The demonetisation boondoggle
In view of the costs and disruptions that have ensued, the scrapping of ~500 and ~1000 notes was a sledgehammer move that does not appear to have relied on a clear-headed cost-benefit analysis
It has now been over three weeks since the demonetisation of 86 per cent of India’s circulating cash. The main logic that has been given for the measure is that it is a decisive blow to holders of undeclared income, that is, black money. Black money has both a stock and a flow aspect. To assess the impact of the demonetisation we need a quantitative estimate for both of these aspects.
A recent World Bank survey suggests that the parallel economy is around 25 per cent of India’s GDP (gross domestic product), which gives us an estimate of the flow share of the underground economy. The wealth share of the underground economy is more difficult. A recent Credit Suisse study estimates the wealth-to-GDP ratio in India at around two. Assuming that wealth creation is similar for both declared and undeclared income, this would suggest that black wealth is about 50 per cent of GDP. It is likely larger, since the savings rate out of undeclared income is probably greater than that out of declared income. Nevertheless, armed with these two estimates, let us go through the impact of the demonetisation move.
How much can the demonetisation mop up? One measure would be how much is exchanged as a share of what was demonetised. The demonetised money is about 10 per cent of GDP. Even if the entire amount was left unexchanged, it would amount to around 40 per cent of the underground economy (or black income) and 20 per cent of black wealth. My guess is that about 85-90 per cent of the demonetised cash will be exchanged (note that as of November 28, around 60 per cent of the demonetised cash had already been turned in). Hence, the amount that this move will net will be around two to three per cent of the black wealth in India (or four to six per cent of black income).
These estimated numbers are rather small when compared with the overall stock of undeclared income held in other forms and in view of the disruption the move has created. This is primarily because most undeclared income is not held in cash but rather in gold, jewellery, real estate, foreign currency or quickly laundered through round tripping. Ironically, the Reserve Bank of India (RBI) is now issuing ~2,000 rupee notes, which will make it marginally simpler to use cash to store undeclared income.
What about the costs of the move? It is very unlikely that the move will have serious long-term implications, save for one concern that I will highlight below. The short-run costs, however, are unlikely to be insignificant. As has been pointed out by a number of different commentators and analysts, the Indian economy is heavily cash-dependent. The informal sector in particular depends almost exclusively on cash for transactions. Given that this sector accounts for 80 per cent of employment and 45 per cent of GDP, the costs can clearly be large. Assessing the size of these costs can however be difficult.
Given that the disruption is due to people not having cash to make payments, one way forward is to use a macroeconomic model that is based on the transactions motive for holding cash. This model is fairly rudimentary and is known as the “Quantity Theory of Money”. The theory predicts that for a given speed with which money circulates, a fall in money supply would translate into a fall in nominal GDP. Thus, suppose 85 per cent of the demonetised cash is returned by December 31. As long as inflation remains as expected, the quantity theory would predict that real GDP growth for FY16 would be 1.7 percentage points lower than expected.
There are a number of assumptions underlying this projection. By varying them, one could easily come up with real GDP growth reductions for FY16 that vary from a low of one per cent to a high of 3.5 per cent. Hence, one shouldn't be surprised if the cost ultimately comes in above two per cent of GDP growth. That is high.
There is one other important aspect worth noting. The demonetised currency was originally issued without any contingencies. Now the government has announced that these liabilities will only be redeemed if the holders can meet various conditions, such as satisfactorily documenting the source of the cash, and exchanging it within a given time period. These conditions were not there when the RBI originally issued these liabilities. This is akin to debt repudiation. Countries that repudiate their liabilities often pay a price in their future ability to issue similar liabilities due to a loss of credibility. While India might yet escape such a reputational hit, one nevertheless worries about the potential loss of credibility.
In terms of the creation of flows of black money, demonetisation will do nothing. The problem is getting people to pay taxes. Forcing people to use banks and provide tax identification numbers for large transactions will help in reducing the creation of black money flows. But these measures are independent of demonetisation.
The long-term goals of reducing the cash dependence of the economy and encouraging more financial inclusion are good. So is the desire to eliminate black money. But this is a sledgehammer move, given the costs and disruptions. It probably does signal the intent of the government which, if credible, could alter private sector behaviour. But that is a big unknown. All public policy must rely on a clear-headed cost-benefit analysis. This one appears to fail that test.