Pitfalls of a secretive economic manoeuvre

It is now close to a fortnight since the government banned the use of Rs 500 and Rs 1,000 notes, which together constitute 86% of the total value of currency in circulation. Media reports highlight the significant and continuing distress afflicting the poor and the middle-class since this decision was announced.

The prime minister has suggested that the transitional period will last 50 days. In fact, liquidity chaos may well continue into the next financial year, especially in rural areas. Several deaths have been recorded so far that can be directly related to demonetisation. Whether the obvious transitional costs are “minor inconveniences”, as the finance minister reportedly suggested, or cataclysmic, as the families of those who have died while waiting in bank queues may believe, depends on one’s perspective. The broader question, however, is the exact nature and magnitude of the long-term gains that the government has promised. What are these gains likely to be?

Corruption has both flow and stock aspects. The former refers to the income generated per year from illegal activities or from legal activities on which tax is evaded. The latter refers to the total stock of wealth held at any point in time, as a portfolio of various assets, including real estate, shares, gold and jewellery, deposits in foreign accounts, luxury cars and cash rupee holdings that is acquired from past illegal income.

Currency demonetisation, being a one-off, does nothing to address the flow aspect of corruption. Undeclared cash transactions in, for example, real estate deals or bribe payments, will be carried out in 2,000-rupee notes once the currency supply is replenished. Nor can it do anything whatsoever to dissuade future terror funding or currency counterfeiting. Demonetisation affects only the cash component of the existing stock of illegally acquired wealth.

What is the size of this component? Assessments range from 6% to 10%. Prof Arun Kumar, India’s leading authority on the underground economy, estimates the total amount of ‘black’ wealth held in cash at Rs 2-3 lakh crore, compared to the Rs 13 lakh crore that is the approximate aggregate value of the currency notes being withdrawn.

A significant proportion of illegal cash holdings has already been converted to jewellery and high-end consumer durables, or deposited in ‘benami’ accounts, since the policy declaration. More will be converted over the next few weeks. Adding creative business accounting in terms of ex-post cash flow adjustments, explaining away of profits as tax-free agricultural income and exploitation of legal loopholes by smart tax lawyers, it is reasonable to estimate that at least half of the ‘black’ cash holdings will be whitewashed.

It is therefore quite unlikely that demonetisation will reduce the stock of black wealth by more than 4% or Rs 1.25 lakh crore; about 0.8% of the projected nominal GDP of India in 2016-17. The total black income generated every year is usually estimated at about 25% of the GDP.  Hence, demonetisation at best is likely to have the same direct effect on the balance sheets of the corrupt as reducing black income by about 3% just for this year.

Some may derive moral gratification from even a 4% reduction in the value of the asset portfolio accumulated from illegal earnings. Pragmatists will, however, insist on asking how much of this reduction will be available for public purposes. Some of the currency will be destroyed by their holders, as the government threatens to impose punitive penalty rates on tax evaders. It will also cost a few thousand crore rupees to print the new currency. 

Banks’ bad debts

Additionally, the government will have to pay for transport of new currency, greater security, new ATMs, recalibration of ATMs, additional staff in banks and tax offices to handle extra workload etc., which will probably add up to more than Rs 10,000 crore. Demonetisation is thus unlikely to deliver more than Rs 1 lakh crore, that is 0.7% of the GDP, next year to the government as additional tax earnings.

For comparison, the total Gross Non-Performing Assets of banks (mostly bad debt given to large corporates) stood at about Rs 6 lakh crore at end-March 2016, and is expected to move close to Rs 7 lakh crore by March 2017. The cash squeeze is going to have a serious negative impact on production and aggregate demand for at least two quarters, reducing tax revenue in 2017 so that the net increase in tax revenue may even fall below 0.5% of GDP, to the region of Rs 60,000 crore-Rs 75,000 crore.

 It is insufficient to prevent the contractionary impact of demonetisation from spilling over into the next fiscal year, as people keep consumption low to rebuild savings portfolios run down to survive the current crisis, and informal credit remains restricted due to destruction by demonetisation of much of the cash-based micro-level informal savings and credit institutions.

The growth rate is therefore likely to fall, both in this fiscal and the next, below earlier projections, unless the government significantly increases its budget deficit to expand demand. Indeed, the budget deficit may rise even as the growth rate falls, due to the revenue squeeze mentioned earlier.

Therefore, the most likely long-term outcome of demonetisation exercise is an almost negligible expropriation of black wealth but extensive collateral damage suffered by the common people through a combination of lower growth for at least a year, and a large loss in their cash holdings due to distress sales of high denomination notes at much below face value.

This damage could have been entirely avoided and the revenue gains improved had the government been able to retrieve even 10% of the bad debts owed to banks by corporates.

(The writer is professor of economics at the Indian Statistical Institute, Kolkata)