Demonetisation has resulted in, at best, marginal improvements in India’s tax compliance and digitisation. But at what cost?
Artists protest against the demonetisation of Rs 1000 and Rs 500 notes through a street play in Kolkata. Credit: PTI
Ever since Prime Minister Narendra Modi’s surprise announcement of a year ago, demonetisation has been the single most hotly-debated issue in India. Modi and members of his government have given a series of justifications for the sudden move, shifting ground from one to the next as each in turn has lost its emotional appeal. One year after the move it is possible to make a dispassionate appraisal of its impact.
Modi’s first justification was that it would destroy large hoards of black money. In a way that he never explained, this would enable him to put thousands of rupees into the bank accounts of the poor. In fact, very little black money was destroyed: only Rs 16,800 crore in old money did not get converted into new. Needless to say, no money has come into any bank accounts.
His second justification was that it would cut off the funds for terrorists. This too has not had any perceptible impact on ‘terrorism’ in Kashmir, but even if had, the success would have lasted just till Pakistan’s ISI was able to forge the new bank notes. His third justification, that it would root out black money by forcing shell companies indulging in benami transactions out into the open has some validity, for the government has deregistered more than 217,000 companies and disqualified 319,000 directors.
But while this drastic sweep is welcome, it is difficult to see how it relates to demonetisation. This cleansing operation has been done by the Ministry of Corporate Affairs, and it is difficult to see why the weeding out of companies that had filed no returns or annual accounts could not have done it without the aid of demonetisation.
Modi’s final assertion, that demonetisation has been be a giant step towards a cashless economy, is equally open to question, for while both the number of taxpayers and the tax revenues have risen, neither has departed significantly from the long-term trend in India. The single most unambiguous indicator of a shift towards a digital economy would have been a sharp increase in the number of outstanding credit cards. But after a small surge from 829 million debit and credit cards in October 2016 to 886 million in March 2017, this has sunk back to 853 million in September 2017, an increase of only 3.1% over 11 months.
All in all, therefore, demonetisation has resulted in, at best, marginal improvements in tax compliance and digitisation, but at what cost? It is when we draw up the debit side of the balance sheet that the tally turns heavily negative.
Also read: The Vast Difference Between What Demonetisation Achieved and How it was Perceived
First, whether well intended or not, demonetisation was badly bungled and therefore imposed not just severe but also unnecessary hardships upon the poor of the country. If the intention was to destroy black money hoards, then demonetising the Rs 1000 notes could have been justified, but demonetising the Rs 500 was little short of criminal. For in value terms by 2016, the Rs 500 was the most heavily-used currency note in the country, accounting for 45% or Rs 7,89,000 crore worth of the total currency while Rs 1000 notes made up Rs 6,32,000 crore. A better step would have been to issue Rs 5,000 and Rs 10,000 notes to which black money held as cash would have come flocking, and then withdraw them from circulation altogether.
But Modi was in a hurry; the crucial Uttar Pradesh elections were only three months away and he needed to do something dramatic to make sure the BJP would win. So he personally jumped the gun. There is an abundance of evidence that the central bank machinery, including governor Urijit Patel, did not approve of it. In the fortnight after demonetisation, he refused to say a single word in support, leaving the finance ministry’s economic affairs secretary to defend it day after day before the media.
As if this was not shortsighted enough, not only had the new notes that would replace the old not been printed, but the government did not remember that neither the new Rs 500 nor the Rs 2,000 note was of the same size as the old ones. So they could not be dispensed until all the million-plus ATMs had been re-calibrated. This prolonged the shortage of cash in the economy: as late as April 28, 2017, only 90% of the currency withdrawn had been replaced. By this time, a hundred people had died while trying to get their own money out of the banks.
What did demonetisation actually achieve? The simple answer is that by sharply reducing the money supply in the economy, it caused a huge immediate reduction in the generation of the Gross National Product (GNP). By how much can be understood by examining it through the lens of Fisher’s Quantity Theory of Money? The fundamental postulate of this theory is summed up in the equation MV = PT, where M is the supply of money; V is its velocity of circulation or the number of times money changes hands during a year; P is the average price level of all commodities in the market and T is the total number of sale transactions during a year.
Customers outside an SBI branch in Amritsar after the announcement of the demonetisation of Rs 500 and Rs 1000 notes. Credit: PTI
After eliminating double counting (which occurs, for instance, when an intermediate product such as steel is first sold as steel and then re-sold as part of a car), PT is the GNP of a country. So when M nosedives, the GNP has to go down by the same proportion. By how much it will actually go down depends upon the proportion of total transactions that are carried out in cash, as against through bank transfers. In India, while 90% of the volume of transactions is estimated to be in cash, since most big ticket and bulk sales outside agriculture take place through the banks, the value of transaction in cash is in the neighbourhood of 68%. The demonetisation of 86% of India’s cash should have reduced PT, and therefore the GNP, by 58%.
How long this impact lasted would depend upon how rapidly the demonetised notes are replaced. Full replacement did not take place till some time in May, so assuming that the average shortage of cash tapered off evenly to zero by early May, the average reduction in GDP should therefore have been around 29% over these six months and half of that – 14% – for the full year. So how has the government been able to claim that the only impact has been a fall in growth of GDP from 7.3% in July till September 2016 to 5.7% in April to June this year?
A part of the reason is that employers and workers in the unorganised sector resorted to desperate stratagems to tide over the shortage of cash. Till December 31, the cut-off date for converting old notes into new, employers in the construction, other unorganised sectors of industry and trade, continued to pay their workers with the old currency notes leaving it them to queue at the banks to exchange it every week. Many vendors in the cities used this respite to install credit card machines or enrol in Rupay or other online payment portals. All this helped to prop up the money supply and therefore reduce the shock. By December 31, when the conversion facility was withdrawn, about half the old banknotes had been replaced.
Also read: One Year After Demonetisation, Modi Government’s Claims About It Have Clearly Been Proven False
But the second, more important reason is that the Central Statistical Office still relies on extrapolation of growth rates from the formal to the informal sector to estimate output and growth rates in a large part of the latter. Its projections in December 2016 of what GDP growth would be during the whole of the fiscal year, till March 2017, stated this explicitly. It does not, therefore, have a way of estimating the impact of a catastrophe that strikes only the informal sector.
How seriously this can distort its preliminary estimates was demonstrated by the Unit Trust of India’s crash in 2000. This was not reflected in India’s GDP figures till 16 months later because the CSO used to calculate growth in the non-banking financial Sector by extrapolating from the data for the banking sector. When the crash was factored in, the GDP growth estimates had to be reduced by 1.1%.
The full impact of the demonetisation only became apparent when the Economic Survey, Volume 2, noted that the rural India was in the grip of deflation, because while agricultural output had grown by 2.3%, its value had increased by only 0.3%. That meant that average prices had fallen by 2%.
The fall reflected the shortage of purchasing power in the rural economy and helped to complete the story of demonetisation. After the note conversion facility was withdrawn, construction and unorganized sector industry could no longer pay their workers, who were mostly migrant labour from other tates. So faced with having to choose between staying on in the cities and scrabbling for work, and going home to their villages to eke out a living on what they had saved till then, most of them chose the latter.
For weeks in January, therefore, newspapers reported that streams of migrant workers were returning to their homes. When they got back, many sought work under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA). This was reflected in a 30% increase in the number of applications for MGNREGA jobs. But MGNREGA gave only 100 days of work. So by the beginning of summer, that income stream too had dried up. That is when the sharp drop in their cash savings began to be reflected in a decline in their purchasing power.
Prem Shankar Jha is a senior journalist and the author of several books including Crouching Dragon, Hidden Tiger: Can China and India Dominate the West?
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