India’s Lesson in Demonetization

This article was first published by the Global Association for Risk Professionals on November 18, 2016.
http://www.garp.org/#!/risk-intelligence/operational/political/a1Z40000003McKvEAK/indias-lesson-in-demonetization

The victory of Donald J. Trump in the U.S. presidential election was not the only surprise in the global news on November 8, 2016. That evening, Indian Prime Minister Narendra Modi addressed the nation and announced that Rs500 and Rs1000 currency notes would “cease to be legal tender,” effective at midnight. “This step will strengthen the hands of the common man in the fight against corruption, black money and fake currency,” he said.

The announcement shocked the nation. Technically speaking, the move was not unprecedented. But the demonetization was in 1978, and given that 65% of India’s population is under 35, memories of it are limited. According to news reports, http://www.business-standard.com/article/economy-policy/demonetisation-in-the-works-for-6-months-10-people-in-the-loop-including-raghuram-rajan-116111000009_1.html preparations were under way for six months and shrouded in secrecy. Only about 10 senior people in the prime minister’s office, Finance Ministry and Reserve Bank of India were aware.

The scheme in 1978 was not deemed to be very effective, as “the element of intended surprise and secrecy was also not well maintained and thousand rupees notes were already out of circulation one week before the demonetization. Reportedly large amounts of high denomination notes were sent to Gulf countries, especially to Dubai and Kuwait, a few days before the ordinance was announced.” (Kishore C. Samal, Chasing Black Money in India) http://www.ispepune.org.in/PDF%20ISSUE/1992/JISPE2/Chasing-Black-Money-in-India.pdf

So secrecy became an absolutely necessary condition. Any leaks would have rendered the entire exercise futile by tipping off the black-money hoarders.

In a 1976 paper, On Black Money, http://www.jstor.org/stable/pdf/42657322.pdf K. Sundaram and V. Pandit wrote, “Since it is infeasible to demonetize currencies of all denominations, the success of this policy [demonetization] turns on the extent to which black liquidity is in the shape of currency of the denominations to be demonetized.”

Data from the Reserve Bank of India show that 86% of all currency in circulation is in the Rs500 and Rs1000 denominations, amounting to Rs14.2 trillion, or $212 billion.

Sundaram and Pandit added: “. . . insofar as the measure is anticipated in advance by some and conversion of currency in the relevant denominations takes place, success of this measure is further eroded.”

The policy did not take care of black money in the form of real estate or gold or other non-currency  assets. There are expectations and rumors of crackdowns in the near future on those who have bought real estate and gold through black money.

Impetus to Go Cashless

While the Rs500 and Rs1000 notes were to be removed, Rs2000 notes have been introduced. People were given a window of 50 days to deposit and/or convert the 500 and 1,000 denominations at banks and post offices – a deposit bonanza for the banks that lowered bond yields. http://www.bloomberg.com/news/articles/2016-11-15/black-money-purge-drives-world-s-only-bond-gain-amid-trump-rout  There were limits on the amount of money that could be converted on a daily basis.

Those who got Rs500 and Rs1000 notes converted were handed Rs2000 notes by the banks; Rs100 notes were available at automated teller machines (ATMs). The long queues at ATMs, and out-of-order ATMs, indicated that many people were either without cash or, with Rs2000 notes, were unable to complete small-value transactions because retailers, unequipped with smaller-denomination notes, were not willing to accept the Rs2000 notes.

As a result, many people who had never used debit cards began to do so. Many small retailers and suppliers of daily provisions started asking people to pay by card, cheque or digital wallets – cashless modes of transactions that will bring greater transparency and help curb the creation of black money in the future.

Inflation and Taxation

Dr. Arvind Panagariya, vice chairman of NITI Aayog, http://niti.gov.in/ told the Economic Editors’ Conference—2016 that “as the black money goes out of the system, the money supply will shrink to some degree. This will reduce inflation rate in the absence of any open market interventions by the Reserve Bank of India.”

A drop in inflation, coupled with banks deposit flows, will give the RBI room to lower interest rates in the future.

The scheme is designed in such a way that people hoarding large amounts of undeclared income in cash will find it difficult to dispose of that cash. There are no limits to deposits of Rs500 and Rs1000 denominations, but it has been made clear that deposits above Rs250,000 would be scrutinized and matched with the account holders’ income tax returns. Mismatches could lead to penalties of 200% of the tax payable, along with the payment of the tax payable.

Modi Initiatives

One of the reasons for the Narendra Modi government’s coming to power was public reaction to scams and corruption. Modi promised to fight corruption and bring good governance and in his November 8 address listed previous measures taken:

·         A law passed in 2015 requiring disclosure of foreign black money.

·         Agreements with many countries, including the U.S., for sharing banking information.

·         A strict law in force from August 2016 to curb benami (nameless or fake-name) transactions.

·         A voluntary income-disclosure scheme for declaring black money after paying a stiff penalty.

The prime minister told the citizens that almost Rs1.25 trillion was uncovered due to these efforts in the last two and a half years. He vowed that many more measures will come in the future.

Acknowledging the inconveniences, Modi implored the citizens to be patient and support the fight against corruption – to accept temporary hardships in the interest of a better India.

Political Reaction

Although the national mood seems generally positive, there was strong opposition from other political parties. Indeed, many political activities in the country are funded with black money.

Then there are cynics. To them, I would suggest an analogy: Corruption and black money is like cancer. A patient might prefer to withhold information from doctors in order to avoid painful treatments, or might want to avoid treatments without 100% assurance of a cure, which is unrealistic.

Tackling black money is important and should not be avoided. No amount of preparation will be enough in a country of 1.2 billion people, and there is always room for improvement.

Singapore’s The Independent hailed the demonetization, saying, “Modi does a Lee Kuan Yew to stamp out corruption in India,” a reference to that country’s transformational leader.

Time will tell if the policy will contribute towards making India a fairer, transparent and corruption-free economy. Black money and corruption are so deep-rooted that they cannot be completely eliminated. More efforts and persistence will be required. To paraphrase Robert Frost, there are miles to go before we sleep.