Why Demonetisation Will Not Eliminate Black Money or Corruption

Demonetisation will only affect those who conduct transactions in cash, are not a part of the formal banking system or have not converted their cash into assets.

A woman holds 500 and 1000 Indian rupee banknotes as she stands in a queue to deposit her money inside a bank in the northern city of Kanpur, India, November 10, 2016. Credit: Adnan Abidi/Reuters/Files

A woman holds 500 and 1000 Indian rupee banknotes as she stands in a queue to deposit her money inside a bank in the northern city of Kanpur, India, November 10, 2016. Credit: Adnan Abidi/Reuters/Files

The government’s demonetisation of Rs 500 and Rs 1000 notes is a contentious issue, but is understandable. Such schemes may have not worked in the past, but a political commitment had to be honoured. The question is not whether the government is right for demonetising the currency; instead, the concerns are centred on why they adopted this chaotic and surreptitious approach.

The EU had replaced a large number of currencies in 2002. Its citizens were given a two months – between January 1 and February 27 of that year – to comply. In December 2014, the Philippines announced that old peso notes, some dating to 1985, would be withdrawn starting January 1, 2015, with customers given until the end of 2016 to exchange the old notes. Even Zimbabwe gave its citizens a three-month window before replacing the dollar. In all these instances, the old currency continued to be legal tender during the transition process.

The US has had acute trouble dealing with black money and dirty cash for over a hundred years now. Yet, not once has it declared its currency illegal since it began issuing notes in 1862. That is the strength of its financial system, on which the entire world relies.

A currency note is a promise that must be kept, whatever the circumstances. Because this trust has been broken in India, queues have formed outside banks and ATMS, with banks closing down mid-way through the business day, saying they have run out of cash.

Pro-establishment die-hards would snigger and argue that the two high value notes have been withdrawn to check black money. It had to be done in total secrecy, they say, to thwart nefarious attempts by hoarders to dump currency. But what is it that these hoarders could have done in a reasonable time frame that they are not doing now?

They could use multiple bank accounts in other names. They could redistribute their money in small parts, buy gold and convert local currency into foreign. All this and more is happening now and taxmen are reportedly collecting this information with alacrity.

What was the need for creating this chaos and penalising honest citizens who believe in Indian money and trust in the Reserve Bank’s declaration, ‘I promise to pay the bearer the sum of five hundred rupees’? Whatever the 2% are doing to reduce their losses, the rest of us are bewildered. Should we accept Rs 2000 notes? What if these are declared illegal by the next government? Should we go off work and stand in long queues outside banks to withdraw the Rs 2000 or Rs 4000 we have been permitted to access in a day?

India’s majorly cash-based system would certainly benefit by some measure to curtail it. At 12% of GDP, India’s cash economy is nearly four times the size of that of Brazil and South Africa. By demonetising the Rs 500 and Rs 1000 notes, India could get rid of counterfeit currency and fake notes that allegedly entered the country through the Chinese and the Pakistani border. Some tax evaders will surely bring out their cash stashed away in mattresses and false ceilings. But this will be a trickle – a minuscule percentage of the total.

The current demonetisation is the second one since independence. In 1978, the government led by Morarji Desai introduced the High Denomination Bank Notes (Demonetisation) Act and made the Rs 1000, Rs 5000 and Rs 10,000 notes illegal. The expectation at the time was that the black or shadow economy, estimated to be around 15-18% of GDP then, would reduce if not get totally eliminated. But black money went up to 18-21% during 1983-84.

The World Bank has estimated the size of shadow economy to be 23.2% of India’s total economy in 2007, and eight years later one would expect it to have increased further both in percentage and in absolute amount. Note that that last decade has seen a fast pace of GDP growth in India. Therefore if the shadow economy is 25% of the total economy, this will be equal to over $2 trillion in PPP terms (India’s GDP in 2016 is $8.7 trillion in PPP terms or $2.3 trillion in nominal terms).

Given the size of the shadow economy, can one expect to reduce or eliminate it through the recently introduced demonetisation drive? All old Rs 500 and Rs 1000 notes are now redundant. Some provisions have been made to either exchange or deposit these notes in banks in small amounts until the end of December. The government did do the due process and many got the wind of it when a kind of amnesty was announced a few months ago. Weeks before the demonetisation announcement, information about the new Rs 2000 note began to appear across social media platforms.

Many must have got wind of this and saved their money ether through due process or through benami (falsely named) accounts. Note that there is no limit on how many bank accounts one can operate in India. Thus multiple accounts and accounts in the names of relatives and will allow a substantial number of the middle and higher middle class to salvage redundant notes despite the demonetisation.

The real issue is how the common man been affected by the drive. The current demonetisation has adversely affected the poor, wage labourers, small businesses, farmers and other minorities. Often these small income earners save cash for a rainy day. The incidence of bank accounts and bank transactions will be extremely low among these groups. These are the communities who do not engage in the formal banking sector too much. Rather they save their daily or weekly wages in cash, often in large denominations. It is these groups who have been hit the most by the demonetisation drive.

The demonetisation can well trigger a recession, while not entirely addressing the black economy. This will affect only those individuals who hold cash. Others who have already converted their money into assets, and invested in gold and other luxury items will be only marginally affected. This demonetisation is not likely to impact the structure, level and incidence of corruption in India. Often the proceeds of corrupt bureaucrats and politicians never arrive in India; they are handled off shores. They will now be only too happy to have Rs 2000 notes at their disposal.

Abusaleh Shariff is part of the US-India Policy Institute, Washington DC.  Amir Ullah Khan is director of research at Aequitas and policy advisor to the Bill and Melinda Gates Foundation.