Friday, November 18, 2016

Demonetisation won't by itself make a difference to black money

I should have provided this link earlier- I was among the first to comment on this subject in BS.

BS has a pay wall for opinion pieces, so here's the text:

Many have called the decision to demonetise ~500 and ~1,000 notes a “surgical strike”. They were, of course, using for best effect an expression that’s the flavour of the moment.
It’s, however, an incorrect characterisation of the government’s intent. A surgical strike is an operation with limited tactical objectives. The intent behind demonetisation is a frontal assault on black money, with a view to eradicating the problem. However, the expression could turn out to be correct in describing the eventual outcome. Demonetisation is a good initiative but, in itself, cannot be expected to make a big difference to black money in the Indian economy.
The scheme is expected to work as follows. It will render useless large amounts of cash held by black money operators. They will have to come forward, put their cash in legitimate channels and get exposed or they would have to simply discard their hoards.
There are several problems with this formulation. First, it assumes that black money is held overwhelmingly in cash. It’s not. Currency in circulation in the Indian economy is about 10 per cent of gross domestic product (GDP) — in the US, it’s about seven per cent. Black money goes into a variety of assets — business assets, real estate, gold, etc.-  and a relatively small proportion is held as cash. The proportion is higher in real estate than in other businesses. Cash is generated from businesses as required using a variety of means such as under-invoicing and over-invoicing, evasion of excise duties, etc.
Secondly, it assumes that the only means available for people to use their black money hoards is to bring them into the open by depositing these in banks. This again is not entirely true. There is a well-developed parallel mechanism for converting black money into white through the use of trusts and bogus companies. Those who have availed of it will tell you how astonishingly smooth and reliable its working is.  
Thirdly, we are assuming that black money operators are seriously at risk if they bring their money out into the open. This may be true of small businesses and self-employed professionals such as doctors and lawyers. Big-time operators, however, will find ways of handling the problem using their contacts with the bureaucracy and the political class. That’s how they have operated all these years. To expect that things will change radically overnight is to repose a degree in faith in the tax and law enforcement authorities that’s not warranted by past experience.
For many who have black money, the immediate effects could be unsettling. They may face temporary losses. However, once the new notes come into use, it will be business as usual. In other words, any destruction of black money that takes place could be a one-off effect. If it becomes difficult to keep more than a certain amount of black money within the economy, more of it will find its way out than before through the hawala route. It will come back as foreign institutional investment (FII)foreign direct investment (FDI) or private equity flows. Unless, there is a significant breakthrough in unearthing black money abroad – and this is still very much work in progress at the moment – the current measures may merely alter the proportion of black money held in India and abroad.
(The fact of the matter is that- pl delete)  Black money flourishes because it is part of the well-established nexus between business and politics. It is the biggest source of finance for elections and a significant source of income for politicians and bureaucrats. It is there because it suits the interests of the principal players in the system — businessmen, <i>netas and <i>babus. Seriously disturbing this equilibrium would call for changes that go well beyond demonetisation.
There will be consequences for the economy in the short-run, mostly negative.  Consumption will be adversely impacted. Stock market volumes can be expected to fall. Real estate activities will be hurt and there could be a fall in prices. The inflation rate can be expected to decline in the short-run because of the impact on aggregate demand.
Again, these will be strictly short-term effects. It is not clear that real estate prices will fall to a lower level even if the proportion of black money used in real estate comes down. Sellers will now have to pay more by way of capital gains taxes and they will factor this into the sales price. This could well offset the impact of lower demand.
Banks will be flush with deposits in the months ahead. But this need not translate into higher growth in credit. Public sector banks, which account for 70 per cent of bank assets, are averse to lending today because of the pile-up of non-performing loans and for want of adequate capital. They are unlikely to step up lending because deposits have gone up. More likely, they could reduce their dependence on bulk deposits and hence their cost of funds.
It’s interesting that the Reserve Bank of India has portrayed the move to remove higher denomination notes as an attempt to check the use of fake notes, not as an assault on black money. That’s perhaps a more accurate way of describing the initiative. It has all the makings of a surgical strike, not so much an all-out war.


Anonymous said...

Thanks Prof! . You mentioned two points esp ... cash hoarding and nexus between political-administrative and commercial systems. Cash hoarding is a primitive form but it is more of a circulatory nature...either in real estate or in rural hinterlands they double as money lenders (any person who has limited exposure to rural occupations will tell that). technically no hoarding but their money will be in circulation. They might definitely be hit considering momentary nature of demonet desc. ...
Similarly, should state funding be helpful in reducing the extent of black money .. though we are not sure of modalities?


The Big Picture said...

It's not clear that state funding will reduce use of black money by political parties- it will simply add to the coffers of many. We need audited accounts of political parties and a ban on cash donations.


shreyans matani said...

Nice insight sir! I am a young Chartered Accountant and I have published my views on demonetisation and its impact on the banking sector on my blog. Hope you will enjoy reading it! The link is below :-

Rahul Nehra said...

But Prof! you haven't pointed out on how this move can change our habit towards cashless transactions(behavioral) because once that picks up then some of the issues related to taxation could be addressed more effectively, although truly speaking even black money is a source of demand in one form or another and it remains to be seen how that demand actually shifts?