Demonetisation is a Clear Case of How Public Policy Should Not be Made

Demonetisation as a means of tackling the black economy was destined to fail. What's worse is that its ripple effects are having severe adverse effects on India's economy.

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

That 99% of the currency demonetised found its way back to the RBI has been known for some time. The surprise is why it took so long for the announcement to be made. An article in the Economic and Political Weekly in June showed, based on the RBI data, that 98.8% of Rs 15.44 lakh crore had come back by January 13, 2017. So it was difficult for the RBI to delay its announcement beyond its annual report.

Now, the government is putting the spin that almost all the currency coming back is a measure of the success of demonetisation. It is, however, embarrassing because in November 2016, it was expected that Rs 3-4 lakh crore of black cash would not come back into the banks and that black money would be wiped out. This expectation has been belied.

More money than printed

Worse, since Rs 8000 crore is known to have been with the cooperative banks, which were earlier not allowed to return to the RBI but are now allowed to deposit with it, only about Rs 8000 crore would be left. Even this is most likely to be accounted for by money in Nepal and other neighbouring countries. Some amount would have been left lying with those who did not remember where they had kept their savings. They may be the old, infirm or the sick. This money with people is likely to be legitimate. So, in a sense, the entire Rs 15.44 lakh crore may be accounted for.

If more money coming back to the RBI is a measure of success, then the government should welcome people (having old notes) depositing their money in the banks. Instead, the government is fighting tooth and nail against allowing one last chance to the old and the infirm to deposit the money they may have forgotten about.

The government has all along justified the sudden demonetisation which caused havoc in the economy on the plea that secrecy was essential to unearth or extinguish the black economy. It was defended on the ground that black money holders should not be given time to manipulate their holdings and convert them into white. For instance, it was said that they could divide it into small parcels and get the poor to deposit them in the banks, thereby converting it into legitimate money. The government, in fact, shortened the period over which people could exchange their old notes and changed rules repeatedly to make it difficult for people to deposit their old notes. The government cannot turn around now and say it actually wanted all the demonetised notes to come back into the banks. This is another shift of the goal post by the government since it faces an embarrassment of riches.

Further, there is likely to be more embarrassment if the returned cash counted by the RBI turns out to be more than Rs 15.44 lakh crore which was demonetised. That would be the case if counterfeit currency also got counted because either the notes were of high quality or the banks did not have the time to sort them out carefully because of the rush. It is also possible that corrupt bankers accepted the fake notes for a consideration. Since billions of notes returned to the banks went into the currency chests, fake currency could not be segregated and traced to its origin. To avoid further embarrassment of more money coming back, the government does not want to give another chance to return any old notes that may be lying with the old and the infirm.

Black economy not dented

Demonetisation as a means of tackling the black economy was destined to fail. As has been pointed out many times, it impacts no more than 1% of the black wealth which is held in a variety of forms. Further, it does not eliminate the mechanisms for generation of black incomes. So, the amount of black money demobilised would quickly get regenerated. Now that much new currency is back in the system, it can be used again in the white and the black components of the economy and black cash would be regenerated even if some of it was demobilised.

Now that almost all the demonetised notes have come back and possibly more, it can be said that not even 0.01% of the black cash has been extinguished. Credit: Reuters

Now that almost all the demonetised notes have come back and possibly more, it can be said that not even 0.01% of the black cash has been extinguished. Credit: Reuters

Demonetisation only demobilises currency in one shot. With fast remonetisation, this currency comes back so that the earlier activities can continue. Bribes do not have to be paid in cash always. They can be paid via under-valued property. Shares worth Rs 350 each may be allotted at Rs 25 so that if 1 crore shares are given then a bribe of Rs 325 crores is paid.

The mistaken belief underlying demonetisation was that ‘black means cash’ and if cash is squeezed out, black economy would get eliminated. The white economy also needs cash. Most of the cash in the economy is with businesses and households for their legitimate requirements of working capital and day to day expenses. This is especially true of the small businesses and the farmers. They were the worst hit due to the shortage of cash.

Now that almost all the demonetised notes have come back and possibly more, it can be said that not even 0.01% of the black cash has been extinguished. It is possible that some of the black cash was given to the cash ‘mules’ or the corrupt bankers for conversion to new notes but that means that black cash got redistributed and remained black.

In brief, the scheme was doomed to failure from the start since it was going to impact only 1% of the black wealth but now it is clear that it did not even impact a hundredth of that.

Change in goal post

The government also realised early enough that its original goals would not be met. So, it shifted the goal posts by talking of cashless economy, less cash economy, digitisation, money returning to the system, lesser currency/GDP ratio, expansion of tax base via big data analytics and so on.

None of these steps depend on demonetisation. Each of these could and should have been implemented independently. The economy was anyway moving towards less cash economy with increasing use of plastic cards, electronic transfers and so on. If the government wanted to accelerate that, it could have done so without resorting to demonetisation. It needed advance preparation to rapidly move towards a less cash economy otherwise, chances are that this move would get discredited.

Expansion of the tax base requires analysis of data by the tax officers. Computers can only throw up patterns that may raise suspicion but then someone needs to follow it up. Tax evasion needs to be proved to get people to pay more taxes. The income tax department lacks the resources for that.

According to the finance ministry, data analytics can be used to track black money holders who have deposited cash in their bank accounts. But in 2016, during the Income Declaration Scheme (IDS), the same was said but nothing happened. It was announced by the chairperson of the Central Board of Direct Taxes (CBDT) that data exists on 90 lakh high value transactions since 2009. This was announced to scare people because very little was being declared under the IDS. But the announcement did not make an impact. The department is known to have then set targets for each commissioner to get businessmen to declare incomes. Even then, not much was declared under the IDS.

Another IDS was announced during the demonetisation period and more were threats held out, but only Rs 5,000 crores was declared. Most people with black realised that the government does not have the wherewithal to catch them. They also claim that they have a ‘setting’ with the department officers and can get away.

The problem of tackling the black economy is then a political and a bureaucratic one. It is not merely a technical one where demonetisation or digitisation or big data analytics can be used to solve the problem. Technology can be useful but it can also be fouled up and misused. The form of black income changes with use of technology as has happened with internet hacking and phising and blackmail like in the case of ‘Wannacry’ virus attack. The man behind the technology is crucial and that is where reform is needed. The government lacks faith in people and trusts technology to do the needful.

Demonetisation has caused damage to economic institutions like the RBI and the government’s statistical department. Credit: Reuters/Vivek Prakash

Impact on the economy

The economy consists of two components – the organised and the unorganised one. The former can use banks but the latter works largely in cash and got impacted very strongly. It lost output, employment and so on. That resulted in a decline in the demand for the organised sectors also. The economy had a negative growth which led to a further fall in capacity utilisation and thus, a fall in investments. This slowed the growth in the long run which is also reflected in the fall in credit offtake from banks.

The true growth rate of the economy is not being calculated by the government agencies since they are not factoring in the large decline in the growth rate of the unorganised non-agriculture sector. The short term calculation of the quarterly rate of growth is based largely on data from the organised sector and there too, the corporate sector. This methodology was okay for calculating the growth of the economy till November 8, 2016, but not after, since the parameters of the economy completely changed after that day. In fact, the rate of growth of the economy would have turned negative after that day.

The farming sector was also hit badly with a collapse in the prices of perishables and general difficulties in selling the produce. Thus, farmers’ incomes were adversely affected even though production was not hit. This has led to farmers’ protests over large tracts of the country. It has led to the inability of farmers to pay back their loans and demand for farm loan waivers.

Banks were also hit due to their inability to carry on the routine banking work for almost a whole quarter. They were saddled with large deposits which they could not lend. Their non-performing asset (NPA) situation which was already bad has worsened with decline in profits in industry and the difficulties farmers have had to face.

The economy has suffered a big loss, not just in the short run but in the long term, running into lakhs of crores. It would not be easy to recover from this slump till demand revives and that would require increased investment. Since the private sector would not do that on its own when capacity utilisation is low, the government would have to step up public investment. But the government is ideologically averse to doing that. So, it does not look like the economy would recover anytime soon.

Political and social aspects

The opposition has not been able to mobilise the public in spite of the hardships they have suffered. Most of the politicians have generated black money and are open to action by the government. The prime minister has personally benefitted from the move because the public sees it as a strong step against black money. A Robin Hood image has been created. This has washed away the suit boot ki sarkar image.

This political image is now being dented by data on notes returned and news of the decline in the rate of growth of the economy. The decline in growth is also a result of the introduction of Goods and Services Tax (GST) which adds to the uncertainty. GST has impacted the unorganised sectors disproportionately.

Demonetisation and GST have marginalised the unorganised and the poor and are aggravating the rich-poor divide in the country. Moves to accelerate digitisation and a less cash economy will further deepen this divide. The marginalisation of this vast majority of the people is evident. All this can only result in increased social problems and agitations. Protests by the farmers, workers, traders, youth and various other sections of the population are already visible.

The prime minister had initially admitted that there would be pain but it would only last for 50 days. But the short term problem of notes shortage got converted into a long term problem of economic slowdown/recession. So, the pain continues. The unorganised sector was badly hurt and the organised sector less so. The currency shortage still exists in rural areas but due to economic slowdown, less cash is demanded. Demonetisation has caused damage to economic institutions like the RBI and the government’s statistical department. The parliament was marginalised since the prime minister refused to answer any questions there. All in all, demonetisation is a clear case of how public policy should not be made and especially one that is complex and all encompassing.

Arun Kumar is the author of Understanding the Black Economy and Black Money in India: An Enquiry into Causes, Consequences and Remedies (Aleph Publications, 2017) and The Black Economy in India (Penguin Random House India).