Six Months of Demonetisation: Economy Sputtering but High Political Dividend

Demonetisation has not dented the black economy, but it has damaged the white economy, especially the unorganised sectors.

A notice is displayed on the gate of an ATM counter which is no longer dispensing cash in Chandigarh, India, November 21, 2016. Credit: Reuters/Ajay Verma

A notice is displayed on the gate of an ATM counter which is no longer dispensing cash in Chandigarh, India, November 21, 2016. Credit: Reuters/Ajay Verma

Six months have passed since that fateful night when the prime minister announced that existing high-denomination currency notes would become worthless paper. For at least two months after that there was widespread distress among the poor and middle classes in the country. Most accepted it as a price they had to pay for cleansing the economy of the scourge of black money. The prime minister assured the public that there would be short term pain for long term gain. Later, he said that the pain would start lessening after 50 days.

The finance minister recently announced that there was no impact of demonetisation on the economy or society. So what happened to the pain that was so visible for at least two full months? This denial comes out of the confidence gained by the ruling dispensation after spectacular victories in the recent polls held in important states. The opposition is in disarray and is unable to counter the ruling dispensation in any meaningful way. Victory could be snatched out of defeat in Goa and Manipur, and now the AIADMK in Tamil Nadu and Telangana Rashtra Samithi in Telengana are more or less also in the bag for the presidential election. The opposition is trying for unity but given history, this is a tall order. So the ruling dispensation is confidant of getting away with saying what it wants.

Impact on the black economy

Yet, a crucial question remains: what was (or is) the impact on the black economy? This is vital, since demonetisation was touted above all as a means to unearth black money. The answer is unambiguous – it was not able to unearth black money since most of the Rs 15.44 lakh crore of high-denomination notes that were demonetised have come back into the banking system.

Black cash with households would have been around Rs 3 lakh crore and most of that has been converted into new currency. The government was embarrassed at this and has put up a brave front by arguing that it now has data on which it can act to catch black income generators. The government has said that it has issued notices to 18 lakh entities to explain their deposits in the banks.

In his Budget speech in February, the finance minister said, “Deposits of more than Rs 80 lakh were made in 1.48 lakh accounts with average deposit size of Rs 3.31 crore … deposits between Rs 2 lakh and Rs 80 lakh were made in about 1.09 crore accounts with an average deposit size of Rs 5.03 lakh.” These add up to about Rs 10 lakh crore. Thus, two-thirds of the total of Rs 15 lakh crore of old notes returned to the banks were accounted for by 1.1 crore accounts. Is it all black? That has to be proved, given that there are legitimate reasons for people to hold cash for business.

The government has repeatedly stated that they will do data mining to get at those who have black money. This is not new. Since July 2016, there have been a flurry of announcements about tackling black money. For instance, it was announced that seven lakh letters will be issued seeking clarifications from those who carried out high-value transactions in which the PAN was not quoted. These transactions could be deposits of more than Rs 10 lakh in banks or transfer of immovable property valued at more than Rs 30 lakh. The income tax department claims to have information about 90 lakh such transactions which took place between 2009 and 2016. The chairman of Central Board of Direct Taxes, Atulesh Jindal, mentioned that there are one lakh cases where the transaction value is over Rs 1 crore. Apparently nothing has come out of this exercise.

According to a high functionary in the government, there is data that more than eight lakh entities declared an average income of Rs 80 crore in 2012-13. This is 6.7 times the GDP that year. Thus, the black economy that year would be at least 570%. If these eight lakh entities could be investigated and their black incomes caught, the nation would get 200% of GDP as tax. Today, we only collect 5.5% of GDP as income tax.

Thus, by investigating only eight lakh people, one could have unraveled the entire black economy. Then demonetisation, which yielded little, would have become redundant. There would have been no need to put 125 crore Indians through so much hardship. Further, when data already exist on 90 lakh high-value transactions since 2009, why was that not used to tackle the black economy? Again, demonetisation was not needed to generate more data. How would the additional data generated by bank deposits due to demonetisation help when the much larger database was not useful for the last eight years?

Proving that someone’s cash deposit is black or generated out of that person’s black income is complicated. There are many court judgments that add to the complexity of proving that a certain income is black. The rich deploy accountants and lawyers who draft/prepare their accounts making it difficult for the Income Tax department to figure out what is wrong in the accounts.

Did people declare more income due to fear of being caught when they deposited their black cash? Most people with substantial black incomes or black cash would be from the business community or with links to businesses. They would be able to show cash as working capital. Many businesses helped those with black cash to change their old notes at a discount of 30 to 40%. They used their own companies or the shell companies that they operate for this purpose. Hence little would be proved to be black cash generated from black incomes.

Anyway, there is an estimated Rs 3 lakh crore of black cash with about four crore individuals who generate substantial black incomes. This means an average black money holding of Rs 75,000 per person. Not a huge sum of money and way below the limit of Rs 2.5 lakh which is supposed to trigger questioning by the income tax department. The point is that the amount of cash kept out of the black incomes earned is small. Just like out of the white incomes earned annually, one keeps a small percentage as cash. So the cash deposit is not an indicator of the amount of black income being earned by an individual.

In brief, given the history of existence of data on large transactions, it is unlikely that data now generated by demonetisation will help unearth black income generation. Further, cash deposits under demonetisation do not provide a basis for unearthing black income, since it is a tiny part of the black economy.

The economic fallout

On the economic front, the stock market is booming and various national and international agencies are supporting the government’s contention that the economy has continued to grow at 7% or thereabouts. These are the days of ‘fake news’ and ‘manufactured truths’.

The government is yet to tell us what the impact of demonetisation was on the unorganised sector of the economy. That is a sizeable part of the economy, employing 94% of the workforce. The data on the basis of which the government prepares its quarterly estimates are only from a small part of the organised sector. The quarterly estimates are repeatedly revised and for the period after November 8, 2016, they will certainly be revised as more data come in.

The data for the unorganised sector are not independently available for some years since it depends on periodic surveys. So unless the government makes a special effort, the real picture of the unorganised sector and of the full economy will not be clear. But then why should the government make the effort, since it is only interested in arguing that there was no adverse impact of demonetisation. The suffering of the common people for two months was just a bad dream, ‘fake news’. When one meets people in the market who still complain that their business has not recovered to what it was prior to demonetisation, that is characterised as ‘anecdotal’.

Only the government, with its vast number of agencies, can give the data on how demonetisation impacted the economy. International agencies like the IMF, World Bank and Asian Development Bank do not collect data and only analyse government-generated data. They more or less have to concur with what the government says. the RBI cannot be much out of line with the government because it too does not generate its own data on most variables.

Governments often dress up data to paint a bright image of the economy and society. This is not just the case with the present NDA, but whichever government is in power in the Centre or states. The Budget is routinely made to appear attractive. Data on employment or education or health are bumped up to make the situation appear less bleak. A party in opposition criticises the data but when in power uses it to paint a brighter image of its performance. This is political expediency.

The GST was bad when in opposition, but now it is a game changer. Aadhar was bad since it was insecure and would violate privacy when in opposition, but now it is the best thing that could have happened to the country. The idea of privacy is now said to be a non starter. Political parties are now bereft of ideology or principles – the aim is to get to power to serve the vested interests who fund it.

It is also argued that the rate of growth may not have fallen because a part of the earlier undeclared production was declared. This may have been done to show higher incomes and put the corresponding amount of cash in the banks. The implication is that while the actual output made up of the declared and undeclared output has fallen, the declared part of the output has not fallen. Could that happen?

Since most of the black cash was recycled through various devices, like accounts of the poor, payment of wages to the workers, payment of tax and past dues of taxes, purchase of medicines, petrol and groceries at government outlets, buying of gold and real estate and so on, very little black cash would have been left to be shown as additional income from additional production. Suppose 20% of black cash (Rs 3 lakh crore) had to be shown as additional production, that would amount to Rs 60,000 crore and would constitute 0.4% of GDP for the country. This would hardly result in compensating for the loss of production due to demonetisation.

There would have been a bump in sales of medicines, petroleum goods, gold and jewellery, real estate, air travel, and other such items where old notes could be used. However, there would have been a decrease in demand corresponding to the payment of additional taxes which would have dampened demand in addition to the impact of demonetisation.

Many industries reported a buildup of stocks due to decline in demand. This would have reduced capacity utilisation and led to a decline in investment which was already declining. CMIE data suggest a sharp drop in investment in the economy in the third quarter of 2016-17. It would have also led to a fall in production subsequently.

In the net, it is unlikely that the organised sector output went up during the months after demonetisation was announced. The various surveys by SBI, PHDCCI and Manufacturers’ Association reported a drop in production rather than growth.

People holding demonetised currency. Credit: Reuters

People holding demonetised currency. Credit: Reuters

The stock market bubble

Governments do not admit that the economy is doing poorly because sentiments are important for investments and that is crucial for growth. If the government or the RBI even give a hint to this effect, there will be a big impact on the stock markets and investors. So the government has to keep reassuring investors that things are okay or improving. The stock markets have come to be the barometer of the economy’s performance. It is immaterial that the unorganised sector has little to do with the stock market or its performance.

Stock markets can create a bubble, like happened globally in the early part of the last decade and that deflated starting 2007 and led to the global recession. In 1991, when the new economic policies were launched, the economy went into a tailspin but the stock markets kept rising. When the issue was raised in the parliament, Manmohan Singh as the finance minister said he would not lose sleep over the matter.

The bubble kept growing and burst on April 6, 1992. A large number of investors lost money. About 2,500 companies disappeared with public money in the 1990s and there was no action. The Unit Trust of India went bankrupt with public money because of the stock market manipulations.

So, while the stock market is booming due to global factors and the key electoral victories of NDA in the states, the chances are that another crash is inevitable. The underlying economy is not booming and the adverse effect of demonetisation is persisting.

Shifting goal posts, digitisation and less-cash economy

The government quickly realised that demonetisation was a big mistake in an economic sense. So, it started shifting the goal post and said that the main aim of demonetisation was to digitise the economy. It would lead to efficiency gains, make the informal sector formal, make black income generation more difficult because of the paper trail that would be left behind and so on.

It also said that the economy would not need to be fully remonetised because economic entities would move to using digital modes of payment and receipt. So out of the Rs 17.74 lakh crore of currency with the public at the start of demonetisation, there is only Rs 14.07 lakh crore in circulation at the end of April. That is Rs 3.7 lakh crore less than at the start.

Indeed, there is an increase in point of sale machines, use of debit and credit cards and so on. To this extent, there will be less demand for cash. However, the cash-intensive sector of the economy, the unorganised sector, has not yet recovered from the loss of work due to demonetisation and that would lead to a lower demand for cash. Further, there are reports of currency shortages in various parts of the country, especially in rural and semi-rural areas. ATMs periodically run out of cash. The rush for digital transactions that was witnessed soon after the note shortage hit the public has somewhat abated as more and more cash has become available. The huge ad campaigns seen in November and December 2016 from digital platforms have petered out.

The government announced that India would soon become ‘cashless’, but quickly realised its folly and moderated its pitch to a ‘less-cash economy’. But even this takes considerable preparation. There is need for financial literacy, regulation, cyber security, infrastructure like electricity, computerisation and connectivity, and so on. All this is needed independent of demonetisation. In fact, digitisation has to be done independent of demonetisation.

Does digitisation make the informal economy formal? Hardly so. Most of the informal sector activity is not required to be registered with the government agencies. Also, most of the incomes earned in this sector are way below the taxable limit, since in India taxation begins at a high multiple of per capita income (including deductions, at about five times the per capita income). So most of the population falls below the taxable limit. In 2012-13, only 52 million either paid TDS or filed a return. Out of this number, only about 17 million paid effective income tax.

In brief, even if the informal sector gets more digitised in its transactions, there is unlikely to be any dent on tax receipts of the government. What needs to be done is to tackle the black economy linked to the organised sector of the economy, especially the services sector.

The social impact

Demonetisation was a major decision, yet there was little preparation for it. The RBI, government departments, banks and so on were not prepared for it. Debate in the parliament was stalled because the prime minister did not wish to present his case there.

The courts were approached but they also did not intervene. Even now there are cases in the Supreme Court but it is unlikely that it would intervene in the matter. Businessmen are scared of the government and do not wish to be seen as opposed to it. With the changes introduced in the recent Budget, the fear of a raid raj has only grown. The media has been adversely impacted.

Anyone who criticised the move was branded as a ‘black money wallah’. Since most politicians have been dealing with black money and their public image is that they have black money, political parties did not openly oppose demonetisation even though it quickly became clear that it would not achieve its goal of controlling black income generation. Those who did oppose the move like, Trinamool Congress in West Bengal, found that its MPs were systematically targeted for corruption.

The biggest impact was felt by the unorganised sector of the economy and its share in GDP fell. This will aggravate disparities and cause social and political problems to grow. Digitisation and other such moves are also detrimental to the interest of this sector and that could set it back further. The introduction of the GST would add to the woes of this sector.

Demonetisation has not dented the black economy, the main aim of the move. However, it has damaged the white economy, especially the unorganised sectors. According to recent reports and announcements, a lot of data on misdeclared incomes and large-value transactions existed. If this was used to catch those generating black incomes, nothing else needed to be done. The 130 crore Indians who were put to enormous hardship need not have suffered this fate. The setback to the economy would not have occurred.

The government changed the goal posts several times and finally settled on the issue of ‘less-cash economy’. But this has little to do with demonetisation and should have been taken up separately. It also requires a lot of preparation. There is likely to be little impact on formalisation of the informal economy or greater tax collection since the informal economy is a result of jobless growth. Higher tax collection would have taken place if the black economy turned into white but that has not happened.

While the economic decision was not sound, the political decision has paid handsome dividends. The prime minister did not suffer any loss of credibility in spite of the pain that the common person had to suffer. People were convinced that the decision was correct and would hurt the black money wallah. People bought the government’s line that in the long run things would be better off and they only needed to bear the pain for a short time. The prime minister succeeded in creating a Robin Hood image for himself. that he was penalising the well-off corrupt guys to help the poor – a throwback to the ‘Garibi Hato’ of Indira Gandhi in 1971. So we have a case of good politics and poor economics.

Arun Kumar is the author of Understanding Black Economy and Black Money: An Enquiry into Causes, Consequences and Remedies, Aleph Publications and The Black Economy in India, Penguin (India).

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  • ashok759

    Mrs Gandhi could not sustain good politics, poor economics for very long.