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 led to a report on Aspects of Black Money in 1985. The Report of 2012 titled Measures to tackle Black Money in India and Abroad and the 2012 White Paper on Black Money 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. They also recommend risk based monitoring mechanisms, coordination amongst revenue departments and education among other things.
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. 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:
- Establish identity of persons (through PAN Card, Aadhar Card etc.) operating in the country – citizens and foreigners.
- 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.
- Enable electronic register of assets (Underway through electronic land records, digitisation of revenue records)
- 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).
- Widen the net for disclosure by filing Income Tax return. (auto-processing returns for tax refunds)
- Regulations that increase costs for black money creating activities. (Prevention of Corruption Act etc.)
- Create attribution chain for funds entering and exiting the country (such as through P-Notes, FDI, Prevention of Money Laundering Act etc.)
- Create e-trails of both incomes and expenditure.
- 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.
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, 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). 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.
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 naïve as they come from misunderstanding of how central bank balance sheet works 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
 Comparing how some tax authorities tackle the hidden economy by UK National Audit Office Rand Europe 2009
 Reducing opportunities for tax non-compliance in the underground economy – Information Note dated January 2012
 The Shadow Economy Friedrich Schneider & Colin C. Williams, Institute of Economic Affairs, 2013
 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.
 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.
 The numbers based on estimates by various agencies.
 For basics refer to Centre for Central Banking Studies Handbook – No. 32 Understanding the central bank balance sheet by Garreth Rule.