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.
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