Demonetisation anniversary: A clueless govt miscalculated its impact; why Narendra Modi shouldn't have taken the step

In the history of bad economic ideas of this century, it should easily rank among the top 10. Demonetisation – the one announced on 8 November, 2016 by Prime Minister Narendra Modi on national television – was not a policy, it was an event. Economists call it a liquidity shock: The withdrawal of the bulk of a nation’s currency from circulation in a surprise, sudden move. A surgical strike, so to speak, against ‘black money’ created by corruption.

The government’s stated objectives when the Prime Minister announced the withdrawal of two high denomination currency notes – Rs 500 and Rs 1,000 were: 1) to tackle corruption and bribe-taking; 2) undermine counterfeiters and terrorism financiers, and 3) punish hoarders of black money, or undeclared income.

Once these currency notes were demonetised – or so that thinking went – all that illicit wealth would become worthless, since the owners wouldn’t risk exposing themselves to the tax authorities. And those who did declare their ill-gotten gains would lose 50 percent of that to the tax authorities: economists call that a one-time fiscal gain.

The government’s shock therapy was based on a series of miscalculations. To begin with, the government miscalculated the amount of money out of the Rs 15.44 lakh crore that would be returned; they took the black economy to be 25 percent of GDP, a figure made popular but never actually established or validated.

Expectations were that about 6 percent of that Rs 15.44 lakh crore or roughly Rs 1 lakh crore of currency would not be surrendered. In its annual report published is August 2017, the Reserve Bank of India said that less than 1 percent of the demonetised currency say Rs 20,000 crore – is out there; it may be in Bhutan or Nepal, but we don’t really know.

Representational image. PTI

Representational image. PTI

Second, they estimated that Rs 2 lakh crore of unaccounted income held in cash would be deposited in the banking system, on which the 50 percent capital levy would generate Rs 1 lakh crore in revenue. On the numbers available so far, that estimate is also likely to very far from expectations, despite finance minister Arun Jaitley’s confidence that investigations into the source of those deposits will yield expected revenues.

Third, they miscalculated the impact of sudden demonetisation on the economy, or the speed at which the currency sucked out of the system would be replaced by the new Rs. 2,000 and Rs 500 currency notes. Economists have estimated that the impact of the sudden withdrawal of currency will cost the economy about 1 percent of GDP or Rs 1 lakh crore, a conservative estimate. GDP growth also declined relatively sharply.

Reserve Bank of India (RBI) data showed that on March 2017, currency in circulation was Rs 12.45 lakh crore – about 30 per cent of the amount of currency outstanding in November 2016, before the demonetisation announcement. Cash fuels a significant part of the economy – specially the small and medium enterprises, which account for 40 percent of manufacturing output, 8 percent of GDP and millions of jobs.

In all its public pronouncements on black money, the government makes no distinction between the stock and flow of black money. That is, the black money that is held as wealth in the form of immovable assets like real estate, or liquid assets like gold and money held in foreign bank accounts. Numbers on ‘black’ wealth vary wildly, from about $150 billion to $1 trillion, depending on which claim you choose to trust.

This is the basis on which the Prime Minister during his election campaign vowed to bring back and deposit in citizens accounts. Despite many diplomatic efforts with various countries in which these are supposed to help, the results are rather meagre so far.

But let’s listen to the government itself on this topic. In May 2016, in a written reply to a question asked in the Rajya Sabha, then minister of state for finance Jayant Sinha said that the determination of black money sent to foreign countries by Indian persons is being investigated by relevant enforcement agencies. “However, details regarding the amount of money is such cases is not maintained centrally,” he said.

Responding to queries about the estimates by two Bank of Italy economists of Indian black money being between $152-181 billion, Sinha said that there was no empirical evidence that the estimate (arrived at on the basis of certain assumptions and presumptions) was necessarily accurate. Using another set of assumptions, he pointed out, the estimate arrived at was $4-5 billion.

On the flow side of black money, the Goods and Services Tax (GST) was meant to be the principal vehicle by which unaccounted income would be brought out of the shadows into the light. Tax reform – one of the platforms that this government based its agenda on – is the solution to managing the flow of black money. Counterfeiting and terrorism financing need law-and-order enforcement, not economic shock treatment.

In other words, the government had no idea of the real extent of the black money problem, or where and how it is held, or by whom, and all this by its own admission. It could not distinguish between the two kinds of black money, so no differentiated approaches: Everyone became a target, with some really bad results.

When you use an economic measure as a hammer, everything becomes a nail. Demonetisation was an idea whose time should never have come.


Updated Date: Nov 07, 2017 09:28 AM

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