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.