Saturday, December 10, 2016

Demonetisation - Can anaesthesia cure the cancer?

It has been one month since demonetization was announced. So naturally it is time to assess how it is doing. But I am not going to do that. I am going to assess the criticism of the initiative.

Just to reiterate, since the announcement, I have maintained two things. First, that the true effect can only be determined when you consider the whole picture - the entire gamut of initiatives, execution and operations on black money, cash-less economy, and such other co-terminus objectives. Till such a time it is premature to pass any judgment. Second, it is a step in right direction. So let me assess the criticisms.

Draconian move by sidelining RBI
This is factually not true. The Gazette notification states that powers were exercised on the recommendation of Central Board of Directors. However, many commentators rely on fact that there are vacancies on that board. But, as per law, vacancies do not invalidate the Orders of the board. The board was authorized to act and it did recommend. Then people question of all the information was disclosed to the board. Well, it is the prerogative of the board to establish that. Unless the board members complain, citizens raising such questions are undermining the authority of the board.

Certainly, the move was quick and secretive. But that does not make it illegal or unlawful. The legal merits of the move seem to be on sound footing.

The Poor are suffering
This argument is usually the first. In their article in Mint, Krishnamurthy Subramanian & Prasanna Tantri argue that data would show otherwise. The poor will have to visit the bank about 3 times between Nov. 8 and Dec 30 if they continued to accept the old notes. And just once if they refused to accept the old notes. Therefore they wonder:
the long queues seen stem from two sections of the population: (i) people from the top half of the country’s income distribution, i.e. the richer folks, who want to exchange their honestly earned savings for new currency; and (ii) people who are acting as agents for the dishonest. The significant decrease in the queues after the government decided to use indelible ink to identify people that have exchanged their currency suggests large presence of the second category of people.
Note, I am not saying that poor are not suffering, neither are the authors above. What is being said is they are not suffering as much as alleged by these commentators. 

So next, you go and ask the people themselves. Just remember, if you are watching videos online to gauge public opinion - ignore the videos uploaded by the media (pro and against) and political parties (right and left). Search for videos of people speaking directly with common people waiting in line or otherwise. These videos are positive. Better yet, speak to the people directly yourself, they are positive. They are suffering, but they understand and they are positive. Some are hurt but they still understand.

Currency in circulation will be destroyed - will lead to deflation
This was textbook economics commentary - money supply has reduced therefore prices must fall. Unfortunately, it is not true. The principle is sound but the money supply is not reduced. People still have the same amount of money. The form is changed. If people are genuinely transacting, paying taxes on it, then they will merely do it through banking channels.

If they are not genuine then it does not matter if there is a loss of such activity. Please note, demand will be affected, but it will be short term. You may even see a surge in a quarter or two. Just like this lull was temporary the surge will also be temporary - adjustments taking place.

The argument was advanced in light of the fact that for undisclosed amounts tax was 200% penalty and some additional cess. Thus for every Rs. 100 deposited you ended up retaining about Rs. 10. (in top tax bracket). Thus, it was better for such holders of black money to destroy it rather than return it. This, as per media estimate, was "the money that would never return". These IOUs that never returned would be gains for the central bank. This was quickly rectified with a modified amnesty scheme that said that effective tax rate will be 50% and some terms were imposed.

Government will not get windfall gains it was expecting
This is the most fervently promoted falsehood I have ever seen. I have never read any government press release or any official statement saying the government will gain because RBI will give windfall dividend on the notes that are not returned. 

This benefit was claimed by the media and it was false. It showed a lack of basic knowledge of central bank balance-sheet. [Refer to the primer by Bank of England I linked to in my first post.] The nature of adjustment remains on the same side of the balance sheet. There was never claimed to be revenue impact from this activity.

If the government was expecting a windfall from RBI then would the government announce modified amnesty at 50% tax and thus impair its own chances of getting gains.

That said, the fault lies with the government officers and bureaucrats as well. When they speak to the media, anonymously, they fan the rumors about this approach. Some such officials are claiming that RBI Act can be amended by the Government to take the dividend. This undermines the basic structure and legitimacy of the government's initiatives.

[Some idiot will say - maybe they did. Initially, government thought it will get windfall gains, but when former RBI governors challenged that on our channel/ newspaper/magazine, government quickly announced amnesty to save its own face!]

All the currency in circulation will return - so demonetisation has failed
This is another popular argument. If all the currency in circulation comes back, government will not get any windfall and thus costs of demonetisation will outweigh the benefits. Hence demonetisation has failed. 

First, if all money returns to the system, it is good. It means there won't be contraction of currency on hand. And therefore those who got scared about deflation would not get scared.

Second, what if money returned is higher than money in circulation? Does it not mean that there were high quality fake Indian currency notes (FICN)? If they come to the banks is it not a benefit of demonetisation? Based on the present run-rate it is possible.

[I want to ask something to the people who were going to give windfall profits to government. The day deposits/exchanges will exceed RBI's currency in circulation figure, will you ask government to pay RBI for those liabilities?]

No benefits for anti-black money initiative
Then there are people saying once all money comes back to the bank there is no gain for black money initiative. Those who created black money will create black money again. Those who converted are sleeping peacefully. So why trouble everyone.

The benefits to black money initiative will be seen only later. But some are evident right away. People moving to cash-less economy is good for black money initiative. Remember, when black money is deposited into banks it is good. It exposes the total money in the system and its ownership. Coupled with laws on benami holdings, it will reveal the extent of black money problem. Note that by alone it won't do anything. But without it black money initiative would not make proper impact. Thus, viewed from black money prism demonetisation is necessary but not sufficient.

[I am happy these people are not in charge of surgeries or some such life-threatening issue. Just after anaesthesia, these people will criticise the doctor that the cancer is not cured. "I can still see the cancer cells growing". They will come out of the operation theater and tell the patients relative - operation has failed. Cancer refuses to die so better let the patient die.]

Black money is not held in cash so exercise is useless
Tackling black money is like cleaning a tank. Unless you stop/slow the water pouring into the tank will not empty itself. This is a classic flow-and-stock problem. So best way to tackle black money is to attack the flow problem first. Then stock problem. Demonetisation tackles the flow problem.

Because of demonetisation, the black money will be forced into stockpiles i.e. in bank accounts, in gold, benami assets etc. This is good. The flow needs to stop. Hitting the flow is like shooting at a moving target. Hitting the stock of black money is much easier.

Note that if further actions do not continue, flow will resume and the stock problem cannot be rectified. This tells us what kind of initiatives will come after December 30. They will attack stock problems at critical places. 

Government keeps changing the rules, focus on cash-less economy so demonetisation has failed
There is a classic problem involved with government. If they talk too much, their talk is criticised. If they talk too less, their silence is criticised. Government officers have been talking too much. RBI is talking too little. Hence there is a problem for both. Unfortunately, there is no escape for the government or RBI from this. It is a lose-lose scenario.

First, the government has been quite responsive. Asking the government to maintain its stance is foolish. Imagine in Apollo 13, Tom Hanks and crew are calling Houston to help them, but Houston continues to be head-strong. Any exercise of this sort requires nimble-footed decision-making. 

Demonetisation is good opportunity to push people into a cash-less economy. And no-one is arguing that it is bad. The argument is that if sole focus of demonetisation was to push for cash-less economy then it could have been done better. But cash-less was not the focus of the demonetisation exercise - no one said so. Read the initial release. It was an ancillary benefit. But it is a benefit nevertheless. Better push it when you can.

Poorly planned initative - hence bad
This is a genuine issue. But people attacking poorly planned issue slant it differently.

First, there was no way under any conceived planning model to pre-inform any one of the demonetisation move. The move had to be sudden and out of the blue. There was no getting around that part of criticism. 

Second, criticism is at logistics of notes reaching ATMs.  Some say the new notes should have been same size so no recaliberation of ATMs would be needed. Now, even if new notes are same size and weight as old notes, ATMs will have to be configured to understand that these are new notes and not old notes. So there was no getting around recalibration too. Could it have been done in advance? No! Otherwise, the information would be leaked. In fact, 2000 note pictures had started appearing before demonetisation was announced.

Shouldn't RBI printed the notes and kept them ready? Well yes. In fact, if you see the timelines, I think the government was aiming for a January announcement. It appears that some news related to terrorists or FICN coming in the country in a big way pushed the government to announce on Nov 8th. This is a legitimate question to ask the government. It is possible that they will share some information once the anti-terror part of the operation has concluded. We will have to wait for that.

A 2000 rupees will help stock black money - hence demonetisation failed
When the government introduced the 2000 rupee note, people were aghast. This note will definitely facilitate holding black money. 

Arthakranti had proposed a 2000 rupee note. Their logic was that if you are repairing an arterial road with lots of traffic you have to give some by-pass. So this 2000 rupee note is a by-pass. They further said that in terms of printing quantity v/s printed value it reduces time to replenish full currency back into the system in half the time of 1000 rupee notes.

I agree with that basic premise. To add to it, think who will use 2000 rupee note. It cannot be used for transacting as it is too big a denomination. People found 1000 rupee note also too big. The reason we feel that is because of metric design system of currency. (from V. Anantha Nageswaran) But I think it is by design rather than by mistake. In a year or two these notes will find their way back to the black money hoarders. Then these notes will be demonetised gradually. That is the reason why there were rumours about microchips installed in the notes. There are no microchips the notes are traceable to black money holders. That is all. 

Black money holders are depositing money in Jan-Dhan Accounts - hence failed
This logic is applicable to many such devices black money holders are using to launder money into white. In this process, people with Jan-Dhan accounts are also involved. But more importantly, cooperative banks, small businesses and others are involved in a big way.

We must remember that these acts constitute money laundering. They are also under the purview of benami property acts. The fines and penalties are severe. So once investigations are done we will find the culprits.

People have died
That, unfortunately, is true. Some people have indeed died. Should they have died? Absolutely not. That is why implementation is receiving poor marks. The government should have set up a task force and convened the meeting via video conference - all bank CEOs, Finance Ministry and others. The government should have pushed them to monitor this like an emergency situation. There should have been End of day recap meeting and things should have smoothened out.

But I personally thought there could have been more deaths. Seriously! And that was why I was against the policy. We are 700 million not counting old and too young. That's more than the entire population of USA. 700million went to the bank in distress and yet no riots broke out. People are not cribbing they are supportive. That number once verified can be debated. But at present, we are talking about 2 people in one crore. Yet, even one casualty is one too many.

Tax terrorism
At the end of the 50-day period, the authorities will unleash a new compliance program. Income Tax (IT) authorities are  known to be very unfriendly to the lawful and buddies of the corrupt. IT department is the reason that people have joined the black economy in droves.

Tax reform is absolutely essential. Without tax reforms and reforms of tax departments, we will not tame the corruption and black money monster ever. The initiative has indeed armed this monster. So without reform it will unleash a fresh round of terror.  Once victimised the population will be reminded of the pains that pushed them to black economy in the first place. Without this critical reform the political costs of this exercise will be too high to bear.

Chanakya, the person prime minister admires, used to say that governance must BE fair and must BE SEEN to be fair. So also goes a prominent legal doctrine - justice must not only be done but also seen to be done.

I have 100 employees but I cannot pay my employees. 
This is boat-load of bullshit. A person who has 100 employees should be doing business through banking in any case. If this fellow goes to the bank and asks the bank to open the account for his 100 employees, he will be able to do it quickly. In fact, the benefit of demonetisation is that such fellows will come into the formal sector. 

Corporate sector is hurt in a big way
Post demonetisation there has been an impact on demand. People are focussing their spending on essentials. This has hit industry to a certain extent. Yet, there is no reason for high-value goods industry to be affected. Thus, if people are buying cars, there is no reason that should stop. Most of the car purchase was using bank money anyways. Bicycles and Two-wheelers have been hurt.

If businesses are hurt because their distribution chain is cash based then this is no argument. There was no business for this distribution chain to be cash-only if they are paying relevant duties. In fact, these dealers and shopkeepers are a major source of black money creation.  Please note that they are not without bank accounts, they are cash-based by choice. That such businesses will come into the mainstream banked economy, is a boon and benefit of the demonetisation.

So what do we conclude
At the end, demonetisation is not a single initiative that will rid India of corruption. The anaesthesia cannot cure this cancer. The surgery is ahead of us. Possibly, demonetisation will insulate the law-abiding people from the pains of this anti-corruption surgery. But corruption has seeped into the character of this country. Every fellow is corrupt as much as his ability, opportunity and self-conscience allowed. In this game everyone is dirty. The system did push people into the black economy. But that has to change.

The example of Georgia is documented in this World Bank Report hold many learnings as to how a corrupt country can get clean. The president of Georgia started out by firing all the traffic police known to be most corrupt. The result is that Georgia went from a poor country to a middle-income country in a short time.

The process of change has begun. How far the prime minister takes us, how successful he is, depends on the next steps. There are workable models, but India will have to fashion its own solutions. India has to take the leadership, forge new paths against corruption.

Thursday, December 08, 2016

Demonetisation - What if deposits in banks are greater than 15 Lac Crores?

On November 28th the Reserve Bank of India stated that
Banks have since reported that such exchange/deposits effected from November 10, 2016 upto November 27, 2016 amounted to ₹ 8,44,982 crore (exchange amounted to ₹ 33,948 crore and deposits amounted to ₹ 8,11,033 crore). They have also reported that the public have withdrawn, during this period, ₹ 2,16,617 crore from their accounts either over the counter or through ATMs.

The expectation was that thereafter the RBI will release similar data every Monday. On Dec. 5th, when RBI did not release the data for the week past, speculation was rife that most of the money may have actually returned to the RBI. And further that it amounts to a failure of the policy and that there is no black money at all. 

The amount forecasted / estimated by sources of journalists is Rs. 12.6 Trillion. has been deposited in banks till Dec 6. Total bank notes in circulation as of Nov. 8 was about Rs. 15 Trn. We still have about 3 weeks to go. 

The correct way to establish how much money has returned is to look at this 8.44 Tr figure. That is the focus. 

So weekly average is about Rs. 2.8 Trn as per RBI and as per Moneycontrol it is about  Rs. 3.15 Trn per week. Going by the same run-rate estimates we can get at least Rs. 19.64 Trn to Rs. 22.46 Tr. If you understand the "last-minute" psyche of Indians, I think last week will get at least twice the weekly deposits. Then you will get between Rs. 22.4 Tr to Rs. 25.2 Tr. 

Please note that these numbers are more than Rs. 5Tr  to Rs. 10 Tr more than what RBI has printed. 


So here are my thoughts on this:

  1. It is OK if all the money comes back to the RBI and either gets changed or deposited in the banks. It means there won't be any disinflation because of loss of currency. 
  2. If money is deposited in the bank that does not make it white money. It merely becomes visible black money as opposed to invisible black money. Knowledge of the quanta so revealed that itself is a benefit. Further, it is open for authorities to review and tax these proceeds accordingly. So it is ok if the deposits reach Rs. 15 Tr. 
  3. The problem is what happens when the total deposits/exchanged amount exceeds Rs. 15 Trn. Once it reaches 15 Trn can RBI tell banks now don't accept any more notes? Or it accepts and asks Government to pay (reverse of dividend)? [Please refer to my previous blog-post on Black money and demonetisation before demonizing me.]
  4. I would say, the fact that entire Rs. 15 Trn comes back itself means that the problem of Fake Indian Currency Notes (FICN) was more potent than was admitted previously. If our run-rate calculations turn out correctly, FICN could be between 33% and 66% of legitimate Indian Notes. That is not a joke. It is also a success of the Demonetisation drive.
  5. I would say about 20-25% of the notes would have been definitely destroyed. But given the tax amnesty announced let us assume about 10-15% were destroyed. The black economy was estimated at 20-25%. Assuming some can be dissipated as white (through jan-dhan and other tricks) we can say at least 10% would be black. Still about 20% of the currency in circulation could be FICN. Compare this with estimates of about 2-5%. 
To top it all Modi did not ask for 50 days to clean up the black money he asked for 17 months. So there will be more action coming. This will be interesting, to say the least.

Saturday, December 03, 2016

My Response to comments on Idiotic debate on Demonetisation

As expected, once I published this I got some flak. I do not wish to detail the flak here. But case in point is an argument by some let us call her "M". Her point is that there are so many "experts" who have trashed this move. Here is my response to her. This is a response to all the "M" out there. Please don't think I single her out.

I completely understand M. I have written a book on economics myself - two to be precise. And just for your information I gave an "average rating" on Modi's app. 
But I want to form my own opinion. Not simply accept Hanke who is speculating. I admire him too FYI. If you want to negative opinion. There is Jim Rickards who is a gold bug who also has negative view. There are many in this camp in fact.  
I am trying to understand why many poor are giving positive views on this measure. I don't accept that people are so sick-minded that just because few corrupt persons holding cash will lose their money, 700 million will become happy. I think we Indians are better than this.  
So I filtered out the media - all media. You will see I haven't quoted Swaraj mag nor have I quoted the wire. 
I wanted the concept explained properly somewhere. I need to understand what govt wants to put out. That I came across in three interviews - Kant debroy and bokil to whom I have linked to. I also linked to the proposal which was presented to Modi. That is the only media I have linked to. 
The public opinion that I have linked to is from people who at least have no stated affiliation to media. They may be pro Modi but it did not seem so. I have linked to one lady who was ranting against modi too. 
My friend, had visited Guwahati and he saw the situation on ground and he says that there are difficulties but things are calming down. You can check his views on my stream. I personally visited ATMs in South and Central Mumbai - I found long queues. But then I returned at 1030pm and I found quite a few ATMs free. There were lines at some but not others. I withdrew 100 Rupees notes. (These are anecdotal but when MSM is biased we have to rely on that) Roahini Ali whose video I linked to seems to have done better structured feedback. So I linked to her video. 
Then I thought it was important to lay out the goalpost that will tell us if the policy is successful or not. If I see those goals being met then I will change my mind and say the policy is a success.  
By now you know that I am not yet sure if this is good policy or not. I wrote a prior post explaining black economy and demonetisation.  
Please consider what will make YOU change your mind on the policy either for or against. Establish your own goalpost. Do it in your own mind - but do it. You will love to see the events against it. 
Sometimes people tell me - look 100 people died in the last almost one month. I personally thought there could have been more deaths. Seriously! And that was why I was against the policy. We are 700 million not counting old and too young. That's more than the entire population of USA. 700million went to the bank in distress and yet no riots broke out. People are not cribbing they are supportive. That number once verified can be debated. But at present, we are talking about 2 people in one crore. 
To end I must suggest one exercise. "M", try to connect with people and get their feedback. Positive, negative it doesn't matter. Let the real feedback come through. Unedited. Post it on YouTube. I will be happy to see it. Don't let these biased guys from right and left influence you. Between unbiased you and unbiased me there won't be conflict. But we know the biased even go to war with each other.

The thing is we are passively choosing the sides. Both sides are wrong - the reality is the third side. If we try to find that side, we will enter into a healthy debate. Please try, country and society will be thankful to you.

Friday, December 02, 2016

Idiotic debate on Demonetization

Since the announcement of demonetization we have quite a lot of noise but no analysis. I am on the look out for genuine criticism of the policy.

Semantics of false criticism
There is a lot of criticism of the government's policy. The international criticism is uninformed and disconnected from Indian ground realities. Quite a bit is a shallow analysis of Nigeria, USSR and some other countries which had demonetized previously. Generally, the criticism falls into the following buckets:
  1. Demonetization alone will not stop black money: That is not proper criticism. 
    1. The government never maintained that it will. 
    2. In fact, Finance ministry circular highlights various measures undertaken by the government till date. 
    3. Further, the prime minister indicated that this was just the beginning and more announcement will come.
  2. Removing 85% of the currency will cause a lot of pain to the people
    1. Well when you ask the people, most are happy with it. Some are very angry. In a country of 1.2 billion you will have voices. 
    2. The prime minister took a smart-phone based app poll which revealed 90% approve of the move. Media quickly jumped up stating the questions are biased. I myself took the poll. The questions were not as biased as media made them out to be. It is a fair poll - you CAN express dissent if you don't like the move.
    3. But the fact remains none of the media channels or anyone tried to do a sms-based poll. We can have a poll for Indian Idol or some crazy show, can media people not fashion a proper poll and report if people are indeed pro- or against.
    4. I tried to go through You-Tube videos about demonetisation uploaded after November 28. I suspected people will give proper reaction once they have been in ATM lines for a few days. I left out videos uploaded by news channels and focussed on videos uploaded by general people. Not many have uploaded but I found one by Roshini Ali & her friend exploring the poor of Kolkata informative. One other fellow explored Mumbai and Aurangabad but he wasn't as comprehensive as Roshini Ali.
  3. Economy will be hurt as currency is withdrawn from circulation
    1. This is the closest people have come to making rational arguments. I don't mind general public making this argument. But from experts, I expect more.
    2. Many experts confuse the measured part of the economy (GDP etc) with unmeasured part (black economy). In an extreme view, since the black economy is not measured its destruction won't affect measured economy. That is flawed as black and white economies intermingle often. Yet they are not quite as intermingled as people make it out to be.
    3. A substantial part of the black economy comes from tax evasion. For example, sales without bill are quite rampant in India. Over billing (for cold drinks) is also rampant. These are black transactions. With proper triggers, these transactions will come to the white economy. (Though demonetization is not that trigger).
  4. Only time will tell if it works:
    1. I understand general public expressing this sentiment. It is a healthy attitude to take.
    2. But when experts take this position, I don't like this. I expect the experts to define their goals for the policy - when will they say it worked. 
    3. And I want them to state it now not once results are out. Because once data is available the narrative will be tailored to the outcome.
    4. Further, be realistic as to what can be achieved by demonetization. I don't want people setting targets "I want black money to become zero".
    5. I want to see the goal post that is set out by all these experts.
  5. Bull-shit interviews/feedback:
    1. Many interviews of government officials and supporters of policy are quite brash. The interviewer does not want to know the policy but instead he wants to hammer the expert. Karan Thaper did that to Bibek Debroy (who I don't really admire - but he is most lucid in the lengthy Ashok Malik interview).
    2. Most media reporting is negative and most general people reporting is positive. One TV channel interviewed a Hindi Speaking shopkeeper in Chennai.
    3. If I watch TV channels interviews then I get different pictures. Pro-government channels say good things and anti-government channels always highlight bad things.
    4. Some channels have shown non-working ATMs quite a few times. And others have shown longer queues giving impression that the queues are that long all the time. People who are on the ground dont find that many long queues all the time.
    5. I have concluded that most of the people do not yet understand what exactly the possible strategy is. None have read the Arthakranti proposal even those who have interviewed the founder Anil Bokil.

Basic framework
Just wanted to clarify one thing here.

Tackling Black money requires a repository of measures. Yes many measures together will help reduce black money. Black money cannot be eliminated completely, it can be reduced drastically.

Demonetisation results in many things out of which one is hurting black money transactions. It freezes the black money transactions and not the assets created out of black money. It also results in other effects - anti-counterfeiting, promoting cash-less transactions etc.

The two are only slightly overlapping. Government hasn't claimed that demonetisation is only aimed at black money. It has correctly stated the what demonetisation can achieve. To confuse the two only shows your ignorance.


Policy Details - possible and others
For interested readers who want to know what is the possible logic behind Government's measures, you can parse some of the links here:
  1. Amithabh Kant on CNN (focusses on going cash-less)
  2. Anil Bokil on ABPMaza (in Marathi) in Anil Bokil in Hindi
  3. Arthakranti Proposal (click here for benefits, benefits to individuals, objections)
  4. Bibek Debroy on Demonetisation and other issues
  5. Ken Rogoff author of The curse of Cash advises gradual demonetisation of high-value notes.
  6. James Henry's article calling for surprise currency recall (from Ken Rogoff)


Setting Goalposts
It is important to set out clear goals when we announce the success of a measure. My goalpost is thus:
  1. I want to evaluate current demonetisation on following parameters:
    1. Total amount deposited with banks / total currency in circulation: I suspect we will get close to entire currency in circulation back into the bank accounts/exchanged. This is because I suspect counterfeit currency in the system is to the tune of 40% i.e. ~ Rs. 6 Trillion making total currency in circulation at ~Rs. 20Trillion.
    2. GDP in Q3 and Q4 of FY 2017 should not reduce more than 1.5%. Thus I expect Q3 and Q4 to be at least 5.8%
    3. Net bank deposits gain: After stabilization, i.e. say by Sep 2017, bank deposits should appreciate by at least 40% of currency in circulation i.e. Rs. 6 Trillion. This is figure after deposits and withdrawals have stabilized.
    4. Share of E-transactions: As per Mastercard data 2% of transactions (number) are cash-less. I would like this number to be around 33% ~ 1 of every 3 transactions should be cashless. 
  2. With respect to Black Money targeting, there should be a continuous targeting of black money holders and black economy.
  3. Tax simplification and rationalization proposal in Union Budget 2017 (which will be in January). I think we should try Banking Transaction Tax once 2 out of 3 transactions are cashless.



Monday, November 14, 2016

Black Money & Demonetization


The Government of India announced that the Rs 500 and Rs. 1000 denominated currency notes will cease to be legal tender. The move was targeted towards tackling black money, corruption and terrorism. After initial euphoria, questions began to emerge. What are the costs of this demonetization? Will it be effective if people can still create new black money thereafter? Will it increase the GDP? Will it increase inflation? What about tax revenues? We look for answers.

Black money and demonetisation
To start off, black money is a wider societal ill and demonetisation is but one step in the war against black money.

Black money and black economy are also two different constructs. The terms shadow economy and underground economy are also used as synonyms for black economy. 

Black money is the currency of black economy. It refers to illegal money earned from illegal sources which has not been disclosed to the government. The advantage of black money is that it links into the legitimate economy, uses the advantages of the legitimate economy but does not pay the costs.
Research on tackling black money

The issue of black money has been well-explored. The National Institute of Public Finance and Policy has been active in research about black money. Their 1983 survey of estimates of Black Money[1] led to a report on Aspects of Black Money[2] in 1985. The Report of 2012 titled Measures to tackle Black Money in India and Abroad[3] and the 2012 White Paper on Black Money[4] by Ministry of Finance covers the various research studies and updates them. These studies however have not been able to determine a consistent estimation of the black economy. The estimates, including from other sources, vary from 15% to 45% of the total economy. The papers, however, give a broad spectrum of mechanisms to deal with black money.

Apart from the above Indian initiatives, there have been global initiatives to tackle “underground economy” or “shadow economy”. Primarily, the principles remain the same. Internationally, I find, they focus more on facilitating voluntary compliance than enforcement. Maintaining trust and confidence in tax system takes precedence[5]. They also recommend risk based monitoring mechanisms, coordination amongst revenue departments and education among other things[6].

Principles of tackling black money
The first principle is that remove the systemic pain that leads to creation of black money in the first place. Blame lies with the tax department. Black money is nothing but money generated in legitimate transactions which are hidden from government so as to avoid paying the transaction cost (usually tax) in the legitimate economy[7]. This is usually done by using physical cash. This cash thereafter must be processed to convert into consumption or investment. Black economy refers to various activities, transactions etc. that help process this physical cash, create returns on this cash, facilitate consumption using this cash etc. 

The second principle has two parts. First, not all cash transactions are necessarily black money transaction. They become black money transactions only if they are hidden from the legitimate economy. Thus, a shop-keeper who does not give receipt but declares the sale (it’s only hypothetical) does not create black money. Conversely, a shop-keeper who gives a receipt but discloses other receipt book to the tax authorities (happens all the time) creates black money transaction. Second, the black money must at some time or other be plugged into legitimate economy. Thus, it cannot be done using user-created currency that cannot be exchanged with local currency. So it depends on legal tender. It means somewhere down the chain there must exist a person for whom part of this black money is legal cash income which he can use for his own consumption in legitimate channels. Usually, this is the construction worker, or other poorest of the poor who will give certain services and his income will remain under the government radar. It can also be illegal traders in gold or diamonds etc. who can convert this into precious items that have quasi-legal tender status. 

The third insight is that black economy is continuously fed by parts of white economy that go underground. Quite a few people who do not want to promote black money contribute to it. They are either coerced – say developer forcing buyer to pay him in cash or government officer seeking bribes in cash. Therefore, preventing white money from becoming black the starting point. The recommendations of Report titled Measures to tackle Black Money in India and Abroad describe some strategies. The core principle is to increase the cost of converting legitimate money into cash (wherein government loses ability to track it) and reducing the cost of electronic transfer also promotes electronic transactions. 

Black money flows through a separate channel. Such channel has infrastructure to handle black money. The fact is black money seldom remains in cash. It moves into high value items like real estate, diamonds, gold, films etc. The people involved in these sectors have well-evolved mechanisms to absorb black money. One way is to create entire value chains that use only cash. It is easy in sectors where workers/suppliers are unorganised, contract workers – e.g. Construction, films production etc. Bringing systematic regulations that make it easy for the participants in the value chain to accept electronic payments will curb black money.

Black economy depends on black money financiers. These are money lenders earning like 2% per month on their investments for financing the activities in black money friendly sectors. Film financing, construction financing, financing retailers, dance bars, alcohol, etc. These financiers also need enforcement mechanism to ensure their money is safe. Naturally they ally with criminal elements. Al Capone, the famous Chicago mobster, was previously an enforcer but later a financier. 

Black money faces the same invest or consume choice as legitimate money. On the investment side, it seeks sectors that are friendly for black money. So those people who buy many apartments from developers and developer later sells these for profit, are contributing to investment side when their agreements are not registered and do not pay stamp duty. Jewellers and traders of precious stones also contribute helpfully in this area.

On the consumption side, black money seeks to buy three things legitimate goods that can be consumed openly (i.e. normal things in abnormal amounts – say many shoes, many suits etc.), illegitimate goods that can be consumed secretly (banned or imported exclusive foods – caviar or expensive wines, expensive furnishings, home decorations etc.) or stored secretly (high-end safes, etc.). Within these sectors there exists trails that lead to the people hoarding the money.

Black money is also used in legitimate investments. Foreign channels play critical role. Quite substantial investments in P-Notes is actually round-tripped black money. The key aspect of these instruments is create anonymity by being away from arms of the laws of the country from where income can be fed into the legitimate hands. In such cases, the source of income is illegal. Thus, many businesses in tax-havens such as Mauritius, Cayman Islands etc. exist to convert illegal money into legal money. Many of these investments come under the purview of money laundering.

Incentives for electronic transactions help prevent use of cash. Income tax deductions on credit cards or e-payments up to a certain limit can incentivise electronic transfers. South Korea used credit card income deduction experiment has been hailed as a success by OECD.

Strategies for tackling Black Money
The distillation of various approaches can be summarised as under:
  1. Establish identity of persons (through PAN Card, Aadhar Card etc.) operating in the country – citizens and foreigners.
  2. Enable low the cost direct bank transfers (Implementation of NEFT/IMPS/RTGS and other formats) including direct transfers of subsidies to the beneficiaries under the Aadhar scheme.
  3. Enable electronic register of assets (Underway through electronic land records, digitisation of revenue records)
  4. Reform tax system so that cost of compliance is lower than cost of tax evasion. (through initiatives such as Saral forms, e-filing, self-declaration etc.) Indirect tax system through simplification (GST).
  5. Widen the net for disclosure by filing Income Tax return. (auto-processing returns for tax refunds)
  6. Regulations that increase costs for black money creating activities. (Prevention of Corruption Act etc.)
  7. Create attribution chain for funds entering and exiting the country (such as through P-Notes, FDI, Prevention of Money Laundering Act etc.)
  8. Create e-trails of both incomes and expenditure.
  9. Control on holding of cash and physical money including Indian and foreign money. (FEMA, recent demonetisation)
It is clear that black money clean up is underway on many fronts. Many of the pieces of puzzle have been put in place.

Semantics of the current demonetisation
Demonetisation is the mechanism by which the government states to withdraw the money which is current legal tender. The government being sovereign can take such decision. The effect of this announcement is that the currency notes in circulation will now cease to be valid tender and can only be exchanged at the banks. Demonetisation of higher denomination notes as an idea has been around[8].

There are two important issues with respect to the present demonetization. First, that the notes ceased to be legal tender from midnight of 8th November just 4 hours after announcement. So in effect the only places where they will be accepted will be banks. Second, even the banks have been given time until when they can accept the notes – 30th December. Third, the cash swap carries restriction. Thus, in effect the announcement forces these notes into the banks deposits within a short period of time.

As per RBI estimates[9], 15billion notes of 500 denomination (approx. Rs. 7853.75 billion) and 6 billion notes of 1000 denominations (approx. Rs. 6325.68 billion) exist. In addition, RBI estimates that fake 0.2 million notes of Rs. 500 and 0.15million notes of Rs. 1000 were discovered. The actual number of fake notes in circulation will be higher. These will be worthless from 09 November 2016 but you can get the credit for the money held as these notes in the form of bank deposit. Naturally, those who can disclose deposits equal to the amount they hold in cash will have no problem.

Hasn’t it been done before?
Indeed, it has. The first demonetization took place in 1946 and Rs 1000 and Rs 10,000 notes were demonetized. Later in 1978, Rs. 1000, Rs. 5000 and Rs. 10,000 were demonetized. This is the third time demonetization has taken place. 

The critical difference is in the quantum however. The first and second demonetisations effected really high value notes which formed a small part of notes in circulation. We can arrive at the estimates by comparing the denomination of the note with the annual per capital GDP. In 1960, India’s per-capita GDP was Rs. 400 (then currency), in 1978 per capita GDP was Rs. 1722/- whereas today it is Rs. 103,000/- (today’s currency). [10]Thus in 1960, a 1000 Rupee note was 2.5X and in 1978 it was 0.5X per capita GDP, considerably easy to withdraw. The second aspect is that today the 500/- and 1000/- currency notes represents ~85% of physical money in circulation. At that time, it was considerable less[11].

RBI earlier removed pre-2005 notes of all denominations from circulation as they have fewer security features compared with subsequent notes. The process of removing the older notes from circulation continued for nearly one year. The deadline was extended till December 2015 and those notes continued to remain legal tender till November 8. This was not exactly demonetisation but removing from circulation and has now subsumed into the present demonetisation.

Why attack the cash?
First, who holds black money in cash? Mostly corrupt people. Their pay-offs are in suitcases and hoarded in their houses. These are balances held till they find their target investments. A lot of black money itself is mainly held in gold and land. 

As explained earlier, cash, i.e. black money is the currency of black economy. The government cannot do much about black money that remain stagnant if it remains a legal tender. But remove the legality of it and the government is able to alter the cost-benefits equation of corruption. Demonetisation attacks the currency supply of the black economy. But removing the cash available to buy these gold and you affect the supply chains in black economy. When the flow gets interrupted the cost of corruption increases and payoff reduces dramatically. Such action attacks the chain that processes black money.

It is possible that as a result land prices and gold prices will fall. If land prices fall, middle class will be able to purchase land. If gold purchases are reduced, the forex pressure on INR will ease a bit. Thus, legitimate money which was being priced out of the economy gets an opportunity. Further, it prevents the black money processing chains from forcing white money into black.

Inflationary or Deflationary 
Firstly, part of the actual money in circulation is never recovered. Depending on various conditions, at least 20% of this paper money will never reach banks. This stock of money is lost. Many believe this to be deflationary. It isn’t. Since this money was never within the legal purview it was meaningless anyways. From government’s point of view, it was like the money we forgot in an old diary and the diary was lost. This money did contribute to the economy but to smaller extent.

Some say “but this money was being used to buy Audis and other luxury goods”. This is weak argument. Audi as a company does not receive unaccounted money (if they do that is criminal as well). The black money chain in such cases effectively starts with the dealers who game the system by discounting the vehicle or by making the vehicle pre-owned, prior owner being the dummy person. In either of these cases the black money is circulating to other illegal users. If such deals are curtailed it is good – not bad. In any case a black money purchaser who pays Rs. 2.5 million to buy Rs. 4 million Audi then can buy a Skoda legitimately. 

Will it work?
One argument is we tried it in 1978 and failed. Of course we failed. First the notes demonetized were too large for the size of the economy. Second, we can fairly estimate that the black economy may not have used the super high value notes as much too. The present action has better chance of success as it proceeds logically. First, people across India were given an Identity card (Aadhar), then bank accounts were opened for them (Jan-Dhan), and people across India can transfer money using SMS today. No strategy can succeed without proper systems in place. This time there are better mechanisms that people can switch to.

Another argument is that people can deposit the money now and withdraw cash five months later for black money transactions. Of course they can. But there are various laws in place that track the cash withdrawer. These guidelines were framed for Prevention of Money Laundering Act. As per RBI rules under that, every withdrawal needs a PAN card reference. Further, every branch manager is required to file detailed statement of weekly/monthly cash transactions. The cost-benefit for legitimate fellows becomes high. It is easier to monitor for the tax authorities. One person claims to have sent his 200 or so employees to convert old currency into new currency. Thus, per day at Rs. 4000/- per person he is converting Rs. 0.8million into cash. So has the system failed? The answer is no. It appears from the logical approach followed by the government that this is merely the beginning of effort against black money. I suspect these two mechanisms will be taken care of in subsequent actions. 

The more fundamental answer is that black money is not a pool but a chain. Break the chain or make the chain costly and you inconvenience the poor who did not have access to bank systems. But with Jan-Dhan accounts, poor have ready access to banking channels (though not credit). So if you are law-abiding citizen then you can sail through mostly unscathed no matter how poor you are.

Black money in real estate gold etc. 
Usually, black money is used to purchase the following items – gold, precious metals, precious stones, real estate, high end consumer goods, high-end liquor, drugs, and entertainment. The total quantity of Gold, precious metals, precious stones, liquor and certain high end consumer goods in the market that is disclosed and purchasable is unknown. Their price is reasonably known. The quantity of real estate, entertainment etc. is known but their prices are not known to the government. For high-end alcohol, drugs and other items, both quantity and price are unknown to the government. 

This sort of black-money driven consumption is out of purview of the legitimate formal economy. The effect of demonetization on such consumption will be positive. Either this spending will cease thus reducing illegal imports of gold, precious metals, stones, liquor, drugs, entertainment of certain types (dance bars for example) etc. Other parts will integrate into the formal system thus prices of real estate, entertainment will generate legitimate revenue for government.

In short, the demand for these items will not be affected that much in short term and definitely not in long term. There is no denying that the contours of demand will shift from shadow economy to formal economy.

No magical government windfall gain
One argument goes that if a certain portion of the cash does not get deposited then RBI will no longer have to be liable for those notes. That reduced liability will be transferred to Government. If you estimate that about 30% of the currency notes will not come back, Government could be receiving about 30% of Rs. 14 Trillion is more than Rs. 4 Trillion. Such gains will be a game changer. Such arguments are na├»ve as they come from misunderstanding of how central bank balance sheet works[12] and also how money is created. 

One must remember that Balance sheet is an accounting construct to understand the capital deployment. Destruction of soiled notes, removal of older notes and other activities also do not create any income for government. Such activities merely adjust the balance-sheet on the liability side only. Simply put, there will be no gain to the government if RBI’s liabilities are written off. 

The issue in present case is the quantum of readjustment. If RBI balance sheet shrinks by 30% one fine day, there will be panic. But this effect can also be muted by writing down in phased manner while keeping the liability alive on paper. If this was possible you could have seen demonetization every 5 years. The only effect is that it will improve the quality of RBI balance sheet but no further.

The second part of the argument is that such a windfall need not wait for demonetization. The windfall is nothing but quantitative easing. That has consequences and is a well debated concept. 

Do Terrorists carry money in trunks?
One of the stated aims of the demonetization was to tackle terrorism. It has met with lot of ridicule. People are asking if terrorist do carry money in suit cases while coming across the borders. Again these people are missing the point. 

In fact, money laundering is one of the most important financing mechanism for terrorists. It was after 9/11 that the US initiated substantial push towards enacting of anti-money laundering laws to prevent financing of terrorists. The anti-money laundering investigations fails when the money trail leads to cash. In India the terror-finance trail starts and ends with cash making it impossible to get early alerts of terrorist active in the country. Demonetisation will upset the financing chain for the terrorists.

As noted, black money is the currency of black economy. It is the black economy, including financiers that need extra-judicial enforcement mechanisms. The terror groups are at the apex of criminal elements that provide this enforcement mechanism. If film producers do not pay their financiers, they get call from D-company – in effect an enforcement call. The black economy is also as innovative as any other. The criminal elements then seeking alternative revenue streams indulge in various terror activities. The terror finance chain comprises gold, diamonds and counterfeit currency. The counterfeiters don’t keep the money in cash but quickly convert it into legitimate, legal bank accounts through SMEs and other small businesses. Using these fronts these terrorists use this money to buy information and access. The actual terror attack is only the “last-mile” effect. The ultimate “attackers” are usually pawns without any knowledge of systems.

Yet, the main effect of demonetisation and subsequent introduction of new notes will be to increase the costs of the counterfeiters. It will serve to shock this supply chain.

The unscrupulous SMEs
The biggest elements in the black money creation chain are the SMEs. SMEs are flexible entities like sponges when it comes to cash. The question of scale of SMEs in the black money chain is mind boggling. Over years I come to believe that at least 30% of SMEs exist solely for serving the black money chains and about 80% contribute to the black money chain (many don’t have a choice). 

Their modus operandi is thus. SMEs themselves exist so as to help tax management. I refrain from using tax evasion because many of these acts are in fact legal and encouraged by law. Next, using a complicit banker the SME’s get loans. Their auditors are complicit in the process too. Now, unscrupulous promoters siphon cash away from these entities and fund private gains/marriages etc. Banks lending to SMEs are left holding the bag. This has also caused substantial stress in the bank balance sheets. Many of these SMEs are quite lax about filing financial statements with the authorities.

Thanks to the demonetization, some of these SMEs will be used to convert the black money from promoters’ holdings into the SMEs holdings. Conversely, those having illegal cash can push it into the SME balance sheet and “make it legal”. Readers may have guessed that banks will benefit from this when their bad loans suddenly start turning good. The net effect, I suspect, will be positive. 

It is clear that the next element in the fight against black money should be SMEs. These entities are critical elements and cannot be missed for this fight to succeed.

Other black money creators
There are other critical elements in black money chain or black economy. These elements represent turning smaller amount of white money into black by aggregation and misrepresentation.

For example, take NGOs. Some of the NGOs existing only on paper. Their model is thus. These NGOs collect legitimate amounts from citizens and push it into causes like animal shelters, girl child, medical aid to needy etc. The main problem is that the costs of these NGOs is unreasonably high. They also commit fraud by misrepresenting number of animals and kind of facilities etc. creating a source of black money for the promoters who get salary and or benefits like cars and drivers from the NGOs.

Cooperative banks are another piece of the puzzle. These accept smaller deposits from individuals and loan to founders and directors. The process is illegal and escapes the law only because it is not regulated by the RBI but by Politicians who are themselves directors in such institutes.

Government aided/recognized schools, colleges and institutions which look innocuous and have no actual teachers, students or infrastructure but simply using approvals from complicit education officers create a chain wherein legitimate money turns into black money. Others institutes have proper systems but use management quota to pool students’ money into black money pools for the founders. Some use both mechanisms.

Such entities are inherently different from SMEs which exist to service the needs of a wealthy black money holder or create black money through banks. These elements will be hit substantially by the demonetization and their promoters will be forced to declare these amounts or destroy them. However, the issue is that they can continue to create black money sources since their model has not been dismantled.

Role of Religious and other public trusts
The model of trusts is a little different but they are as important elements in processing black money as SMEs and others listed above. The trusts are both receptacles and users of black money. They are not creators.

Some allow devotees to make small but numerous donations while spending substantial amounts on expenditures related to their promoters. Others are created out of anonymous black money donations with specific beneficiaries. Their nature makes them a hot-potato issue where they seem to be untouchable by any government, religious entities being protected by constitution. 

These trusts will die over time as their feeder mechanisms are constrained. Yet, the reason they are highlighted here is because within the next two months we will see a lot of trusts being formed with weird articles of constitution that violate the basic premise of laws on public trusts. 

So will demonetisation eliminate black money?
Not by itself. It is just one move of one piece in the chess board of black money. To check-mate the black money king, you have to win the board. There are various steps required as detailed above. Government can play all these moves and still fail if they play improperly. All we can say is that Government is playing well. But will it succeed? The efforts will bring massive amounts of cash into the banking system – a benefit in itself. Once the money is in the legitimate channels, it should be better utilized and revenue will be generated from its use. If that is success enough then yes. 

Then again the government has tackled GST which represents 2/3rd of its revenues. It has tried to increase the size of the pie on which taxes are imposed by forcing the transactions into formal economy. The next part is reform of Income Tax which will tackle the remain 1/3rd of the revenue. Then will come loophole plugging. There seems to be well thought out method to this madness. Rest time will tell.


Notes and links
[1] http://www.nipfp.org.in/publications/working-papers/1509/ 
[2] http://www.nipfp.org.in/book/927/ 
[3] http://dor.gov.in/sites/upload_files/revenue/files/Measures_Tackle_BlackMoney.pdf 
[4] http://finmin.nic.in/reports/whitepaper_backmoney2012.pdf 
[5] Comparing how some tax authorities tackle the hidden economy by UK National Audit Office Rand Europe 2009 
[6] Reducing opportunities for tax non-compliance in the underground economy – Information Note dated January 2012 
[7] The Shadow Economy Friedrich Schneider & Colin C. Williams, Institute of Economic Affairs, 2013 
[8] Proposed by various people such as Arthakranti and also by Peter Sands in essay titled Making It Harder for the Bad Guys: The Case for Eliminating High Denomination Notes, M-RCBG Associate Working Paper Series | No. 52 in February 2016 and later discussed by Lawrence Summers and others. 
[9] https://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=1181 
[10] World Bank data in currency of respective year. Earliest data available is 1960 so we have used 1960 data. Devaluation was in 1946 which was way before this year. 
[11] The numbers based on estimates by various agencies. 
[12] For basics refer to Centre for Central Banking Studies Handbook – No. 32 Understanding the central bank balance sheet by Garreth Rule.