Demystifying the Demonetization Demon

Article Originally Published in the Salute magazine 

http://www.salute.co.in/demystifying-the-demonetisation-demon/

Much has been written and said about the demonetisation move of the government that was triggered on midnight of November 8th of 2016. And yet, the ramifications of the initiative is yet to be understood in the larger context. Demonetisation sucked out 86% by value of currency notes from the Indian economy, which is a highly cash dependent economy for monetary transactions.

Demonetisation is not a new tool and has been adopted in India twice before in 1946 and 1978, albeit in a significantly smaller scale. Demonetisation has also been used in other countries such as Myanmar, Zimbabwe, UK, US, France, England, Holland, etc. It was adopted in India purportedly for two reasons, (a) for curtailing black money and (b) for curtailing FICN (Fake Indian Currency Notes), crime and terrorism. It also has an impact on the political process and influencing of voters through cash incentives that impacts the cornerstone of democracy – the fair judgment of the people.

If media reports are to be believed, then clearly, demonetisation has had an undeniable significant impact on FICN and on crime and terrorism, including human trafficking, stone pelting, rioting etc. Each of these activities have apparently come down significantly since demonetisation was effected.

To understand the impact of demonetisation on its primary objective of curtailing black money, one needs to understand the mechanisms of (a) generation of black money, (b) transmission of black money and (c) hoarding of black money.

Black money is generated either because of income from illegitimate activities such as crime, rent-seeking, corruption etc or because of tax (indirect taxes or direct taxes) not been paid on sales or income generated from legitimate sources such as property transactions, transactions of good and services etc. Illegitimate wealth is also acquired through transfer mispricing, round tripping, leveraging treaty loopholes and these become white money if the process is undetected and if tax is eventually paid on it as declared legitimate income. As per the World Bank estimates, black money in India in 2007 constituted 23% of the economy. Subsequent estimates, using the same model, shows that the proportion of black money in India had sharply risen to over 30% of the economy by 2014. However, all these are estimates and by definition, the amount of black money is not known with any level of certainty. But what is largely agreed upon is that the black money is a considerable part of the total Indian economy and clearly, it is intertwined with the white economy. It is akin to cancer wherein taking out the cancerous parts also impacts the healthy parts of the body. Therefore, any action to curb black money, needs to be done with deep analysis of its impact.

India recently became the fifth largest economy in the world, surpassing the UK’s economy. If the black part of the Indian economy is added to the total Indian economy, Indian economy would surpass Germany’s economy to become the fourth largest economy in the world, and would become the third largest economy by 2020, surpassing Japan.

Black money is transmitted primarily in the form of cash, but is also reportedly transmitted in the form of gold, benami properties and foreign assets. Therefore, any step to curb black money transmission, would need to impact all these mechanisms of transmitting black, with the primary target being large cash transmissions.

Finally, black money is stored in five key asset classes. These are (a) cash, (b) gold, (c) real estate, especially benami, (d) benami stocks and mutual funds and (e) foreign assets. Hence, any realistic assault on black money would need to target all these asset classes.Clearly, demonetisation apparently only targets cash in hand. In addition, as per the popular commentary, demonetisation does not impact the other asset classes of black money. However, contrary to the popular commentary, this is not necessarily true.

Demonetisation impacts all asset classes of black money. This is because when black money is to be used eventually, it would be used to pay someone. That would imply that in most cases, the asset class needs to be converted into cash or gold to be paid. As large cash transactions would imply transacting with hoarded cash which becomes a difficult proposition after demonetisation or would imply withdrawal of large amounts of cash from banks, which also becomes a difficult proposition in the transformed government systems. In addition, the regulations on purchase of gold would also tighten large amount of conversion of any other black asset classes to gold. So clearly, demonetisation will have impact on all asset classes of black money by choking the transmission of the money, which primarily would happen through cash or through gold. However, it may not stop transmission of black money through transfer of real estate or foreign assets. But such transactions would be difficult as the value of the real estate may be more or less than the value of black money that is to be transmitted.

Clearly, to further tighten the operating envelope around black money, more steps need to be taken besides just demonetisation. Cash and gold are getting targeted by existing legal and regulatory steps. But what about real estate and foreign assets? In what has emerged from the last radio address for the year 2016, the Prime Minister has made it clear that the Benami property act that was passed in 1988, but was never notified, will get notified in the form of Benami Transactions (Prohibition) Amendment Act, 2016. The act would provide teeth for using modern analytics to track down and choke out black money stocked in benami real estate. It may not be easy, given the issues with property systems in place, that are deed based and not title based. However, it would allow the initiation of the process of squeezing out benami from real estate.

Similarly, the Tax Information Exchange Agreements (TIEA) with 13 countries, in addition to the reported information exchange agreement with Switzerland, is expected to tighten the flow of black money into foreign assets and to uncover existing black money stashed away in foreign assets.

The triangulation of all these information sources, in addition to information of consumption by individuals in the form of foreign trips, purchase of high value items etc, will be used to find mismatches between declared incomes and detected incomes, helping the government machinery to further clampdown on the generation, transmission and storage of black money assets.

In addition, a slew of regulatory measures will provide significant disincentives to tax avoidance. GST being the first of the lot, which will ensure that indirect tax avoidance is disincentivised and curbed. Other regulatory measures include GAAR (General Anti Avoidance Regulation) for dis-incentivising tax avoidance structures, POEM (Place of Effective Management) to curb tax avoidance that leverages cross border tax arbitrages etc. It is also expected that direct tax rates will be rationalised to reduce burden on the 3% who file direct tax returns (and an even smaller number of the 3% actually pay any direct taxes) and incentivise others to start paying their direct tax share.

The process also provides greater regulatory teeth to dealing with any future discovery of cash stashes as even purportedly legal sources of income such as agricultural income, cannot be cited as reasons to have a cash hoarding as it is illegal to take out large sums of cash from the bank. So it seems logical to believe that even if some people may have connived with the bank staff to convert their old cash hoardings into new cash hoardings, it would be a matter of time that this black money gets caught or it stays unusable.

The process of squeezing out black money from the economy will not come without a cost. As the large number of digital havenots do not have access to digital money and are overwhelmingly dependent on cash for daily transactions, it is going to cause considerable hardship to this lot till they move into the formal banking systems and get empowered by semidigital interfaces such as Aadhar based payments wherein only their thumbprint would enable them to make a payment, making plastic cards or smart phones irrelevant for payments. Of course, the entity receiving the payments need to have the requisite digital assets to receive the payments. In the process, India will emerge as a global powerhouse in fintech solutions and can export the same to other economies, including the advanced economies.

Demonetisation may also increase the NPA’s (bad loans) of banks as more assets may become non-performing due to reduced demand for goods and services in the short run. Also, reducing availability of black money itself will impact sectors that attracted large black money spends such as luxury products, tourism etc. This again would impact the economy negatively. One can already see the impact it is having on the wedding industry, where the weddings have become significantly muted. However, this can also be viewed as a positive equalisation effect in the society as the crass show of wealth was driving a wedge between the haves and have-nots and creating considerable dissonance in the social fabric.

This is also perhaps one of the reasons why there appears to be a strong groundswell of support from the masses, despite being negatively impacted in the short run.The larger positive impact of the demonetisation move will be in the form of reduced cost of capital as the unproductively lying cash assets are now available with the banks to redeploy for productive use. In addition, with the fall in real estate costs, it would incentivise industries to borrow capital and leverage lower cost of real-estate to start new ventures that would employ more people and create jobs.

As mentioned earlier, demonetisation will also have a positive impact by reducing the distortion in democracy brought in through vote buying through cash. It would now be difficult to pay large number of people anonymously without using cash and it would be difficult to hoard large amounts of cash. This may motivate people to vote for the right reasons and not because of cash incentives. This may bring in better governance as the country moves forward.

In summary, the verdict on the demonetisation initiative would be the measure of the black money reduced compared to the red bottom lines that may be incurred by companies and by individuals. But the impact of black money will not be confined to the realm of economics. It would definitely have an impact on the thought process and attitude of the people, the social fabric, the corporations and the politics of the nation.

—Jaijit Bhattacharya is a noted Government transformation expert and is Partner at KPMG. He is also President of Centre for Digital Economy Policy Research (C-DEP)and Adjunct Professor at IIT Delhi.