Losses From Demonetisation Far Outweigh the Gains

With the end of the crisis in sight, the gains and losses from demonetisation can be assessed with some confidence.

Normal cash flows will be restored in stages. Rs 15.4 trillion in Rs 500 and Rs 1000 notes were demonetised on November 8, 2016.  By the end of March 2017, new Rs 500 and Rs 2,000 notes worth Rs 12.4 trillion would have been supplied, and RBI has removed all restrictions on cash withdrawals from banks and ATMs.  However, considering that for much of 2015 and 2016, the normal level of currency circulation was Rs 16.5 trillion, an adequate level of cash availability may be attained only by the end of April. Even then, there could be problems in remote areas of a disproportionate share of Rs 2,000 notes. Early holders of new notes would have also tried to hoard them. Normal functioning of the cash economy may be resumed only in the second quarter of 2017-18. The end-date for the repatriation of old high value notes from Nepal and Bhutan is also June 30.

Economic activities that were impaired would also recover in phases. Low-income groups would pay off emergency debts and replace stocks of essentials before using cash to buy clothes or footwear – investment in consumer durables would be postponed.  Traders and small businesses would wait for sales to improve before restocking. Lost livelihoods of urban wage labour, migrant workers and petty traders would be slow to return to earlier levels. Demand for agricultural labour would revive only with the sowing season. The lack of demand for consumer durables – reflected in current decline in output of a number of organised industries – would continue into the second quarter.


That the sudden withdrawal of 86% of the currency would disrupt the cash economy could have been foreseen – demonetisation in 1978 affected less than 1%. The worst sufferers have been the lakhs of urban and rural labourers and migrant workers who were left jobless because employers had no cash to pay their wages. Then came street vendors and petty traders who were left without customers. Small farmers lost heavily on perishables they could not market. Many transporters, rural and urban, had to stop plying. Small businesses in hundreds of trades – ranging from dhabas and repair shops to makers of bidis and jaggery  – closed in the absence of buyers and a lack of working cash.

Middle class households, more vocal in protest, suffered extreme inconvenience in getting their money out of banks. As weeks passed, the organised sector – especially construction and real estate – felt the effects of a loss of liquidity. Then slackening demand led to cut-backs in consumer goods production, including durables like three-wheelers. Wholesalers’ stocks of cement and fertiliser rose.

Losses of income of vulnerable groups, and declining sales and output, do not show up in our economic statistics. Various projections have been made of aggregate losses from demonetisation – a plausible estimate would be a loss of 1% of GDP, which is about 1 lakh crores – spread over three quarters.

Combating corruption

Demonetisation, the government said, would weed out corruption by eliminating black money from the economy. The reasoning was unclear. Corruption includes, besides bribery of public servants and electoral malpractices, illegal activities like drug trade, gambling, trafficking, hawala operations and unauthorised mining. Black money is partly the proceeds of crime and illegal activities, but also income from legal businesses concealed from the tax authorities. Illegal businesses do not depend on hoarded black money for their operations, with a few exceptions like property dealing and hawala. Unearthing black money would reduce corruption, at most, by deterring those detected, from further wrongdoing.

Even this would have limited impact, because demonetisation affects only one class of black money holders – small businesses which deal in cash, like jewellery, and money-lenders. Only 3% of black money is generated as cash. Larger entities – corporates and firms of high-earning professionals who work through banks – escape detection. Demonetisation also cannot touch another class of black money – tax-evaded funds held by Indians in bank accounts and fixed assets in tax-shelters abroad.

Economic benefits

Expectations of direct economic gain from demonetisation have proved illusory. Some, misled by electoral rhetoric, had believed that black money unearthed by demonetisation could be confiscated by the government and distributed to the poor through Jan Dhan accounts. Later there were hopes of windfall gains to RBI from unreturned notes, which could be transferred to the government for distribution to the poor.  Most of the old notes have been returned; if say 1% remains unaccounted for, the gain to RBI would just about offset the cost of printing new notes.

The extent to which investible resources with the banks have risen in the process of demonetisation will be known after some time, when households and small business have withdrawn their cash requirements. The net increase in bank deposits will be a one-off gain; it will not mean a higher domestic savings rate.

Fiscal gain

Attention is now focused on a single attainable objective – identifying individuals and small businesses who have concealed their income from the tax authorities – and recovering taxes and penalties. By December 30, deposits of Rs 5 lakhs or more in demonetised notes had been made into 1.8 million bank accounts. Preliminary notices are being issued to these depositors. Possible tax evaders will be identified on the basis of responses. Verification, detailed scrutiny, possible searches and seizures will follow. Thereafter taxes and penalties will be assessed and collected after appeals. The procedures will take two years or more. For comparison, the IT department detected Rs 31,000 crores in unaccounted income in the two years before demonetisation.

Revenue gains in the financial year 2017-18 will come only from the income disclosure schemes, optimistically estimated at Rs 1 lakh crore. The extent to which the tax-base will be raised is uncertain. Many offenders will go out of business or change identity. Further, tax compliance will depend on deterrent penalties.

Clearly the losses from this ill-conceived exercise outweigh the likely gains.

Ajit Mozoomdar is former secretary, ministries of finance and planning, government of India. 

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