By now, everybody, but everybody, has commented on the bad implementation of the demonetisation (DM) policy announced by Prime Minister Narendra Modi on November 8. In simple terms, Rs 15.4 trillion (or lakh crores, hereafter referred to as T) were taken out of circulation on 8/11. Less than 3.5 T of new currency notes entered the system. Even by the end of December 2016, there will only be Rs 6 T of the new notes. Won’t this shortage of Rs 7 trillion severely crimp transactions, diminish GDP growth and future tax revenues? These are important questions. Most reputable economists (both domestic and international) have opined that this radical demonetisation policy, while well-intentioned, was inappropriate and very costly.
In this discussion, we will take it as given that the implementation of the policy has been terrible. But we differ with most on the expected short-run benefits, that is benefits without future policy changes. The latter, we think, are critical to the long-run success of demonetisation. At the same time, we think that fear mongering about the short-run costs needs to be discussed in a dispassionate manner.
First some broad “facts” to place the policy in perspective. GDP in 2016/17 was expected to be Rs 150 T; Rs 15.4 T of cash in circulation was withdrawn on November 8 (in the form of Rs 500 and Rs 1,000 notes) . As of November 27, Rs 8.5 T had been deposited/exchanged with the banks, and unofficial rumours are by November end, almost Rs 11 T of old notes were deposited.
Currency with the public forms part of the transactions demand for money. While the demand for money question has been researched extensively by monetary economists, the demand for currency question has received only limited attention. The reason is obvious — typically, currency forms about 45 per cent of the sum of cash and demand deposits (M1) in emerging markets, that is not big enough compared to demand deposits. In fiscal year 2014/15, cash in India was 62 per cent of M1, a number that places it among the top 25 per cent of emerging markets (EMs). (In 2000, the EM average was 36 per cent, and India 45 per cent). This is our first crude estimate of black cash (BC) in India — about 17 per cent of M1 (difference between India and EMs: 62 minus 45), which, as of end October 2016, was Rs 28 T, that is BC on November 8 was Rs 4.8 T.
A more rigorous estimation of the demand for currency for purposes of consumption in EMs for the period 1980-2015 (with urbanisation, size of the agricultural economy, per capita income etc being part of the determinants) yields the following result — the demand for excess cash in India is the tenth highest among 60 EMs. Excess cash is defined to be the excess over that predicted by the currency demand model.
On an average, black cash is a negligible proportion of household consumption in the region excluding India and Nepal — actually, a negative 0.7 per cent. The tenth most black cash economy in EMs is India (9.2 percent), and Nepal is eleventh at 7.8 per cent. Interestingly, Thailand has more black cash than India, 10.3 per cent of consumption; and Pakistan, considerably lower, at 2.7 per cent.
Household consumption is estimated to be around Rs 89 T in 2016, so black cash on November 8 in India was close to Rs 8 T. We feel that this is a very robust estimate — and several policy implications follow this analysis.
The “belief” among “experts” is that black cash is only about six per cent of the black economy. The black economy is variously estimated to be 25 per cent of GDP or around Rs 40 T; the “popular” estimate of six per cent would place BC in India to be Rs 2.4 T (what is the basis of the “six per cent of cash is black” conclusion?).
In an article, Monumental Mismanagement (IE, December 4, 2016), former finance minister, P. Chidambaram, vehemently argues that DM is a monumental failure. His reasoning: GDP will conservatively drop by one per cent this fiscal year, and at least 90 per cent of currency notes will return to the system, leaving the economy with zero benefits from DM (GDP is Rs 150 T, and notebandi cash is Rs 15.4 T).
How accurate is Chidambaram’s calculation likely to be? First, on GDP decline by at least one per cent. Since all comparisons are with respect to FY15/16, what we do know is that agricultural GDP will be at least five per cent higher this year. The kharif crop was over by the time of demonetisation, and the rabi acreage, despite dire forecasts, is proceeding at a five per cent faster pace than last year. Industrial growth in November (PMI data) was also expanding in November. The one sector definitely affected by DM is the most important sector of the economy — services (60 per cent of the GDP). Like Chidambaram, assume conservatively that services consumption for the remaining five months of the year (November through March) of the fiscal year declines by five per cent, with most of this decline coming in November-December. The service sector for five months (November through March) was expected to be Rs 38 T. A decline of five per cent is a loss of Rs 2 T. Some of this (around Rs 1 T) will be made up by five per cent growth in agriculture, yielding a net loss of around Rs 1 T.
So it does appear that the Chidambaram calculation is about right — that is the costs of DM are about equal to the benefits. But let us get back to our earlier calculations — Rs 8 T is black cash, not black income stashed away in real estate, gold, foreign currency etc. Assume for a moment that black cash is the average of the two estimates — Rs 2 T (“theirs”, the six per cent formula) and Rs 8 T (ours, based on estimation of excess demand).
If Rs 5 T is returned to banks with a tax penalty of 50 per cent, then that is a tax gain in 2016/17 of Rs 2.5 T. At a lower 30 per cent tax rate in the future, this is an extra Rs 1.5 T in perpetuity because these individuals will now be permanently in the tax net with a higher level of income than before. At a five per cent discount rate, Rs 1.5 T in perpetuity is Rs 30 T. This is under the assumption that black cash has a low shelf life because smart money doesn’t keep black income in cash.
So a proper static benefit cost analysis of the DM policy is as follows. In 2016/17, costs are Rs 1.5 T and benefits are Rs 1.5 T + 2.5 T or Rs 4 T. Just a one year calculation shows a more than 200 per cent return on investment! But future gains, through higher direct tax revenue collection of Rs 1.5 T means a very, very large return on the investment. This result is predicated on the assumption that two-thirds of notebandi reflected legitimate income or savings, and only one-third was illegal. One can change various assumptions (amount of legitimate returns, discount rate etc), the result will not be changed. Even on a static no-future-policy-change base, the demonetisation policy will likely be a huge success.
But, if other policy measures to reform India are not forthcoming (decline in personal income tax rates to discourage tax evasion, elimination of stamp duty and long-term tax rates on property, a clampdown on the extortion power of tax officials, and reform of election funding), then history will view demonetisation as a colossal failure of thought and reform. It would be so unlike PM Modi to stop here, and I am not betting that he will.