Economic Survey 2016-17: Chapter -03: Demonetization: To Deify or Demonize?

In its third chapter, the survey tries to analyze {and to justify} the rationale behind governments move to demonetize, impacts of demonetisation, benefits of demonetisation and way forward. We note that there were two previous instances of demonetization, one was in 1946 and other was in 1978, but the demonetization of 1978 did not have any significant effect on cash the way the current demonetization drive has done.

The Helicoptor Hoover

The economic survey has used the phrase “helicoptor hoover” to the way demonetization was conducted. This term, derived from earlier concept of Helicopter money. This particular word is a metaphor {not implemented practically anywhere} and involves printing large sums of money and distributing it to the public to increase money supply and stimulate the economy in deflationary periods. The metaphoric imagination is that the printed currency should be dropped from helicopters {Helicoptor drop}. The survey has called demonetization as “Reverse Helicopter Drop”  or “Helicoptor Hoover“.

Rationales of demonetisation

The key rationales enumerated behind government’s move to demonetize the high currency notes are:

• To curb corruption
• To prevent Counterfeiting of notes, where high denomination notes are counterfeit to be used for terrorist activities
• To curb accumulation of “black money” which is generated by income that has not been declared to the tax authorities.

The survey recounts the earlier efforts of the government to curb the illicit activities viz. Creation of the Special Investigative Team to probe Black money; Passage of legislation such as Black Money and Imposition of Tax Act 2015 and Benami Transactions Act 2016; Information exchange agreement with Switzerland; Changes in tax treaties with Tax haven countries such as Mauritius, Cyprus and Singapore to prevent money laundering and income disclosure scheme to give one time opportunity to hoarder of Black money to disclose his income which is not taxed.

Reason for targeting high denomination

There are few reasons cited by the survey as to why Rs. 500 and Rs. 1000 notes were targeted. Firstly, the soil rate of higher denomination is less. Soil rate is the rate at which notes are considered to be too damaged to use and have been returned to the central bank. Survey says that soil rate of currency notes of Rs. 500 and Rs. 1000 is 22% and 11% which is much lower than soil rate of lower denomination which is 33%. This suggested that notes of higher denomination are not used for transaction, instead used to stash black money. Secondly, the link between higher denomination and illicit activities is well established across the globe. The higher the amount of cash in circulation, the greater the amount of corruption, as measured by Transparency International and this made the 500 and 1000 denomination the soft target. Thirdly, high value notes are easier to store and carry in comparison to smaller denominations or other stores of value such as gold.

The economic survey mostly tells us the things which we already know and does not tell us what we want to know. The above rationales are correct but still we are unable to understand the rationale of introducing Rs. 2000 currency. Is that a stop gate currency and yet another demonetisation is in cards? This is not  hinted by Survey, which talks of rapid remonetisation rather.

Impact of demonetization

The impacts of demonetisation are summarized in economic survey as follows:

On Money/interest rates

In the short term, the cash declined sharply; Bank deposits increased sharply. In the long term, the cash will recover but settle at a lower level.  Deposits will decline, but probably settle at a slightly higher level. RBI’s balance sheet will shrink, after the deadline for redeeming outstanding notes.  Loan rates could fall further, if much of the deposit increase proves durable.

On Financial System Savings

Increased in the short term and will increase in long term to the extent that the cash-deposit ratio falls permanently.

On Corruption

In the short term, the stock of black money fell, as some holders came into the tax net. In the long term, the corruption and black money could decline if “incentives for compliance improve“. In the long term, the formalization would reduce the flow of unaccounted income.

On Private Wealth

In the short term, the private sector wealth declined because some of the high denomination notes did not return to the system; and the prices of real estate fell. In long term, the private wealth could fall further if real estate prices continue to decline.

On public sector wealth

In short term, there was no impact on public sector wealth. However, in long term, the RBI’s wealth will increase due to extinguished liability of RBI towards unreturned notes.

On formalization / Digital transactions

The demonetisation has set off the digital revolution and many new users adopted digital payments for the first time. In long term, some of them would return to cash mode but digital revolution will continue.

On real estate

In short term, the prices declined and wealth fell. In long term, the prices could further fall because people have invested unaccounted income in real estate.

On broader economy

In the short term, there were job losses, decline in farm incomes, social disruption, particularly in cash intensive sectors. In long term, the economy should stabilize with remonetisation.

On GDP

In short term, the GDP reduced demand, supply as well as working capital and increase uncertainty in cash intensive sectors. However, the impact will be lesser on recorded GDP. In the long term, as the economy becomes more formalized, the underestimation would decline and recorded GDP will give realistic picture. GDP will increase with more share of formal economy.

Benefits of demonetization

The survey has enumerated various benefits of demonetization as follows:

Taxing black money

It has resulted in a transfer of wealth from holders of illicit black money to the public sector, which could have been used in various productive ways such as recapitalization of the banks and retire the government debts.

Tax Compliance

The move would lead to increased “tax compliance” because evaders may decide that it is better to pay regular tax than face a sudden penalty and social condemnation.

Tax on informal savings

The informal savings will be channelized into formal financial system and the deposits would provide a base for banks to provide more loan at low interest rates.

Digitalisation

One of the intermediate objectives of demonetization is to create a less-cash economy in India. This would ensure that the savings are done through formal financial system and tax compliance. The survey notes that India has very high predominance of cash consumer transactions relative to other countries. The Watal Committee recently estimated that cash accounts for about 78% of all the consumer payments. However, the survey also points out to impediments to digital transactions which include – lack of internet connectivity, lack of smart phones which are needed for mobile transactions, lack of enough POS (points of sales), lack of digital literacy and cybercrimes.

Steps taken by Government to promote digital transaction

The following are steps taken by the government to promote digital transactions:

• Launch of the BHIM (Bharat Interface for Money) app for smart phones. This is based on the new Unified Payments Interface (UPI) which has created inter operability of digital transactions.
• Launch of Aadhaar Merchant Pay, aimed at the 350 million who do not have phones. This enables anyone with just an Aadhaar number and a bank account to make a merchant payment using his biometric identification.
• Reductions in fees (Merchant Discount Rate) paid on digital transactions and transactions that use the UPI.
• Encouraging the adoption of POS devices beyond the current 1.5 million, through tariff reductions.

Way forward and Survey Recommendations

The most important effort must be to replenish the cash shortage as quickly as possible. The faster remonetisation takes place, the shorter and less severe will be the impact of demonetization. The RBI should re-establish internal convertibility, guaranteeing to give the public the amount of currency that the latter wants by elimination of withdrawal limit

Hence Demonetization is a powerful stick which now needs carrots as complements. A multi-pronged strategy could be adopted to complement demonetization needs to be adopted. Firstly, GST with broad coverage to include activities that are sources of black money should be implemented. Secondly, Individual income tax rates and real estate stamp duties could be reduced. Thirdly, Income tax net could be widened gradually and, consistent with constitutional arrangements. Finally, tax administration could be improved to reduce discretion and improve accountability.