UPSC Mains 2019: Black hole of silence on demonetization

Demonetization

 

Topic: Black hole of silence on demonetization

Topic in Syllabus: GS Paper 3 : Indian Economy

Demonetization

 

Context:

There is one “surgical strike” from two years ago that will not be celebrated this year the 8 November 2016 demonetization of ₹500 and ₹1,000 currency notes. Two years on, the economy and its institutions continue to experience the negative after-effects of the processes and the events surrounding demonetization.

 

More about on news:

  • Since there is always an official fog of rationalisation spread around demonetization, it is important to remember what the objectives were as laid down in that late evening speech on 8 November 2016 of Prime Minister Narendra Modi and the gazette notification later that same day.
  • The prime minister outlined three sets of objectives, (i) “to break the back” of corruption and black money, (ii) to end the circulation of fake currency and (iii) to end terrorist financing. The gazette notification outlined the same three objectives but did not mention corruption.
  • The BJP-led NDA government, which places so much importance on packaging, had to suitably wrap demonetization in a manner that would sell. It was therefore not surprising that ending fake currency circulation and terrorism financing were tagged along with the main objective of rooting out black money.

 

Demonetization:

  • Demonetization is a situation where the Central Bank of the country (Reserve Bank in India) withdraws the old currency notes of certain denomination as an official mode of payment.
  • Demonetization is the act of stripping a currency unit of its status as legal tender.
  • It occurs whenever there is a change of national currency: The current form or forms of money is pulled from circulation and retired, often to be replaced with new notes or coins.
  • Sometimes, a country completely replaces the old currency with new currency.
  • The opposite of demonetization is remonetization, in which a form of payment is restored as legal tender.

 

Demonetization is undertaken by nations for a number of reasons:

  • to combat inflation
  • to combat corruption and crime (counterfeiting, tax evasion)
  • to discourage a cash-dependent economy
  • to facilitate trade

 

India’s Demonetization:

  • In 2016, the Indian government decided to demonetize the 500- and 1000- rupee notes, the two biggest denominations in its currency system these notes accounted for 86% of the country’s circulating cash.
  • With little warning, India’s Prime Minister Narendra Modi announced to the citizenry on Nov. 8 that those notes were worthless, effective immediately – and they had until the end of the year to deposit or exchange them for newly introduced 2000 rupee and 500 rupee bills.
  • The government also introduced new Rs 500 and Rs 2000 notes and urged people to move towards cash-less economy. But the opposition has been protesting the government’s decision, even stalling Parliament. A ‘Jan Aakrosh Diwas’ was observed by Left and other major parties.
  • The Reserve Bank of India on August 30, 2017 released its report on demonetisation. In the report, it said 99 per cent of the banned notes came back into the banking system which trashes all claims of Narendra Modi that the move will flush out the black money and counterfeit currency.
  • With 99 per cent currency back in the system, the failure of demonetization hints two things, either the black money held in cash was very low or the government failed to implement the demonetization efficiently and all the black money held in Rs. 500 and Rs. 1000 bank notes laundered back to the banking system.
  • The government’s goal (and rationale for the abrupt announcement) was to combat India’s thriving underground economy on several fronts eradicate counterfeit currency, fight tax evasion (only 1% of the population pays taxes), eliminate black money gotten from money laundering and terrorist-financing activities, and to promote a cashless economy.
  • Individuals and entities with huge sums of black money gotten from parallel cash systems were forced to take their large-denomination notes to a bank, which was by law required to acquire tax information on them.
  • The Specified Bank Notes (Cessation of Liabilities) Ordinance, 2016 was issued by the Government of India on 28 December 2016 ceasing the liability of the government for the banned bank notes.
  • Demonetization technically is a liquidity shock a sudden stop in terms of currency availability.
  • It created a situation where lack of currencies jams consumption, investment, production, employment etc.

 

India’s past experience with demonetization:

  • This is not the first time that demonetisation has been implemented in India. In 1936, Rs 10,000, which was the highest denomination note, was introduced but was demonetised in 1946.
  • India has carried out demonetization exercises twice before, in 1946 and 1978.
  • In Jan 1978 episode, currency worth INR 1.46 bn (1.7% of total notes in circulation was demonetized. Of this INR 1.0 bn (or 68%) was tendered back.
  • In 1978 the value of demonetisation was very small (only 0.1% of GDP). However, the 2016 demonetisation efforts covers 86% of the total currency in circulation (11% of GDP).

 

Following are the main impacts.

  • Currency crunch in our economy
  • Welfare loss for the currency using population.
  • Consumption was adversely affected
  • Consumption
  • Production
  • Employment
  • Growth
  • Tax revenue
  • Loss of Growth momentum
  • Increase in bank deposits and reduced interest rate
  • Countering of black money
  • Check on counterfeit currency

 

How money laundering took place?

  • The total reduction in black money was much smaller than what might have been envisaged. To the extent that it was possible to exchange money legally, individuals did so. After that it was done illegally.
  • Those who could not exchange money legally found money changers. When the government announced that old notes could no longer be exchanged, but only deposited, new ways of changing the stock of unaccounted cash emerged. Individuals with bank accounts, including Jan Dhan accounts, and companies showing cash accrual from sales came into business.
  • Large amounts could be laundered through this route as it did not involve immediate cash payouts by banks, since cash shortages still persisted with the RBI and banks scrambling to remonetise the economy.
  • Even when people have to pay tax on their hoarded cash, and a change fee they preferred to do that rather than lose the whole amount.
  • Data from Prowess, a database of companies in India, shows that in the quarter of demonetisation, when purchasing power had fallen sharply, net sales by companies rose significantly.
  • At the same time, the number of tax payers and tax collections rose. The tax department is said to have found thousands of shell companies which were possibly engaging in the activity of depositing money in their accounts during the demonetisation period, claiming that it was cash from sales. This provided a means for laundering money.
  • There is no doubt that those with holdings of unaccounted cash lost some of their wealth in the process of laundering it. To some extent, taxes were paid on it in the process of legitimising it. But in addition to that, illicit wealth was redistributed from black money holders to money launderers. Whether the money launderer was a company owner, a bank employee or a Jan Dhan account holder, there was now a need breed of criminals with wealth obtained from illegal means.

 

Potential advantages of demonetization:

  • Attack on the scourge of black money, tackling corruption, counterfeit currency, terror funding and reducing dependence on cash.
  • Changed narrative from Black money to cashless economy
  • The original intent of demonetisation was to address the issue of black money. There is enough work that suggests that people with black money hold a very small proportion of it in cash. Most of it is usually invested in gold, or real estate, or in the stock market, or abroad, and the share of black cash is 6% of the total black economy.
  • The primary pitch and narrative of the demonetisation drive by Prime Minister seems to have taken a major shift to cashless economy from the initial key highlights of war against black money, corruption and counterfeit currency.
  • Now Government says that idle money has come into the system, the cash-to-GDP ratio will decline; the tax base will expand. But none of these required demonetisation and could have been implemented independently.
  • The government now also said that demonetisation is only one of the many steps to tackle the black economy.
  • The government’s argument that cash coming back to the banks will enable it to catch the generators of black income, and there will be formalisation of the economy, may not hold.
  • Then the goalposts started shifting when it became apparent that the main reason was not justified by what was happening. First it was cashless, then less cash economy, then formalisation of the economy. The final step was in saying this would give IT authorities the information to go after people who had deposited black money.

 

Analysis:

 When, soon after November 2016, the aim of destroying black money looked to fail, the government’s attention shifted to creating new objectives and to then arguing that the deposits of the HDNs in banks was a positive development because this gave the government information that it could use to track down the money-launderers.

 

The big shift in objectives was of course to talk about digitalisation, better tax compliance, “formalisation” of the economy, the goods and services tax (GST) and demonetization as inter-connected parts of one giant mosaic of a modern and clean economy in which the success of the announcement on 8 November 2016 was crucial.

  • First, nobody was going to be fooled with this new grand narrative. Everyone knew that this was an ex-post rationalisation as the black money objective began to collapse.
  • Second, demonetization—a surprise decision eight months before the tortuous introduction of GST—was a disruption that did not make the transition to GST easy.
  • Third, digitalisation was not a new initiative it had been in progress since the early 2000s. Demonetization did compel an acceleration in the process (which subsequently slowed but has since remained at a higher level of adoption), but as many have said we did not need the sledgehammer of demonetization to push digitalisation.
  • Fourth, this new talk of “formalisation” of the economy driven by digitalisation, demonetization and GST seemed to see the vast informal sector as nothing more than a community involved in regulatory arbitrage and tax evasion. Such talk ignored the fact that while there are indeed arbitrageurs and tax evaders in the informal sector, India’s ocean of informal activity consists of workers involved in low productivity jobs because there is no alternative.
  • Fifth, credit is claimed for and much is made of the fact that the cash-GDP ratio post demonetization is now about 1.5 to 2 percentage points less than before. It is always assumed that a less cash-intensive economy is a mark of progress. Yet, Japan and Switzerland have much higher cash-GP ratios than India and no one sees them as being backward. True, the use of cash can mask an audit trail and facilitate tax evasion. But we should not be blind to the fact that the larger part of black money generation now takes place inside and not outside the circuits of the banking system. Nirav Modi and Mehsul “Bhai” Choksi looted the banks and transferred wealth through banking channels; they did not do so with suitcases of cash.
  • Finally, there is the metric of improved tax compliance. Depending on what the data can be made to say, the metric that is used by the government to claim success is either (i) income tax collections, or (ii) number of returns filed, or (iii) the number of assesses or (iv) the income declared. Direct tax collections have indeed gone up. Some of it is to be expected as the money launderers make one-off payment of income tax. Some of it is also because to register under GST you also needed to be filing returns and with a PAN.
  • After a 6.6% growth in direct tax collections in 2014-15, there was an acceleration to 14.5% in 2016-17 and then to 18% (unaudited) in 2017-18. Yet, it is far too early to claim any transformation in tax revenue collections. Growth of over 15% in a year is not unusual. In 2010-11 as in 2017-18, direct tax collections jumped by 18% before growth fell off thereafter.

 

Objective seems unachieved:

  • The objective of reducing counterfeit currency seems unachieved.
  • In 2015, the National Investigation Agency established that at any point only Rs. 400 crore of counterfeit currency is in circulation. That’s 0.028% of total currency.
  • Now, CNBC has calculated only 0.0007% of the returned Rs. 1,000 notes as being fake and only 0.002% of the Rs. 500 notes.
  • In value terms the total is just Rs. 41 crore. So either a lot of fake currency hasn’t been detected or didn’t exist.
  • In terms of tackling terror funding, the Finance Ministry has said: “As a result of demonetisation of specified bank notes, terrorist and Naxalite financing stopped almost entirely.” But no proof has been provided.
  • Reduced dependence on cash: Both in number and value, digital transactions increased sharply after November but also dipped sizeably thereafter.
  • There were 671.49 million transactions in November, rising to 957.50 million in December before shrinking to 862.38 million in July. So, the use of cash initially diminished but has been steadily increasing thereafter.

 

Criticism against demonetization

  • Critics say, the Demonetisation as a means of tackling the black economy, carried out on the incorrect premise that black money means cash. It was thought that if cash was squeezed out, the black economy would be eliminated. But cash is only one component of black wealth: about 1% of it.
  • Black money is a result of black income generation. This is produced by various means which are not affected by the one-shot squeezing out of cash.
  • Any black cash squeezed out by demonetization would then quickly get regenerated.
  • So, there is little impact of demonetization on the black economy, on either wealth or incomes.

 

Negative economic consequence of demonetization:

  • The disruption of unorganized supply chains that are dependent on cash transactions; it is still not clear how smoothly they were being rebuilt as the economy was remonetized.
  • No less has been the damage to institutional credibility. The RBI is yet to convincingly demonstrate that the demonetisation decision was not forced on it. At any rate, it was ill-prepared to deal with the aftermath, in terms of making available adequate quantity of replacement notes in the right denominations.
  • That remonetised notes are mostly of the illiquid Rs 2,000 denomination — constituting over 50 per cent of the total value of currency in circulation even as late as March 31 — didn’t help matters.
  • The economic costs— whether manifested in a crash in farm produce prices or a wide swathe of cash-dependent informal enterprises going bust, not to mention the sheer time wasted waiting in lines — are incalculable.
  • In the period immediately after demonetisation, there was expectation that it would bring a windfall for the Centre. To the extent that the scrapped Rs 500 and Rs 1,000 denomination notes were not deposited or exchanged at banks — especially by those who had hoarded their ill-gotten wealth significantly in cash — the resultant reduction in the Reserve Bank of India’s (RBI) currency liabilities would generate a “profit”, which it could then distribute as dividend to the government. But this did not happen.

 

Significant gains from demonetization:

  • Nobel laureate Kailash Satyarthiand others working to fight human trafficking said that the note ban had led to a huge fall in sex trafficking.
  • The Demonetisation has badly hit Maoist and Naxalites as well. The surrender rate has reached its highest since the demonetisation is announced. It is said that the money these organisations have collected over the years have left with no value and it has caused them to reach to this decision.
  • Mumbai Police reported a setback to Hawala operations. Hawala dealers in Kerala were also affected. The Jammu and Kashmir Police reported the effect of demonetisation on hawala transactions of separatists.
  • Several e-commerce companies hailed the demonetisation decision as an impetus to an increase in digital payments, hoping that it would lead to a decline in COD returns which could cut down their costs.
  • The demand for point of sales (POS) or card swipe machines increased. E-payment options like PayTM and Instamojo Payment Gateway, PayUMoney also saw a rise.
  • The number of I-T returns filed for 2016-17 grew by 25 per cent and the advance tax collections during that period rose 41.8% over the 1-year period, as increased number of individuals filed their tax returns post demonetization.

 

Way forward:

  • Government should focus on ensuring growth, job creation and investment. The urgent need is to get the private sector to start investing. One way to avoid winds of deflation is to kick-start private investments.
  • Reviving the investment cycle and tackling bad loans will be the key challenges to be tackled on a priority basis in the current fiscal.
  • Government has launched a multipronged attack on corruption and black money. Government discretion has been reduced particularly in the allocation of natural resources.
  • There is a concerted attempt to improve ease of doing business, and technology is being used to deliver public services without leakages.
  • It is far too early to write-off any of these efforts, and demonetisation. There is a future beyond the present.

 

Sample Question:

What were the objectives of demonetization? How far was it successful? Critically analyze.