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Mainstream, VOL LV No 1 New Delhi December 24, 2016 - ANNUAL 2016

Curbing the Black Economy: Demonetisation Not the Way

Monday 26 December 2016, by Arun Kumar

Tackling the black economy is laudable. The PM has announced demonetisation of the high denomination currency notes to do that. But most analysts are of the opinion this is not the way to even dent (much less eliminating) the black economy in India. The faulty notion is a result of the incorrect understanding that black economy is all cash. The logic of the step taken is, once ‘black money’ (cash) is sucked out of the economy, the black economy would get eliminated. It is as if, once oxygen is sucked out of a closed room, the bad guys sitting there would all die. But, so would the good guys. Further, what if the bad guys had oxygen masks while the good guys did not?

Political Aspects

The political fall-out of the demonetisation and its aftermath is being felt in Parliament with the Opposition largely united in opposing the move given the hardship the public (especially the poor) is facing. However, outside Parliament, there have been dissensions and the protest day on November 28 showed the cracks. The public at large, initially at least, seemed to have accepted that the government was serious about tackling ‘black money’ (synonymous in the public mind with the black economy) which is the scourge of the country. Some said that the PM has levelled the ground between the rich and the poor because the former also had to stand in the queues in the banks.

Anyone who has opposed demonetisation is being branded by the ruling party as having ‘black money’. Since no one wishes to be so labelled, the political parties have hesitated to go the whole hog in opposing demonetisation. They do not as yet know how much hardship will this move cause to the public and whether the public will react in anger after the initial welcome. The government has been arguing that the pain will be short run and the PM has asked for 50 days. He has said that after that period, things will not only become normal but become better. Many analysts are also unsure whether that would indeed be the case or the effect would persist longer.

The government is also not sure of the implications of what it has started and is coming out with more and more orders and procla-mations for curbing the black economy since its moves are unable to take care of the problems arising from demonetisation. This not only suggests that the scheme had not been thought through but also that the implementation of such a complex scheme of things is difficult at the best of times. However, given the ingenuity of the black money generators and the leakiness of our bureaucracy and banking system, they are finding ways of subverting the scheme. Now there is admission that all the money demonetised will return to the banks. So, no gain is likely.

The government has hurriedly got a Taxation Law Amendment Bill passed through the Lok Sabha to tax those who are depositing money in their accounts. If all the cash comes back, certainly black cash is also being deposited. There is a surge in deposits in Jan Dhan Accounts and also in the banks. Given the haste with which this Bill has been passed, it is likely to have lacunae and may come up for challenge in the courts. Further, corresponding to the deposits in banks, people doing so may declare it as income in the preceding year for which a revised return may be filed and also in the current year for which the return has to be filed by next September. This would be perfectly legal and if not accepted by the Income Tax Department, it would be challenged in the courts.

The PM has asked the BJP legislators to give details of their bank accounts to reveal their deposits. The idea is to show to the public that there is transparency. But how does one ensure that a correct picture will be given by the declarants? After all, those generating black incomes do not give the correct picture to the authorities.

A shift in emphasis is visible. Since most of the high denomination notes seem to be coming back into the banking system, it appears even to the government that its link of elimination of black cash with elimination of the black economy may not be taking place. Thus, a new spin is being given that the move was designed to move the economy to a ‘cashless economy’ which would pay high dividend. It is also being said that demonetisation is only the first step in curbing the black economy and more steps will be taken soon in this direction. There is a need to analyse these matters more carefully to understand what is going on.

Role of Money

The media is full of stories about the effect of demonetisation of 85 per cent of the currency. The pros and cons of this move need discussion. The former PM, Dr Manmohan Singh, has said that this move will lower the growth rate of the economy by at least two per cent. Those in the government have challenged this assertion. The government is saying that the pain will be temporary while there would be huge gains over time. But, according to official data, the economy was doing well and had become the fastest growing major economy of the world; so why this sudden move which threatens this achievement, even if temporarily?

The reasons are political and not economic. But the economic consequences need to be understood both in the short and the long run because they have the potential of impacting the political calculus as well.

Money is not consumed by individuals; so its shortage should not have a direct effect on them. But it is crucial in a modern economy, because it circulates incomes which people need to live. It enables people to exchange goods and services which is required for production and generation of incomes. It removes the need for a double coincidence that is essential in a barter economy. In such an economy, if I produce shoes then I need to find someone who needs them and can offer in return something that I need, maybe food. If I exchange shoes for cloth that is not good enough since I will still have to find someone who needs cloth and has food spare to give to me. All this can become very circuitous and leads to a waste of an individual’s time which could be better used to produce more of the things that the person can produce. Hence, in a complex economy, barter leads to inefficiency. Presence of money simplifies exchange (there may be other complications).

Money does not mean cash alone. One can use cheques, credit and debit cards and electronic money to carry on transactions. But currency issued by the Central Bank (RBI, in our case) is the base on which the other forms of money are created. So, a shortage of currency means that the medium of exchange is in short supply and it affects production and distribution in the economy.

Impact on Growth and Output in the Economy

While money does not mean cash alone, the unorganised sectors of the economy are small and tiny units of production which largely use cash. So, a shortage of cash for their transactions has adversely affected their production and incomes. Agriculture is a large component of this sector and there are reports of farmers suffering due to shortage of cash in rural areas. There are few bank branches there so that exchanging old currency for new notes has been difficult. Further, bank branches have not had adequate supply of new notes so that rural households have not been able to acquire enough cash. This has caused difficulties in payment of wages, purchase of inputs required for the crop, etc. Reports are that the ‘Arthiyas’ have not been able to make payment to farmers; so produce has not been coming to the wholesale markets.

Cottage and small producers also pay wages in cash and buy their inputs in cash. They have also had a problem in continuing production due to shortage of cash. Small traders have similarly been adversely affected. Some credit is extended for purchases but this has its limits. A shopkeeper can give some supplies to his known clients on credit for a limited time since he also has to get supplies from the wholesale dealer. These people do not have the machines for swiping cards or the smart phones to receive money transfers. Further, the workers in the unorganised sector who have bank accounts have had to spend much time trying to draw cash which has meant a loss in wages. In brief, various components of the unorganised sectors have been hit adversely by demonetisation.

The organised sector has also been hit. While it can use cheques, plastic money and even electronic transfers, it is facing a demand shortage. People, even the well-off, facing a shortage of cash have postponed their discretionary demand. The unorganised sectors also buy the product of the organised sectors; so that their loss of incomes also adversely impacts the demand for the organised sectors. As it is, major industries in India have been working at about 75 per cent capacity utilisation. With decline in demand and reports of inventories building up, production would have already been curtailed and capacity utilisation would have dropped further. Unemployment is likely to grow and become more permanent. Workers are already reported to be going back to their villages due to lack of work in urban areas. This would aggravate the crisis in rural areas. Many families depend on cash flow from migrants to urban areas. Not only would these remittances decline, the returning workers would add to the family burden.

Profitability of many industries would have already been hit, like transport, automobile, cycle, hotels, tourism, consumer durables, FMCG and a variety of services. Banking, which was already suffering due to the pile of NPAs, will find recovery of loans more difficult and that would only increase the NPAs. Demand for credit was already weak and this would further decline. These effects would be more long lasting and go beyond the immediate shortage of cash.

Investments are likely to be hit adversely due to lower capacity utilisation and build-up of the NPAs. Banks will be too busy dealing with circulation of cash and tackling cash shortage. They would have little time to do the routine job of lending. Once investment is hit and it was already on the decline, the effect would become even more long lasting. No one is yet using the term recession but there is a distinct possibility that this could happen if the above mentioned effects take effect after a month or two of disruption. Then economic recovery could take a few years.

Moving toward a ‘Less Cash’ Economy

The government, to divert attention from the ill-effects of demonetisation, is arguing that its real goal was a ‘cashless society’. It feels that this will eliminate corruption. Unfortunately, they are mixing up two different things.

While many businesses and the well-off and the middle classes may use cheques or plastic cards or electronic transfers, the unorganised, small and cottage sectors, the poor and unbanked and illiterate people are not so fortunate. They use cash for their transactions. A cash shortage hits them the most. For the more fortunate also, it is a matter of habit whether they use cash or plastic money. No wonder, there are long lines at the banks to withdraw cash and these are not just the poor but also the middle classes.

In the US where plastic cards have been in wide use for many decades, use of cash continues. It is a question of habits. Further, in spite of widespread use of plastic cards and electronic money in the US, the black economy flourishes. So, a link between cash and ‘black money’ is weak. Given this situation in the US and the weak infrastructure (electricity, connectivity, etc.) India cannot soon become cashless. But it can move towards a ‘less cash’ economy.

If money is in short supply, gold may be used or payment made abroad or in foreign exchange, etc. Thus, the demand for gold and foreign exchange will rise in India and this was seen soon after the demonetisation was announced. Under the gold monetisation scheme, the government has issued gold coins which can be easily used. So, a ‘less cash’ economy does not imply that black income generation will stop. Only the circulation of black incomes will take place differently.

Yes, the nation should move towards a ‘less cash’ economy so as to reap the benefits of efficiency but that should not be confused with checking the growth of the black economy. That requires a wholly different approach. As stated earlier, black economy does not mean cash. Further, new currency is being issued; so it is not as if cash will not be available for circulation of the black economy. Even larger denomination currency (Rs 2000) than earlier is being issued. If less cash is issued than existed earlier, it may cause problems for the white economy and especially the unorganised sectors but the black economy, which is concentrated in the hands of the well-off, would not be dented.

In government departments, payments are made via cheques but bribes are extracted in a variety of ways. In private institutions, salary maybe paid via cheque but only after cash is paid to the management. Post-demonetisation, many ways of converting the stashed black money in old currency into new currency have been devised. The argument that cashless transactions will mean that the poor will receive their correct salary will not hold since they can be coerced in various ways to give back in cash. For instance, manipulation of the muster rolls is well known. Jan Dhan accounts are being widely used. If the unscrupulous deposit Rs 10,000 per account in 20 crore accounts, Rs 2 lakh crores would be converted into new currency. So, black income circulation would continue as earlier.

Currency is neither coloured black nor white. So, whatever cash is available in the economy can be used to circulate both the black and the white economies. The two economies are not parallel—where the twain does not meet—so it is not that if the money is used in one component it cannot be used in the other. Thus, the idea of demonetisation and ‘less cash’ economy have little to do with the curbing of the black economy. The banking channels, share markets, informal money markets, hawala, flight of capital and so on will continue to be available to circulate the black economy. In fact, some of these ways of circulating the black incomes will become more active, leading to loss of savings to the economy. The reports are that the poor, the farmers, the small producers, big business and industry are being hurt due to the fall in demand and loss of employment.

Is a Windfall Gain Likely?

Would the government get a windfall gain as a result of some of the Rs 14 lakh crores of notes not coming back into the system? This could be used to argue that the black economy has been tamed. It may also enable the government to increase pro-poor spending—a Robin Hood syndrome could politically help the government.

When cash is deposited in the bank by an individual it goes into that person’s account as saving. The bank is obliged to return that to the RBI so that the old notes may be destroyed. The banks’ deposits will increase above what they are required to keep with the RBI (called, CRR). The currency issued by the RBI was its liability; so, as soon as the demonetisation was announced, its liability decreased by the amount of demonetisation. But its assets did not fall. So, in its balance-sheet there is now a huge surplus. Can this be used by the government for the pro-poor schemes?

However, the RBI is obliged to give new currency in lieu of the old extinguished currency. People are going to banks to withdraw what they have deposited in their accounts so that they can carry on their transactions. The banks are obliged to give people the money they ask from their accounts and they will have to get it from the RBI. But the demand for cash will be higher than earlier since people are hoarding currency and not circulating it. So, even if some of the old money does not come back into the banking system, the RBI will have to issue more cash than earlier to maintain the credibility of the system; otherwise the cash shortage will continue with all its adverse effects.

Conclusion

In brief, black economy cannot be curbed by choking off cash via demonetisation but this move will adversely hit economic activity both in the long and the short run. What can be done to get out of the morass the economy is going into? Liquidity needs to be immediately restored, by allowing the old notes to continue to be used. Most of them are still with the banks and have not yet been destroyed. Some of the adverse effects in the economy would immediately reverse. But if cash shortage is allowed to continue for a month or more (the government says 50 days but others say shortage will continue for many months more), there would be irreversible and long lasting damage to the economy and the political fallout would be negative for the ruling coalition.

The author is a retired Professor of Economics, Jawaharlal Nehru University, New Delhi. He is the author of the book, The Black Economy in India, published by Penguin (India).