The demonetisation of currency after a long period of 38 years was a welcome and bold step taken by the Government of India on November 8, 2016. The last demonetisation was implemented in 1978 by withdrawing Rs 1000, Rs 5000, and Rs 10,000 notes that were in circulation. Every reform will have its merits and demerits. The question is whether the merits outweigh the demerits. A careful analysis is required to answer the question.
Black Money and Counterfeit Currency
The Modi Government has taken the bold step of demonetisation of Rs 500 and Rs 1000 notes in circulation with the intention of curbing terrorism, black money and counterfeit currency. Over the last seven decades, each has reinforced the other. The Prime Minister himself claimed this in his forty- minute speech to the nation. In his own words, “… on the one hand is the problem of terrorism, on the other is the challenges posed by corruption and black money.” The big bet in demonetising is to break the unholy nexus of corruption, black money and terrorism.
It is expected that the problem of counterfeit currency can be addressed at least for a short period, until anti-nationals develop the technology to print the newly issued currency. This is not a simple advantage. Once counterfeit currency is curbed, the intensity and spread of terrorism can be addressed. Quoting Modi’s words, “… the five hundred and thousand rupee notes hoarded by anti-national and anti-social elements will become worthless pieces of paper.” We do not have clear statistics regarding fake currencies. A study in 2015 showed that at any given point of time, Rs 400 crore worth of fake notes are in circulation (The Indian Statistical Institute, Kolkata, 2015). It also said that Rs 70 crore worth of fake notes are pumped into the economy every year. The National Crime Records Bureau (NCRB) revealed that various enforcement agencies seized 1,78,022 pieces of Rs 1000 and 2,99,524 pieces of Rs 500 notes in 2015. To that extent, it will address the problem of terror financing and fake currency. Naturally, this will be a blessing for the common man and the middle class. The same advantage cannot be reaped in the case of black money.
Demonetisation will not act as a successful strategy for curtailing black money, as the major chunk of black money is invested with financial institutions outside the country. But it is a useful tool to make black money, reserved by anti-nationals in the form of currency, non-legal tender and valueless. It is true that those who have bought land and housing property, gold and jewellery, art treasures etc using black money cannot be penalised through the demonetisation process. It must be remembered that no country has enacted a reform that would help cure all problems. However, a detailed investigation is needed to evaluate the effectiveness of demonetisation on controlling black money.
A Note on Black Money
Two central issues with black money are, ‘Who has it?’ and ‘How much do they have?’ What are the major sources of black money? There is no clear data on the quantum of black money in Indian economy. Estimates vary from 10 to 40 per cent of GDP, i.e. anywhere between $100 billion to over $400 billion. According to the Government of India (2012), the extent of black money is somewhere between $500 billion and $1400 billion. Certain estimates show the following statistics:
Black money is accumulated through different sources. The three main sources of black money are corruption, hawala and crime. Among these, corruption is the chief villain.
Key Episodes of Corruption
In 2011, Corruption Perception Index ranked India 94 among 176 countries with a score of 36. India’s rank has now improved to 76. It is not at a satisfactory achievement, as it is evident that cross-border flow of money derived from criminal or corrupt activities is around $1.5 trillion annually. Nearly $40 billion of this is accounted for bribes paid to public officials in developing countries. There was widespread corruption at the top, middle and bottom levels of governance in India during the import substitution regime. Economic reforms could be a source of huge one-time rents to politicians in power, for example, privatisation of public monopolies. This reduces their ability to use the public sector for political patronage in the future. The sources of corruption can be traced to scarcity, property rights and their enforcement, transaction costs and information asymmetries, and political position (Patibandla and Sanyal, 2009).
Corruption through scarcity is generally seen in terms of a mismatch between demand and supply. In the case of goods, the market structure of an industry (monopoly versus competition), price regulation, quantity limits, zoning and differential tax treatment in different states result in scarcity, which creates opportunities for rent (corruption). In the case of service sector, a supplier or a government body may refuse to provide a service, unless a bribe is paid. In the post-reform era, some sources of scarcity-related corruption have been magnified, owing to weak property rights and high transaction costs of enforcement. As a result, corruption has been part of the society, including the pre-reform period. The following evidences, though do not form an exhaustive list, substantiate the argument.
Mining scam in Karnataka, land grabbing in Tamil Nadu, Madhya Pradesh and Chandigarh are a few other scandals that are not cited here, due to space constraints. The ultimate effect is the accumulation of black money. All these amounts are invested safely outside the country and hence demonetisation is a helpless tool in combating black money.
Hawala and Crime
Hawala works by transferring money without actually moving it. It is estimated that an amount ranging from $100 billion to $300 billion flows through informal remittance systems globally every year. ‘White hawala’ is used to refer to legitimate transactions. ‘Black hawala’ refers to illegitimate transactions, specifically hawala money laundering (associated with some serious offence such as narcotics trafficking and fraud). In the case of India, Interpol estimates the size of hawala at possibly 40 per cent of the country’s GDP. In India, hawala is only a civil offence and persons violating its provisions are penalised with fine up to three times the amount detected in a contravention. This is a grossly inadequate deterrence to terrorists indulging in hawala for their sustenance and operation. There is fake currency circulated through the hawala system. Hence, demonetisation would help check the flow of hawala money.
Criminal offence includes drug trafficking, gunrunning, money laundering and extortion, murder for hire, fraud, human trafficking, poaching and prostitution. Many criminal operations engage in black markets, political violence, religiously motivated violence, terrorism and abduction. Other crimes are homicide, robbery, assault etc. Property crimes include burglary, theft, motor vehicle theft and arson. Demonetisation will be effective to the extent these activities are carried out with Indian high-denominated currencies. A sizeable volume of business is done by way of high-denominated currencies, though no scientific data is available in this respect.
Illicit black money not only finances terrorism but also fuels inflation. There is a possibility that inflation will be contained through demonetisation, especially land and housing prices. Counterfeit currency and black money are largely used in the real estate sector (particularly in unorganised sector and for secondary sales), where prices continuously remained high, due to the presence of black money. It is a known fact that a sizeable portion of the transaction value of land and building is done through black money, which is in currency form. Though some have converted a part of this amount into real assets, demonetisation is a useful tool to address the amount that is kept in currency form. This will reduce the prices of land and houses and thereby act as a blessing to the poor and middle-income groups. Likewise, there are a number of intermediaries in the fishing sector, agricultural sector and service sector with unaccounted money in currency form. Arresting this phenomenon will be beneficial to the society. However, there should be proper institutional reforms to address these issues. Otherwise, demonetisation is not going to produce any wonderful results for the country’s economy. Sometimes, a deflationary situation cannot also be neglected which will hamper the economy.
Earlier, the high tax rate was considered a source of black money in India. Now, India has moved to a low tax regime. Yet, tax reforms are not adequate and the issue of black money is not settled. It means that low tax regime will not address the problem of black money. In this context, demonetisation is a relief to a certain extent. What is necessary is to rein in corruption and for that, institutional measures should be taken. The government has already taken some steps in the direction. For the effectiveness of demonetisation, some drastic steps are required. An urgent remedy is to withdraw all high-denominated currencies from the economy. The decision to print Rs 2000 notes is not a wise step, as it would aggravate the problem of black money and related issues. Small denominations up to Rs 100 (or maximum Rs 500) should be allowed, which should be accompanied by a mechanism to propagate the wider use of debit/credit cards in place of currency.
In conclusion, whoever expects that the demonetisation process will be a great success is mistaken. The inherent limitation of demonetisation has to be kept in mind, while evaluating it. To make the final point, the effects of demonetisation can be split into three periods, such as very short, short and long periods. In the very short period (three to seven days or less than one month), there will be some adverse effects, especially for the poor and middle-income groups. Hence, it will be in a pain economy. In the short period (less than a year), it will produce positive outcomes, barring a few limitations. This period will naturally be in a pleasure economy. In the long period, counterfeit currency and black money (which is not the result of demonetisation but bad governance)may make a comeback, unless proper institutional measures are taken. This coupled with the spread effect of the positives in the short period will usher in a ‘neutral economy’. No doubt, demonetisation will not produce bad outcomes in the long run, except a few hardships faced by low-income aam aadmi for three to five days. The possibility of some positive outcomes like bringing all the black money out of hiding and throttling terror funding in due course cannot be neglected.
*Dr Martin Patrick is Chief Economist at Centre for Public Policy Research. Views expressed by the author is personal and does not reflect that of CPPR.
Gupta, S (1992): Black Economy in India, New Delhi, Sage
NIPFP (1985): Aspects of Black Economy in India, New Delhi: National Institute of Public Finance and Policy
Patibandla, M and Sanyal, A (2009) Corruption: Market Reforms and Technology in Rajesh Kumar and Mutr Patibandla, Institutional Dynamics and Evolution of the Indian Economy, Palgrave
Demonetisation, in simple terms, is the withdrawal of a particular form of currency from circulation. It is the act of stripping a currency unit of its status as legal tender. Demonetisation is necessary, whenever there is a change of national currency. The old unit of currency must be retired and replaced with a new currency unit.
The High Denomination Bank Notes (Demonetisation) Act, 1978
Corruption is generally defined as the ‘misuse of public office’ to extract an illegal rent. It is a major political and economic issue in India.
Money transfer without money movement is an easy definition of hawala.
Dr Martin Patrick is Chief Economist at CPPR. He holds a PhD in Applied Economics from the Cochin University of Science and Technology (CUSAT), Kochi and also had a post-doctoral training at Tilburg University, Netherlands. Presently, he is a Visiting Fellow at Indian Maritime Institute, and Xavier Institute of Management and Entrepreneurship, Ernakulam.