On November 8, 2016, Prime Minister Narendra Modi announced that from midnight, ₹500 and ₹1,000 notes would no longer be considered legal tender in India . The government’s stated aim was to curb corruption and the pervasion of black money in the economy , as well as the proliferation of fake currency which was also being used in terror funding. Pronab Sen discusses with Vikas Dhoot the after-effects of the demonetisation gambit and whether the intended outcomes have been achieved. Edited excerpts:
What has been the assessment of the extent of black money in the Indian economy?
PS: Black money and the black economy are not the same. Black money is transitory and there’s not a whole lot of it. The black economy, particularly black assets, is large. Various studies to quantify it have yielded a wide range of estimates (20%-60% of GDP). Black money, or cash which has not been shown, is a very small component of this larger black economy because nobody who has made black income hangs on to that cash for long. They invest it in some asset. So, most of the black economy is in the form of assets. And when you look at any asset, there is always some person or entity holding it. Whether that name is benami or not is impossible for a researcher to find out and the statistical system to capture.
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What was your first reaction when you heard the decision to scrap what constituted about 86% of the currency in circulation at the time?
PS: Horror. The reason is that every economy in the world depends on transactions. I produce something, I sell it to you, and the transaction creates value. In a country where cash is the most common means of transaction, this was horrifying because what it said was that until we bring that cash back into circulation, transactions are going to be severely hit. This is bad news to begin with and becomes worse when you think about who was transacting in cash. Large corporates have a very small proportion of their transactions in cash. It is the unorganised sector and the Micro, Small and Medium Enterprises (MSMEs) sector which have a large proportion. It was clear that these sectors would be the ones severely hit. And these sectors included 90%-93% of our population then. So, we were talking about a very broad-brush damage to the Indian economy.
Despite several rule changes, the Reserve Bank of India (RBI) eventually found most of the cash returned to the system. Could implementation have been better?
PS: If I was shocked by the move, the RBI was even more horrified, because it would be its job to contain the damage. And from what I gather, the RBI didn’t have a clue that this was about to happen. It was not prepared. The net result was that the remonetisation process to replace the cash took almost a year when it should have been over within a month.
The cash in circulation is now higher than it was five years ago. Have we come a full circle, at least in terms of being a less-cash economy?
PS: Let us thank God for that. Because if it had not happened, our economy would be in deep trouble. There is a sequence in which the various targets were announced and the less-cash economy was the last in that sequence. It was an afterthought and has not happened. We now have about ₹28.5 trillion in cash floating around, compared to about ₹18 trillion at that time. Non-cash transactions have gone up but the real question is whether that was an organic process or was accelerated by demonetisation. It appears from the data that I have seen that there was an initial sharp acceleration, which then gradually tapered off over time, and then started picking up again. So, the transition to a less-cash economy had already begun before and it has again gone back to trend.
The ₹2,000 note is no longer being printed...
PS: Other than the sheer physical inconvenience of carrying a stack of notes, nothing inherently demands cash to be in high denomination notes. I have no problems with high-value notes being phased out, provided there is a sufficient supply of low denomination notes to substitute them. The problem is that we again have a situation where the ₹2,000 and ₹500 notes are dominant and the low-value notes continue to be about 15% of the total cash. If you are bent on making it more difficult for people doing high value transactions with cash, moving to lower denomination currency makes a lot of sense. The non-printing of ₹2,000 notes is a good idea but the real question is whether these should be replaced by more ₹500 notes or whether we should re-invent the ₹1,000 notes.
The Goods and Services Tax (GST) was introduced about nine months after the note ban. Has this sequencing, aimed at increasing formalisation and the tax to GDP ratio, worked?
PS: I am glad you asked this because it’s not a question of whether the GST should have come but of the sequencing. Had the GST come six months before demonetisation, things would have been a lot better. Because GST encouraged, not forced, formalisation. So, the effect of demonetisation would have been less draconian if that had happened. The fact that GST came later added to a problem that demonetisation had already caused — parts of the economy dependent on cash transactions were already in the doldrums. The GST brought the rest of the MSME sector, which is less-cash dependent, into trouble as well, and compounded the problem. GST by itself should have come, but it should have preceded demonetisation and not succeeded it.
So that explains why the tax to GDP ratio has not really seen a dramatic improvement despite GST and demonetisation.
PS: That is absolutely correct. The tax system, measured in terms of GDP, will tend to start looking better. And that is a result not just of demonetisation, but what has happened with the COVID-19 measures as well. But altogether, all of that is going to work. But if you are looking purely at the effects of demonetisation, frankly we need to stop because from March 2020, the effects of the pandemic really start dominating.
A State Bank of India (SBI) research report says the informal sector shrank to 15%-20% of formal GDP in 2020-21, from 52% in 2017-18.
PS: The informal sector is of critical importance as it generates livelihoods for the vast majority. Now, if there has been a shift in the segments of the economy that used to be dominated by the informal sector to the formal sector, the question is, who is going to provide employment? For people who are not part of the formal sector, the future looks very bleak. And this effect will persist for a while, because the question that then arises is whether or not the informal sector will be able to bounce back and make inroads into the market share that the formal sector has already captured — not because the formal sector is any more efficient or anything, but because policy decisions changed the goalposts in its favour.
So, this is a phenomenon of the big getting bigger with each subsequent shock? Where does that leave India’s inherent strength of a huge captive market with opportunities at the bottom of the pyramid, if incomes don’t grow there?
PS: Yes, each of the shocks has had that effect. At the end of the day, the vast majority of the huge Indian market is at the bottom of the pyramid. The top of the pyramid is very thin. Unless incomes at the bottom of the pyramid rise consistently, the market will stagnate. We saw this happen post-demonetisation. The corporates will make a killing in the initial stages but then the lack of growth of demand starts biting. After demonetisation, 2017-18 saw handsome growth but growth then dropped like a brick in the next two years.
When the pandemic hit, we were already seeing several quarters of dipping growth. Now, we are again seeing corporates getting more dominant…
PS: Yes. The pandemic effect is an add on to what was there before it. The informal sector had clearly not recovered and the pandemic added to that problem. So, if you think of the chain of causation in the post-demonetisation pre-pandemic period, the negative effect on the informal sector was the lack of cash in order to carry out transactions in business. Post-pandemic, the cause was different — the lockdown led to all businesses, formal and informal, being shut. Now, since the informal sector doesn’t have a lot of reserves to be able to last out two months of lockdown, a lot of businesses closed down. The formal sector, particularly the large players who build up reserves or contingencies, not only survived but thrived after the lockdown was lifted. So, the sharp bounce back that we are seeing in the economy is entirely driven by corporates. The informal sector has had three sequential shocks and is in dire straits, which is what the SBI report is suggesting.
This time, it may be even tougher for the informal sector to bounce back...
PS: Yes. After the first lockdown, the RBI took a series of steps to try and mitigate the damage such as the moratorium on loan repayment and additional working capital lines for MSMEs. After the second COVID-19 wave in March, April and May of this year, there were no such measures. So, those who had been spared by the first pandemic lockdown became vulnerable in the second.
So, who gained from the demonetisation, GST and COVID-19 shocks?
PS: Unquestionably, Corporate India, which has grabbed market share which it wouldn’t even have dreamed of before demonetisation happened. And now it has to pay lower taxes.
But there’s a limit to investment opportunities, if demand doesn’t pick up to create a virtuous cycle.
PS: This is the problem. I think we have got stuck in a low-level equilibrium trap. The informal sector will find it very difficult to bounce back. So, the dynamism of the Indian economy, which is the bottom of the pyramid moving from poverty-stricken to merely poor and then to lower middle class — that has stopped.
What about demonetisation’s other goals like curbing terror financing and counterfeit notes?
PS: An RBI study suggested that the total fake currency was ₹3,500 crore, which was borne out later. That is a laughable amount. On terror financing, it is about whether terrorists hang on to the cash paid to them. I suspect not. The fact that almost the entire amount of currency that was demonetised came back is an attestation of that. If terrorists had currency they couldn’t transact with, they managed to exchange it.
On the hope that people depositing cash and being forced to disclose incomes will invite income tax action, we didn’t see any big numbers.
PS: I don’t know where to put the blame for that. Is it that the Income Tax department simply didn’t take the opportunity? As far as I am aware, banks were meticulously keeping records on this, but then somebody would have to aggregate those records, identify the people, and then proceed. If anything, that would have been the one big thing, but it shows up nowhere in the income tax data.
Is there any evidence that corruption has gone down?
PS: There’s a lot of anecdotal information that petty corruption has not gone down, but has, in fact, gone up. Because the associated risks have risen and the risk-adjusted return to the bribe-taker has gone down, so they have raised their price. The real question is large-scale corruption but is that transacted through cash? Probably not. Those are probably done through transfers abroad. Moreover, now we have cryptocurrencies through which a huge amount of corruption can take place and we won’t even know about it.
What are the lessons we learn from such policy shocks?
PS: When you take a measure of this magnitude, somebody should be doing the homework on which agencies have a critical role to play in making it a success. In this case, there were at least two — the RBI and the Income Tax department. Neither of them was geared up to take advantage of the situation. So, we got all the damages and very few of the benefits.
A former SBI chairman has said it might take 30 years to assess the actual benefits of demonetisation. Do you think we might have more evidence a few years down the line?
PS: No. People will make all kinds of efforts and econometric tricks will be used to try and tease out the effects. But the pandemic will muddy the waters so thoroughly, I don’t think you will be able to segregate the effects.