,000 rupee notes is poor economics, a leading economist says. The "collateral damage" is likely to outstrip its benefits.

 

The overnight ban on the notes last week was intended to crack down on corruption and so-called "black money" or illegal cash holdings. But it sparked scenes of chaos outside banks and ATMs.

 

Low-income Indians, traders and ordinary savers who rely on the cash economy have been badly hit with hordes thronging banks to deposit expired money and withdraw lower denominations. As the anger mounted, the government raised limits on cash withdrawals on Sunday.

 

The rich will not suffer as corruptly acquired fortunes have almost all been converted to shares, gold and real estate. But the poor who make up the bulk of the nation’s 1.3 billion people will lose out. For them getting to a bank and queuing for hours will cost money and time they don’t have. In less than a week the policy has claimed more than a dozen lives. The government says that it will take weeks to sort out the problems.

 

But some economists say the move will have a limited impact as people will simply begin to accumulate black money in the new currency as soon as that becomes available.

 

The government hopes this will bring cash worth billions of dollars in unaccounted wealth back into the economy. The two notes accounted for more than four-fifths of the currency in circulation.

 

Prof Basu, who now teaches at New York's Cornell University, says India's Goods and Services tax, was "good economics, but demonetisation is not". "Its economics is complex and the collateral damage is likely to far outstrip the benefits,”.

 

What Prof Basu, who was chief economic adviser to the previous Congress government, means is that this "demonetisation" just witnessed in India is at best, a one-time flushing out of the system and the return of black money is likely if not inevitable.

 

Many economists say the costs of such a one-time "flush" will be huge. They say hundreds of thousands of ordinary people (including farmers who do not even have bank accounts) who hold cash but not black money will get caught out and the fear of harassment by officials could trap them in a bureaucratic net they don't know how to deal with.

 

So it is possible that all this achieves is a sudden curtailment in the total money supply, effectively a kind of contraction of the economy.

 

Economists have long talked about "helicopter drop" of currency - printing large sums of money and distributing it to the public in order to stimulate the economy.

 

India's decision to scrap high denomination notes is simply the reverse and according to economist Prabhat Patnaik the government's move "betrays a lack of understanding of capitalism".

"Typically, what happens in capitalism in a situation like this is that there would be a new business opening up about how to change old currency notes into new ones... A whole range of people would come up who will say you give us 1000 rupees and we will give you 800 rupees or 700 rupees or whatever. Consequently, instead of curbing black business it will actually give rise to the proliferation of black business,"

 

But not all experts agree that it is such a risky move.

 

India now operates under a monetary policy regime known as inflation targeting. If a portion of the stock of currency in circulation, consisting of currency and demand deposits gets 'burned', metaphorically or literally, the Reserve Bank of India, the central bank, can in principle fully offset this through what economists call 'open market operations',. These involve purchasing bonds from the markets and injecting money (and therefore liquidity) into the markets in return. This is standard operating procedure for central banks.

 

To put it more simply: suppose a warehouse of cash owned by someone goes up in flames and the money stock drops. The central bank, economists say, can augment the money stock. The loser is the individual whose money went up in flames - in other words, by analogy, someone holding illicit unaccounted cash that cannot be converted into new currency or deposited.

 

There will be short run adjustment costs as the old notes are replaced by new ones, but see no medium to long term impacts on growth, inflation or other pertinent macroeconomic variables. The gains will be a one-time tax on black money and a possible disincentive for future black money accumulation, in the event that there is a prospect for future demonetisations.

 

A currency note is a promise note that must be kept whatever the circumstances. Because this trust has been broken in India queues have formed outside banks and ATM’s with banks closing midway through the business day saying they have run out of cash… Pro establishment die-hards would snigger and argue that the two high value notes have been withdrawn to check black money …. it had to be done in total secrecy they say to thwart nefarious attempts by hoarders to dump currency.

 

Mr Modi’s scheme has more in common with the failed experiments of dictatorship which led to runaway inflation, currency collapse and mass protests. While Mr Modi campaigned to end corruption it would have been better if the government had updated its antiquated tax system to realize such a task.