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A broken promise: Demolishing Centre's rosy narrative on demonetisation

Prime Minister Narendra Modi on November 8 announced the decision to scrap Rs 500 and Rs 1000 notes. Here is an analysis of what government is claiming it would achieve.

Avinash Mehrotra Avinash Mehrotra New Delhi Published on: November 28, 2016 15:29 IST
demonetisation, note ban, Narendra Modi, BJP, NDA
Image Source : PTI A bank official displays the new Rs 500 currency notes in a bank in Jammu

Understanding the Promissory Note

The Government of India, through the governor of the Reserve Bank of India had “promised to pay” to the bearer of the currency note the sum mentioned on it. The note did not say, “I promise to pay if you prove you are a tax payer”. It did not say, I promise to pay only if you are an Indian, Adhar Card holder, etc. 

The promise was unconditional and without any limit, notwithstanding the number of promissory notes you may carry, e.g. Rs 4000 a day or even less. The Government of India has walked away from its promise and is looking at excuses for not honoring its promise. This is a very serious issue. Loss of faith in government will not improve the economic situation in any way.

I travel to many countries of the world. I have had many kinds of currency notes, which I have reused after many years. All of them work. Singapore has issued new kinds of notes many times over in the last two decades, right up to issuing plastic currency notes a few years ago. But my old paper notes, even those which are more than 20-year-old, still work. You can trust the Singapore currency. US-Dollars are the best example. 

When Europe changed its currency and all national currencies were demonetized, physical Euros in coins and notes were issued on January 1, 2002. The earliest to become unexchangeable were the Portuguese Escudos in coins which were cancelled on 31st December, 2002, while the notes remain valid till 2022. All Banknotes which were issued and valid on January 1, 2002 would remain valid till end 2012. 

On the other hand, in this demonetization, imagine an NRI whowent out of India a few years back, and has a few thousands in Indian currency with him for paying for taxi and other expenses. Will all these guys have to return to India before the 30th of December? They have been robbed of the value of the promissory note they had. 

The Loss of Trust at Banks 

Even my Bank is not trustworthy anymore. The deal was that I have given them my money for safe-keeping and it came with a promise to withdraw on demand. Now I cannot withdraw more than Rs 24,000 a week, even that if the Banks have the currency to issue. This is change in terms.  

This was not initially agreed upon. They are going back on a contract. This is unfair and illegal. The lines outside Banks and ATMs are looking like what happens in a Bank Rush. Are these Banks failing? No. Then why can’t they give me my money? 

The huge lines outside Banks and ATMs are evidence that the RBI’s management of the currency change has been completely ineffective. The small guy is seriously constrained in his day to life due to absence of money. Most people in India do their business in cash. The credit-default laws have been traditionally very week and even when a suit is successful it takes so much time that the lender’s business suffers seriously.  

The ability of the common man to live a cash free life comes from better financial infrastructure and ability to recover credit defaults fairly and in speed, and not from decisions like these. Demonetization without notice is bad in faith, bad in law and in principle. Not even Sweden, which has less than 2% of their money[1] in cash, is bale to go completely cashless. India’s number is more than 15%. 

The Tax Payers Feel Cheated As Well 

The assessment and collection of tax is a separate process. The Government cannot dump the failure of its efficiency in collection of tax on the people who trusted the government and accepted its currency. Only about 5% of Indian people pay income tax (estimate as per CBDT as of 2016).  

And the government does not know how many of them are tax thieves. Most of these tax payers are normal salary earners, small businesses and professionals, who are fully tax compliant. But even these people cannot exchange their currency notes. 

There is no incentive to being an honest tax payer. Had you not paid the taxes, and cheated on them, you could still draw 2000 from the ATM and 20,000 a week from the Banks. Why are these people being denied the use of their own hard earned and fully tax paid money?

Has The Stated Objective Been Achieved? 

The stated objectives are the removal of counterfeit currency, management of terrorist funding and exposure of Black Money, in that order. Let’s evaluate how the demonetization effects these. 

As to counterfeit currency, the government wants us to believe that Pakistan prints and pumps in counterfeits to destabilize the Indian Economy. Some questions that need to be answered are, 

Is Pakistan pumping in more counterfeit notes into the systems than the real notes that are going underground due to “black money”? Both these are ideas the government wants us to believe. If no, the impact should be minimal, and creating a national storm may not be required. 

Is the Pakistan made counterfeit is so good as to be undetectable? If yes, how will you avoid those notes going into the Bank? In the replacement drive, the hoarders and circulators of the counterfeit will be helped by the Banks not being able discern the notes due to the quality of the counterfeit compounded by the huge national rush in cash handling. And if the counterfeit is not good enough would educating the people of India in identifying the counterfeit not be a much easier exercise? 

What rocket science has gone into the making of the new currency that Pakistan will not be able to start delivering the high-quality counterfeits in a very short time? And what if the speed at which Pakistan provides the new notes is faster than the speed at which RBI can do it? How does demonetization help where better policing would not? 

And the ‘loss to the terrorists’ argument is equally frivolous. The proposed terrorist is Pakistan. Let us presume they were holding Rs 500 crores of counterfeits, which means only 50 Lac one thousand rupee notes. And let us now presume the cost of printing the same for them was 1.5 times the cost to RBI, which would become Rs 6 (The Hindu reported the cost to be Rs3.17to print one note of Rupees one thousand in 2012).  

This amounts to Rupees 3 Crores only, that considering the presumption that the counterfeits are good-quality, this cost can also be borne in counterfeits. Add one or two zeros to these numbers, and they still are extremely small change for Pakistan to afford. 

The impact on the terrorist funding should also appear to be not consequential.Assuming (but not admitting) that, for the next 50 days, the terrorists will also be busy depositing their respective monies into the Banks and would have no time to plan their events. But what after the 50 days?  

Each terrorist, or his host or contact in India, would be able to get Rs. 1.4 Lacs replaced from the Banks at 20K per week in seven weeks, and they can further deposit Rs 2.5 Lacs each into their bank accounts, no questions asked. Now, the Government will not be in a position to prevent the withdrawal of these deposits from these Banks after the 50 days, or the whole economic system will collapse. How much impact does this mean for the terrorists? 

Black Money Generators Go Unscathed 

Now let us discuss the exposure of Black Money theory. What is happening is that the Black money is moving a small cycle through the Bank and will come back stronger in the coming months. Let us look at an example: A trader has Rs 1 Crore in cash, presume it to be black, and has Rs 3 Crores of stock in his books, not black. He is forced to show sales of his inventory (not black) in the last month as cash sales, to be able to deposits the cash in his Bank account.  

He has a fully justified explanation for the deposit now. But what has happened is that his Rs 1 Crores worth of stock, which he showed as sold, is still lying with him, now black. So black money goes to bank and becomes white and white stock goes out of books and becomes black. In the next few months when he sells this stock for real, he will not be able to deposit that money in his account and his black money is back with him in new notes. Great achievement of exposure.  

Another example: someone who was in real-estate business and was sitting on lots of cash (presume black). He is now going to have to manage this cash back in to the Banks. Not very difficult, as he already has lot of construction going on. He will show inventory of construction material sold in cash and send to bank, he will pay his labor in cash and ask them to deposit in their bank, etc.  

All this money WILL go back in to the Bank. And in the next month, when he gets the new notes from Banks, he will withdraw and show labor payment, cash withdrawn is converted to black, and then use that to buy stocks again from the trader whose stock has become black. Full cycle. 

Whether there is demonetization or not, the black money generated by unscrupulous politicians and government officials in power will continue unabated. This is because there is aninherent transactional nature in the way, both corrupt politicians and government officialswork. 

There is nothing in demonetization drive that will stop the practice of they dispensing official favors in the form of licenses, building permits, governmental sanctions, immunities, prosecution, etc. for illegal gratification in hard cash.  

Politicians and government officials who have been corrupt for decades are not going to be reformed from their corrupt ways by this demonetization drive of the Government. Even today, bribes are still being sought for performing routine official functions. 

The real solution to black money problem is lower tax rates and simple and straight forward tax-laws, smaller and cheaper government, focusing more on self-compliance through incentives and automation than harassment and penalization, and most importantly reduce the various kinds of taxes, because if you want to escape only one tax which is trade-destroying at one time, you end up being non-compliant with all the taxes.  

The present government, on the contrary, is presently working hard to hire more tax officials, create more processes and prosecutions and create a bigger scare rather than comfort for the tax compliant. The total population of tax payers in India is less than 5% and the total number of persons who will be exchanging currency is over 95%.  

If the government actually does attempt to survey and validate each transaction of currency deposit or exchange, as presently proposed, or threatened, the cost of such processes would be far higher than the recovery coming from the same. 

Consequences In The Very Near Future 

Considering the experience of the last 15 days, the people have been able to change or deposit only about a third of the currency expected to come to the bank for exchange. Out of this, what gets deposited is also not allowed to be withdrawn. Thus, the quantity of the new currency brought in circulation is hardly 20%.  

This has caused extreme hardship to many people, and the queues outside banks have been ever increasing. The dissatisfaction is now turning violent, at many places. The rural are the most resilient, but if new currency is not quickly delivered there, and the farmers rise in violence, it will be unstoppable. How do they believe the government will not Demonetize the new notes before the next election? 

And even if all this gets managed, and India does nothing but exchange notes for 50 days, the productivity will fall. Also, if the productivity assisted by back money vanishes, GDP will be impacted. Losses of very immediate nature are showing up already. The inability to sell fruits and vegetables due to absence of currency is causing rotting food-stocks across India, mostly in suburbanareas where the organized retailers are not available (they accept plastic money). 

Further, if the black money based economy does vanish, as expected by the Government, many businesses, especially small and very small ones, will close shop due to inability to cope with the new tight regime. Many mid-size businesses will also downsize due to the loss of business. Real estate will come to a virtual stand-still.  

Hundreds of traders will be forced to reduce their stock holdings to match the reduced business cycles. All this will cause a short-term surge in unemployment too. Expect a 15% to 20% dip in the GDP for this quarter. Crime rate may increase substantially due to surge in unemployment as well as due to the vulnerability of the people to increased cash handling in the next few months. 

Corruption will surge substantially in the next few years fueled by the additional opportunities afforded to the officers due to the cash deposited. And not just Income tax, this will help make lots of money for State tax officers, Central Excise, Service Tax, and of the many other kids of tax officers too, who will be using the opportunity to imagine tax-loss due to an imaginary business from which the cash was generated.  

Even if you have all the answers, they are not bound to accept, harassment is certain, leading to corruption and increased litigation. The government instead of getting smaller is getting bigger. 

A thoroughly confused and complicated GST will add to the opportunities for bureaucratic corruption.  

Now Consider This 

As it appears from the above analysis, the Political Party in control of the government is bent upon taking the highest political mileage without considering the impact on the Indian Economy, they can also now go ahead and make good on their other promise, transferringmoney to each bank account out of the profits of black money eradication, whether the black money is eradicated or not. 

Say the government decides to transfer a sum of Rs 1 Lac to each savings account in India and makes a huge politically motivated show of having honored their promise to the poor man. The RBI’s annual report for the year 2014-15 shows that Indians have a total of 439.5 million (43.95 crore) savings accounts, including the Jan-Dhan Accounts.  

The report for 2015-16 is not out yet. Let’s presume that by the time the government is ready for the next general elections, driven by the force of Jan-Dhan scheme and also the fact that “black money has been eradicated”, the people of India have 50 crore (500 million) active accounts. If the government does the trick, they only need to credit Rs. 50 Lac Crores to these accounts, around 1 years GDP.

This is not an impossible figure for the government to make this plan possible. The resulting inflation will kill the whole and a little more of the gain in a very short time, but the election would have been won by then, let the economy go to dogs. 

Someone has failed to think the whole thing through and has caused the whole nation to suffer serious pain, loss of credibility, immense cost of new currency (printing, circulation and logistics), and serious difficulties to the common man who has nothing to do with any of your purposes – counterfeits, terrorists or black money. Or, may be, there was some other motive which prompted this move, and to hell with the common man and his trouble. 

Disclaimer: The author is a financial and management consultant. Views expressed are personal. 

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