Maximum pain

Objectives of demonetisation could have been served better by doing a cost benefit analysis

Written by Ila Patnaik | Published: September 1, 2017 12:36 am
demonetisation, rbi annual report, demonetisation objective, cost benefit analysis, demonetised notes, indian express editorial This number does not include the old notes with District Central Cooperative Banks for the short window when they were allowed to accept deposits. (Illustration by C R Sasikumar)

The RBI Annual Report reveals that almost all demonetised notes have been returned to the central bank. This number does not include the old notes with District Central Cooperative Banks for the short window when they were allowed to accept deposits. It also does not include the notes within Nepal. The shortfall of Rs 16,050 crore between the notes in circulation when the notes were demonetised and those that were returned, could therefore also be made up once these notes are returned to the RBI.

It should come as no surprise that almost all the notes have been returned, including the stock of black money held as cash. To the extent that it was possible to exchange money legally, individuals did so. When cash limits for withdrawal made it difficult, friends and families participated. The inconvenience of long queues was overcome by household staff. A private company offered booking of “chhotus”, who would stand in long queues for people for Rs 90 an hour until their turn came. Bank employees were averse to being unhelpful to regular customers and found ways to serve them. Innumerable ways were found to work around the changing rules of exchange, cash limits, indelible ink and specified uses of old notes.

Those who could not exchange money legally found money changers. Innumerable anecdotes, media reports and arrests of bank staff tell stories about how this was done all over the country. 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.

It was to be expected that even if people have to pay tax on their hoarded cash, and a change fee, they would prefer 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.

The total currency in circulation, according to the RBI’s annual report, is about Rs 2 lakh crore short of the pre-demonetisation period. This is partly due to the increase in focus on printing of lower denomination currency notes. Initially, the RBI had focused on printing the Rs 2,000 notes to rapidly remonetise the economy. In addition, there could be some reluctance to hold cash. The replacement of cash transactions by digital transactions, the slowdown in small-scale industry, in the rural economy, construction and other informal segments of the economy could also lead to somewhat lower demand for cash. However, it is less probable that the cash of black money holders has not been withdrawn because they are unlikely to leave that in the bank accounts of the money launderers for long. It might have partly been settled for bitcoins, gold, or similar assets that are difficult to trace.

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. The total reduction in black money was therefore much smaller than what might have been envisaged.

International evidence suggests that few countries address the problem of black money by demonetising their currencies. If the problem is large-scale crime, corruption, bribery, bureaucrat-politician nexus, rent seeking, tax evasion etc. the answer lies in reforming the criminal justice system, law and order, administrative reforms, bringing transparency in the functioning of the state and rationalisation and simplification of the tax system. In this context, the GST will be a far more effective mechanism to bring down tax evasion in indirect taxes considering the greater incentive for compliance that its design holds.

The real rationale for new notes by the RBI is a rather innocuous paragraph hidden away in its Annual Report. It says: “As a standard international practice, the design and security features of banknotes are reviewed periodically. In line with this practice, a new series (Mahatma Gandhi New Series) of banknotes in new design, dimensions and denominations, highlighting the cultural heritage and scientific achievements of the country, was introduced during the year. As part of this process, banknotes in the denominations of 500 and 2000 were introduced on November 8, 2016. New design notes in other denominations are due for phased introduction.” (Section VIII.15, RBI Annual Report 2016-17).

The best way of achieving this objective would have been to slowly replace old notes with new ones, giving the public adequate time to exchange and deposit old notes, as is also “standard international practice”. The outcome would have been the same. The pain would have been much lower.

This episode in India’s policy-making highlights an essential tenet of policy-making — the need for a cost benefit analysis. For any objective that is to be achieved, we need to examine various policy options and analyse their costs and efficacy. For an economy on the path of reform, with many more reforms still to come, long-term sustainable impact can be achieved only when we strengthen the policy-making process as well.

The writer is professor, National Institute of Public Finance and Policy

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  1. Shrikant Sharma
    Sep 1, 2017 at 11:42 pm
    The demonetize policy leads to a regime where modi emerged out like a black money and corrupt money killer the robinhood of Indian economy was cheered by masses every where .the poor was ready to sacrifice their tie for modi it was evident.bravo modi keep it up
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      pankaj
      Sep 1, 2017 at 11:26 pm
      we unfortunately has short sighted and non-doer type of economists and analysts who can do almost anything, and a person like Modi who will try many things to fix system and will eventually fix things because he is courageous and calculative both.. such a person cannot be of their liking because they are losing status quo that kept such economists and analysts in limelight without doing anything but just posting arbitrary gibberish on a routine basis...
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        pankaj
        Sep 1, 2017 at 11:16 pm
        We have tonnes of those people crying in new papers who didn't even stand in lines or who have enough money to buy truck loads of food/services without any cash. And those who had only cash and no other means didn't care their few days of struggle for an honest and good attempt by Modi. Demonetization cost benefit analysis is very simple, it will be very painful for very short term and then you have all the benefits of money getting regulated over a longer time. You can just list the benefits of regulation of money. Here are they- 1) the money once, in bank cannot be used for illegal purposes, once you have banned high value cash transaction, you have more or less confiscated money for illegal transactions, 2) money not desposited, whatever amount becomes useless 3) Banks get lot of money to dispense with for and re-channelize it into formal/legal economy 4) government and income tax department get people to track and grab for illegal money (again a long term thing)
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          pankaj
          Sep 1, 2017 at 11:21 pm
          how difficult it is to see that pain is very short term but gains are long term and will persist forever, you have to check realtors, builders etc to know how difficult things have become for them to use that 50 black money, so they used to sell farm lands and big s worth 10s of crores as 50 white and 50 black, can this lady talking here do it now? the market has that cash, but why can't she do it now??? It is very easy to understand that demonetization was a must to do thing and its adverse effects are not important to any common man after initial months, but markets like buying a house or land will become easier for those who do not have black money..... however people like this lady will stick to their political goal posts and keep harping on something that is done honestly and bravely for somebody who is much more committed to people/nation then them.
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          Sep 1, 2017 at 10:42 pm
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            Ananth
            Sep 1, 2017 at 10:42 pm
            In short according to you Indians are cheats of A1 order and have done their best to pass their black money back into circulation as white without sweat. So what good any cost benefit analysis would ever have worked. As this has never been done elsewhere till date to this scale so how can any other country's experience be of any use. You conveniently didn't touch the real premise based on which this measure was undertaken namely, the fear of fake currency entering our market in unprecedented scale. Must be because you have no answer to that. Please wait and watch. It is too premature to judge the good or bad fall-outs of this measure.
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