Banning Notes Was Easy, Now Comes The Hard Part 
The Narendra Modi government’s move to demonetise might be easy, but the hard part begins now. (Photo: Reuters)
The Narendra Modi government’s move to demonetise might be easy, but the hard part begins now. (Photo: Reuters)

Banning Notes Was Easy, Now Comes The Hard Part 

Prime Minister Narendra Modi’s decision to demonetise the current series of Rs 500 and Rs 1000 notes with immediate effect as been lauded as a “surgical strike” on unaccounted wealth by his government. Yet, a section of economists, traders and hawala operators say the move is likely to temporarily disrupt the “black economy” rather than permanently hobble it.

Also Read: Modiji, Kudos But Why the Rush to Scrap Rs 500 & 1,000 Overnight?

“This decision will disrupt black money transactions in the short term, but will not stem corruption in the long term,” describing the government’s decision as a “bumper-sticker announcement”. “At a deeper level, you need institutional reform to fight corruption. You need to fix things like the tax code, you need to fix election funding.”
Ajay Shah, Macroeconomist at the National Institute of Public Finance and Policy

Shah described the government’s decision as a “bumper-sticker announcement”. “At a deeper level, you need institutional reform to fight corruption. You need to fix things like the tax code, you need to fix election funding,” he said.

Also Read: Modi Set Aside Rajan’s ‘Reservations’ on Demonetisation Plan

Cash, Professor Shah explained, is a useful medium of exchange but a very inefficient way to store wealth. “Demonetising high-value notes assumes a Hindi film idea of wealth involving guys with stacks of hard cash in Indian currency. But today, unaccounted wealth is created in the form of front companies, and benami equity stakes.”

He said cash is only one of many different forms of exchange available to those who seek to evade tax authorities.

Lawyers and chartered accountants who work with high net worth individuals used an analogy of ice and water to explain how the dark economy works.

“Wealth can be frozen like ice in a fixed asset – say land,” explained an accountant conversant with such transactions, “Then you liquidate it into physical money, which flows from one entity to another like water, and then is frozen again into another asset – say, gold, or an art work, or another piece of land.”

Also Read: Junking Those Old Notes: A Way Ahead? Or a Harbinger of Woes?

Snapshotclose

  • Cash is a small component of unaccounted wealth

  • Rupees aren’t the only currency in which black money is held

  • Without structural reform, demonetisation will only disrupt the black economy in the short term, but will not end corruption

Demonetisation, the accountant said, is likely to affect those holding money rather than a fixed asset.

This fluid nature of wealth has also made it hard to estimate the size and scale of India’s black economy. But a 2007 estimate by the World Bank pegs the figure at 20.7 percent of GDP, or about $460 billion. However, there are no estimates of how much of this unaccounted wealth is held in physical currency, and hence will be affected by the government’s demonetisation decision.

A 2016 report on black money by Ambit Capital has suggested that recent moves to tighten oversight on real estate and gold has “resulted in an increase in preference for cash in its physical form”. However, there is no clear estimate on the quantum of this physical cash.
Indians queuing up outside an ATM. (Photo: Reuters)
Indians queuing up outside an ATM. (Photo: Reuters)
“There is no hard boundary between the ‘black’ and ‘white’ market,” said CP Chandrasekar, an economist at the Centre for Economic Studies and Planning at Jawaharlal Nehru University, “Suppose you pay in cash to buy a house from a property developer. He uses this ‘black’ money to pay his workers, who funnel the money back into the formal economy when they buy food from a shop, a train ticket home, an education for their children.”

“In the short term, the move may help the government eliminate counterfeit currency notes – assuming there’s highly efficient detection of such notes at banks and post offices,” said Chandrasekhar. “But it is likely to make life very hard for service sector workers and those in the informal economy – plumbers, domestic workers and vegetable vendors, who may not have bank accounts.”

Off-record conversations with hawala operators before Tuesday’s announcement and their clients after, suggest that transactions have halted for now, but are expect to restart once the operators and clients have clarity on the new notes.

“We work with clients across India, Africa and the Middle East,” said an operator. the operator explained that each operator kept an account of credits and debits that were squared off in US dollars on a weekly, and sometimes monthly, basis through accounts based in Dubai.

“The black economy has been cashless for many years,” said a tax lawyer with clients who have significant cash surpluses, “Accounts between players build up over years, and are often settled in the form of a property transfer.”

The Morarji Desai-led government too had demonetised high-value currency back in 1978. (Photo Courtesy: Wikimedia Commons)
The Morarji Desai-led government too had demonetised high-value currency back in 1978. (Photo Courtesy: Wikimedia Commons)

Professor Shah, the macro-economist, said a comparison with the demonetisation of 1978 would be unhelpful. That’s because the economy has grown significantly since Morarji Desai’s government, yet an excerpt from Economic and Political Weekly from 1978 offers a prescient insight.

“It has also been suggested that the real objective of demonetization is political,” read an editorial in its January 1978 issue, “to destroy the large funds illegally accumulated by certain politicians and political organisations.”

The ultimate measure of how much black wealth was destroyed, the magazine noted, would be to measure the difference between the number of high-value notes in circulation prior to demonetisation, with the notes subsequently returned to Reserve Bank of India.

Morarji Desai never announced this difference. It will be interesting to see if Prime Minister Modi does.