Tuesday, January 24, 2017

Demonetization: The Longer Term

This article was first published in the Global Association for Risk Professionals on January 19, 2017

Beyond India’s near-term dislocations are possibilities for a wider and fairer tax net, financial inclusion and economic growth.

Little else has been on the minds of Indians since Prime Minister Narendra Modi announced the demonetization policy on November 8, 2016. It was undertaken primarily to curb black money and corruption in the Indian economy, a sweeping move with numerous intended and unintended impacts. A few positives are growth in cashless transactions, curtailment of counterfeit notes and terrorism financing, and creating a blip in the minds of tax avoiders. The negatives include the inconvenience to the public and short-term slowdown in many sectors, especially those that are heavily dependent on cash, a large portion of which are believed to be black money, like real estate and jewelry, loss of jobs, etc.

The prime minister asked the population to bear with the inconveniences for 50 days – but when that time passed, no magic wand was waved. What is clear is that the government pulled off an unprecedented gargantuan project and is in no mood to relent to the opposition. “We cannot allow this fight against black money and corruption to stop or slow down,” Modi said in a December 31 address to the nation.

In an earlier speech, the prime minister had said, “Demonetization is not the end, but beginning of a long, deep and constant battle against black money and corruption. It will benefit the poor and the common man. The poor and the lower and middle classes have suffered the most due to black money, counterfeit currency and corruption.”

The battle against black money is expected to be extended beyond cash, to properties, jewelry and gold, and foreign currency, in due course. A sizable parallel economy accentuates income inequality and is a deterrent for honest taxpayers. Hence there can be no question about the intent to curb it.

Success or Failure?
The Rs500 and Rs1,000 notes that were demonetized constituted about 86% of all currency in circulation. As per State Bank of India estimates, on November 9, the total value amounted to Rs 15,440 billion. It is further estimated that more than 90% of the demonetized currency has found its way back to the banks. (Please note that these are the estimates at the time of writing and may not be the final numbers. The government has raised concerns that there may have been double counting of the currency deposited in the banks and has asked the central bank, the Reserve Bank of India [RBI], to check the data again.)

Figure 1
Source: Hermes Investment Management, World Economic Forum

Further, many economists and politicians have argued that cash accounted for a very small percent of the overall black economy in India – 12% according to India Ratings and Research, a credit rating agency. The other 88% is in the form of real estate, jewelry, foreign currency, etc. In effect, only a small percent of the black money has been eradicated.

So was the entire exercise justified? Should the government have taken such a step for just about Rs1,000 billion, or even less?

That cannot be answered now. A couple of years from now, we may be in a better position to make more informed pronouncements rather than conjectures, with the benefit of data and hindsight. There are many far-reaching implications whose impact on the economy and lives of the people is thus far difficult to ascertain.

Hermes Investment Management’s emerging markets team, headed by Gary Greenberg, in a first-quarter Gemologist newsletter, looked beyond the immediate shocks in assessing a range of “Modinisation” reforms including demonetization: “Modi’s moves are excellent from a long-term perspective but the evidence suggests that some of the reforms will continue to have an adverse impact on earnings in the near term. Nevertheless, they create solid foundations for long-term sustainable growth driven by higher productivity – and this is what really matters, in economies everywhere.”

Long-Term Implications
Cashless economy: This will not happen overnight. India will not become a cashless society. However, a less-cash society is a possibility, and never before has India or any other country seen the kind of thrust towards digital payments that has resulted – a huge spurt in plastic card, online banking and e-wallet transactions since the ban was announced. There are infrastructural and cultural issues that must be overcome. Yet, with 65% of the population below the age of 35, change is possible.

Taxation: The prime minister mentioned in his December 31 speech that only 2.4 million people declare income of over Rs 1 million. This cannot be realistic. The number of luxury cars sold in India, the number of premium apartments sold each year, and the number of people going on foreign holidays all point towards the fact that many of those who earn more than Rs 1 million either don’t file tax returns or declare lesser income to avoid tax.

The government has said that about Rs 7,000 billion was deposited in 6 million accounts, and these will be scrutinized by the income tax department to find out if the deposits matched with the tax returns filed by these account holders. This action will definitely result in bringing more people into the tax net in the future.

Cash-less transactions have the added benefit of leaving audit trail that tax authorities can track. A broadened tax net would hopefully result in lower tax rates over time. Many smaller businesses that do not want to be a part of the formal economy due to high tax rates may then voluntarily consider being a part of it.

Economy and Banking
GDP: The parallel economy results in underestimation of gross domestic product. Former Prime Minister Manmohan Singh, a prominent economist himself, criticized demonetization and said that the GDP may decline by as much as 2%.

While this might be true in the near term, research has shown that corruption and black money have a negative impact on GDP and its growth rate. In the long run, reduction in corruption and black money should result in an increase in GDP, everything else being equal. Also, more cashless transactions will bring more small and medium-size enterprises into the formal economy.

Cost of capital: The banks are flooded with cash deposits and as a result have begun to lower interest rates. State Bank of India, the largest in the country, cut its lending rates by 90 basis points on January 1, and many other banks followed suit. While the RBI did not change the repo rate in its December policy review, the banks have still chosen to lower the rates. This indicates that the banks have decided to cut their margins and hope for volumes. The deposits will also have a multiplier effect in terms of stimulating investment.

Financial inclusion: The government used the opportunity to push financial inclusion by asking employers to open bank accounts for all their employees, including contract workers. Prasanna Tantri of the Indian School of Business, based on research published in top economic and finance journals, writes in Live Mint that moving money from home to the bank can have “enormous first-order benefits for the poor: The benefits would include increase in income, business investment and health spending, among other things.”

Prime Minister Modi stressed in his speech that re-monetization and bringing the banks to normalcy is the priority now. He also reiterated that demonetization was just the beginning of the battle to purify the nation of corruption and black money.

The story is still unfolding, so let’s not write off demonetization as a failed exercise quite yet. With appropriate use of technology and continued political will, it might just be what was needed.
Post a Comment