Sunday, Nov 27, 2022

‘You can’t diet for a few days and quit, demonetisation needs policy follow-up’

Ila Patnaik described several aspects of demonetisation to readers of The Indian Express at the second edition of Express Explained in Mumbai recently.

demonetisation, demonetisation effects, demonetisation damage, atm line, no cash, atm money, narendra modi, demonetisation debate, illa patnaik, CPI infaltion, clack money, demonetisation corruption, rs 500 ban, rs 1000 ban, note ban, indian express news, business news Economist Ila Patnaik in conversation with The Indian Express National Affairs Editor P Vaidyanathan Iyer.  Source: Nirmal Harindran & Prashant Nadkar

With many ATMs loaded again, the immediate blow of demonetisation has begun to ease. This week, the Prime Minister defended his November 8, 2016 decision in Parliament. But the debate remains open, and the full impact of the move will unfold over the rest of the year.

Background: The economic context

Demonetisation exercises the world over have been carried out at times of hyperinflation and falling trust in the currency. India had seen two rounds of demonetisation before 2016: in 1946 and 1978 — Rs 1,000, Rs 5000 and Rs 10,000 notes were junked on the latter occasion. In 1978, the value of the demonetised currency was Rs 80 crore, and the Rs 1,000 note of the time would be worth Rs 18,000 now.

In November 2016, India was growing at 6.5%-7%, the rupee was stable, and CPI inflation was less than 5%. On the eve of demonetisation, the total value of India’s currency was Rs 17.7 lakh crore, and Rs 500s and Rs 1000s were 87% of it. By the beginning of 2017, almost all of this Rs 15.5 lakh crore was back in the system.

What is the size of the black economy in India? How is it ‘bad’, and how does it hurt the economy?

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Money or income on which taxes have been evaded is ‘black’ even if they have been generated by legal means. The other kind of black money is the one generated through illegal activities: drugs, counterfeiting, bribery, money laundering, smuggling, etc. There are several estimates of the size of the ‘legal’ black economy; I am not sure you can pin down any one number. Most people agree on the ‘30% estimate’. To assess whether demonetisation attacks black money, we need to consider how much black money is held in cash. In some sectors, such as real estate, a lot of cash is indeed used. But it must be remembered that holding cash is a loss-making proposition, so those who have black money would not like to hold large amounts of it in cash. On whether black money is ‘bad’, I don’t think there can be any disagreement over whether income that comes from illegal activity, or even legal income on which taxes have not been paid, is good or bad…

87% of notes were 500s and 1000s, government data say that between 2011 and 2016, the economy grew by about 30%, currency in circulation by 40%, 500-rupee notes by 107%, and 1,000s by 76%. So, high-value currency growth rate outpaced both the growth rate of the economy and of overall currency in circulation. How did 500s and 1,000s become so ubiquitous? Are they really ‘high-value’, then?

They are not high-value. Let’s also differentiate between number of transactions and value added (to the economy). Think of a situation wherein a farmer grows wheat, makes flour out of it, and finally rotis. No money has been exchanged, but a certain value has been added (to the production process). Now think of an economy where there is a lot more division of labour. Somebody produces the grain, somebody else transports it, a third person mills it, a fourth puts it in a bag, a fifth sells it, a sixth makes rotis and sells them. Think of how many times money changes hands. In this scenario, you need many notes; you didn’t need them in the first scenario. As an economy becomes more complex, it is natural to need money. Money is a medium of exchange; that was the main reason for the existence of the 500-rupee note. Everyone had and used them, which was natural and necessary because of the very complexity of the economy.


Between November 8 and December 20, 2016, about Rs 3.25 lakh crore came into 2 crore new accounts that were opened during that period. Were people holding crores, ill-gotten or not, that they were forced to bring out after demonetisation? Will this be a deterrence against hoarding black money?

There was money with everyone, grandmothers, women in rural areas, which they had to change. It could also be that some people made their black money white by paying tax, that will show up as higher tax payment… Let’s wait and see what data comes up. About deterrence, well, it depends on what happens next. It’s like a detox diet. If one does something for a few days, it does make a difference initially, but we have to keep at it. In the optimistic scenario, if we all change after this, decide that we won’t hoard cash, that’s great; but there’s also the scenario in which we give up the diet, and next year we have to go on another diet. So this exercise did flush out some money, but what happens after this really depends on the policy regime, tax regime, behavioural changes, etc. Especially because there were costs to people who were not the guilty party.

Is there a worry that the government might unleash the taxman on the people to take this battle to what it might think is its logical conclusion?


What improves tax compliance? One, it is about the tax system as a whole: you reduce exemptions, plug loopholes, etc. Second, in the real estate sector, it could help to work on the long-term capital gains tax and stamp duty rates, which should actually go. There have been many studies and a large number of recommendations on which there is agreement. On the other hand, is increasing the discretionary power of tax administration a good thing and does it increase tax compliance? No. The recipe for improving tax compliance is not rocket science. There are innumerable reports, let’s just go down that path rather than doing things which we know have not worked.

Among the objectives of demonetisation were fighting corruption and black money, and weeding out counterfeit currency, which is also used in terror activities. Do you think demonetisation helps tackle these problems?

First, we are always looking for a magic pill for problems with which we have been struggling for many years, and solutions for which are actually slow, painful and politically difficult. Second, in policymaking, all aspects must be considered, and a detailed cost-benefit analysis must be done for each, before a decision is made. In the case of black money, for example, if our objective was to tackle just the ‘stock’, then it’s fine, but if it was the ‘flow’, then a different set of policies was needed. Third, yes, new notes with new security features should be introduced, yes, we should try to keep ahead of counterfeitors, but you don’t demonetise overnight. On counter-terrorism, again, at the moment the money that some elements have would have become useless. The government estimates this to be about Rs 400 crore. But we must compare that with Rs 15 lakh crore, and do a cost-benefit analysis.

Was the secrecy around this exercise required in your view?

The only thing for which secrecy makes sense would be to tackle the stock of black money. How much was that stock of cash? It was the part that did not come back. Was all of this, the secrecy, worth it?


One of the things that did happen though, was the huge jump in digital transactions. Would it have been possible to achieve this in a country like India without an exercise such as this?

For perspective, when digital transactions are 3% of all transactions, what is a 200% increase? Convenience is a key objective of digitisation, but the infrastructure isn’t ready. The BHIM app has high failure rates during transactions, because bank servers aren’t ready.

First published on: 09-02-2017 at 01:06:05 am
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