ONE YEAR LATER
Demonetisation shook the economy. Did it break it, or leave it healthier?
A year after demonetisation was announced, a look at the consequences of Modi’s economic shock therapy
MY DEAR CITIZENS, I hope you ended the festive season of Diwali with joy and new hope. Today, I will be speaking to you about some critical issues and important decisions.” It was a year ago that Prime Minister Narendra Modi first addressed the nation about demonetisation. Late in the evening on November 8, he spoke about corruption, black money and the fight against the two. Then came the bombshell. “To break the grip of corruption and black money,” he said, “we have decided that [ the] five hundred rupee and one thousand rupee currency notes presently in use will no longer be legal tender from midnight tonight, that is, 8th November, 2016.”
The picture grew somewhat clearer in the days immediately after. The rationale for the drastic step was that it would strike at the root of India’s black economy and bring an end to a counterfeit currency market that, among other things, funded cross- border terrorism. Demonetisation was also presented as a turning point for the country, a significant departure from a system that was opaque and corrupt to one that was transparent and honest. It was even suggested that the Reserve Bank of India ( RBI) ( and therefore the government) stood to gain between Rs 3- 4 lakh crore from the fact that the RBI’s liabilities would reduce by the amount of black money ‘ extinguished’ via demonetisation.
There is no doubting the scale of the problem. A report by US- based think tank Global Financial Integrity ( GFI) estimated that $ 21 billion in black money was taken out of India in 2014 alone. Another GFI report estimated that between 2004 and 2013, more than $ 505 billion— over Rs 30 lakh crore— left India for foreign shores. Though this figure was described by the Directorate of Revenue Intelligence as ‘ heavily exaggerated’ in a reply to a Supreme Courtappointed SIT, even as a ballpark amount, half a trillion dollars leaving the country illegally is no laughing matter.
However, a year later, the picture remains hazy. The direct benefits of demonetisation remain difficult to pin down, at least in hard data. Positive signs include a report in January this year suggesting that illegal ‘ hawala’ transactions dropped by 50 per cent following demonetisation. The exercise also provided a liquidity bonanza to banks and led to an increase in tax compliance. The drawbacks of the policy are far easier to spot— for instance, within a week of the announcement, several Indians had died for lack of usable cash, some suffering heart attacks while waiting in bank queues. And today, with Rs 15.4 lakh crore ( 99 per cent of demonetised currency) back in the system, no windfall gain of some- lakh crore appears in the offing either.
This has raised questions about the government’s characterisation of ‘ black money’ as stashed- away cash that could easily be unearthed and ‘ extinguished’. “The answer to the shadow economy is to make the tax system more efficient... not demonetisation,” said former finance minister P. Chidambaram at a businessmen’s meeting in Rajkot on October 28. “[ It is like] saying ‘ there is a mosquito in my house, so I am going to burn down my whole house’.”
Experts say the next couple of years will offer a much clearer picture of what the impact of demonetisation has been. What is already perceptible, however, is a steady movement towards the formalisation of the economy— the result of the government’s stated agenda of greater transparency in financial dealings ( and therefore, increased compliance in taxation). For now, the more populist aspect of the move— as a ‘ clear signal to the corrupt’— seems to have endeared the BJP to voters. The huge majority it swept to power with in Uttar Pradesh in March 2017 is indicative of that— as is the fact that the election took place months after demonetisation was announced, meaning that the painful cash crunch that followed the ambush/ rollout had already stoked as much anti- BJP feeling as it was likely to.
For its own part, the government hails demonetisation as a success, despite the RBI report noting that 99 per cent of demonetised money had been returned. Even though this suggested that the attempt had largely fallen flat, finance minister Arun Jaitley said that outright confiscation of money had never been the objective. He stressed the government’s position— which had evolved somewhat in the face of fierce criticism over the weeks and months after November 8, 2016— that the aim had been to reduce the economy’s reliance on cash, expand the taxpayer net and increase the digitisation of taxation. “[ Now] we have more taxpayers, both in direct and indirect tax, as reflected in the 27 per cent rise in personal income tax returns filed and the GST collections in its first month. A larger tax base, more digitisation, less cash and an integration of the informal economy,” he said in August.
An aspect of digitisation now becoming painfully obvious to businessmen across the country is the fact that computers can process oceans of data in a matter of hours. When it comes to ensuring tax compliance, this includes comparing tens, if not hundreds of thousands of bits of information— like income tax declarations, bank statements, registration forms, ownership documents or digital transactions— to make sure they add up as they should.
‘ Big data’ analysis of this sort also leads to unearthing legal tricks, like ‘ shell’ companies. These are companies ‘ on paper’, often used to obscure who truly owns an asset or sum of money. Other suspicious activities— such as a single company maintaining an inordinate number of bank accounts, or accounts showing sudden deposits and equally sudden withdrawals of immense sums— also become easier to spot. In that vein, in September this year, the government deregistered 200,000 companies on suspicion of being ‘ shells’ and froze their bank accounts. Reports say it is investigating suspicious deposits made by these companies— which have been inactive for two years or more— totalling about $ 1 billion. Government sources also talk of some 28,000 companies that collectively maintained almost 50,000 accounts in 49 Indian banks. On the day demonetisation was announced, these accounts showed a collective balance of about Rs 2,600 crore. Between the next day and the day these accounts were frozen, more than Rs 10,000 crore passed through them. Many other companies were found to be maintaining more than 100 accounts each. Over 100,000 individual directors of suspected shell companies have also been identified as suspicious.
This could well be why finance minister Jaitley appeared unconcerned about the percentage of demonetised cash returned to the RBI— and also why digitisation was not among the government’s initial stated goals for demonetisation. As a finance ministry official puts it, not all the money deposited in banks post November 8 last year can be termed ‘ white’. “There is no more [ anonymous] cash. A trail has been established, and the Income Tax ( IT) department will be using big data to pursue the trail,” said an official. Though new ways of hiding ill- gotten wealth will no doubt evolve, this does, for the moment, shine a strong light on the darkest parts of the Indian economy. “More than 18 lakh people have been identified whose income is more than their declared wealth,” said Prime Minister Modi in his Independence Day speech this August. “They have to answer questions [ about] how they accumulated such wealth.” Over Rs 1.75 lakh crore of deposits were under scrutiny, he said, adding that the government had already confiscated Rs 800 crore worth of benami assets.
Another reason digitisation might have been left out
of the initial narrative is that many Indians had no other option either way on November 9, 2016, and for several weeks after. As a result, the use of digital payment systems increased by about 300 percent in the first weeks after demonetisation. That growth has continued, with RBI provisional data suggesting digital transactions rose 13.5 per cent from August to September this year, growing from Rs 109.8 lakh crore to Rs 124.69 lakh crore. This growth rate is admittedly lower than it had been before demonetisation, but is still impressive given the higher base. The number of transactions on the government’s Unique Payment Interface has grown ten- fold since December. At the same time, the use of debit and credit cards has reduced, falling 5.7 per cent from August to September this year.
Another consequence of demonetisation has been its impact on the financial sector. It has proved a bonanza for banks. The fact that every single Rs 500 and Rs 1,000 note in the economy had to be replaced meant everyone who didn’t have a bank account— but had more than a few thousand rupees to their name— needed one. For a sector saddled with Rs 8 lakh crore worth of bad loans, this was a blessing. The pace of new account growth rose and banks also became flush with funds for several months. “It is true that liquidity in the banking system improved due to demonetisation and interest rates have softened. However, that was an unintended consequence and is temporary,” says D. K. Joshi, chief economist, Crisil.
With the hindsight of a year, a massive change that has gone largely unremarked is a change in saving patterns. Increasingly, households appear to be investing in equity and mutual funds. “Average monthly inflows into equity mutual funds grew from $ 0.6 billion to more than $ 2 billion during the period after demonetisation. In fact, it touched $ 4 billion in the last few months”, says an economist.
Economists also say that a growth in tax revenue could be attributed to better compliance resulting from the government’s move to crack down on black money. Tax revenues to the Central government rose 18 per cent, to Rs 17.1 lakh crore in the year ended March 31, with steady growth in direct taxes and a sharp jump in excise and service tax receipts. This increase took place despite GDP growth slowing to 7.1 per cent, while excise duty collection rose 33.9 per cent and service tax collection rose 20.2 per cent. Policy economists say demonetisation also laid the foundation for other anti- corruption measures, such as the bankruptcy code, the crackdown on shell companies and the Real Estate Regulation and Development Act, which, along with demonetisation and the GST, played a substantial role in reducing the speculative buying of property by investors.
This, among other factors, has hit
200,000 firms were deregistered on suspicion of being ‘ shell’ companies and had their accounts frozen
the real estate sector hard. Long spoken of as the sector that made the most use of black money, some estimates suggested that as much as 30 per cent of all transactions in the Rs 6.5 lakh crore sector ( 2014 estimate) was carried out using money that was ‘ unaccounted for’. “The real estate sector was under pressure anyway, and demonetisation has compounded its problems,” says an analyst.
While property prices saw an expectedly severe slump as a consequence of demonetisation— as much as 40 per cent in some markets— what is more worrying is that there has been no corresponding increase in demand in response to the drop in prices. Some say buyers are still waiting for the market to hit ‘ bottom’, wherever that may be. This has impacted new projects to a large extent. Reports say that for three consecutive quarters, the stalling rate ( or the value of stalled projects as a percentage of projects under implementation) in the realty sector has been in double digits, with the total value of stalled realty projects touching Rs 1.27 lakh crore in the September quarter. Real estate brokers in New Delhi tell india today that there has been a sharp turn in sentiment. “People have a clear sense of fear that they are being watched,” says a policymaker.
At the end of the day, the pain that demonetisation put the economy through is well documented, as was the hamhandedness of the rollout. The shortage of cash in ATMs ( and non- functional ATMs) led to endless, serpentine queues at the ones that did work. The shortage of cash in banks, and the constantly changing exchange limits made for even worse queues, in which people died. The secrecy around the move meant that banks were caught totally unaware. A lack of communication led to Rs 2,000 notes that were differently sized than the ATM cartridges that were to hold them, leading to yet another round of ATM recalibrations and repairs that further worsened the cash crunch.
In August this year, the Central Statistics Office noted that GDP growth slipped to 5.7 per cent in the April- June quarter, India’s lowest in three years. Private consumption expenditure— the single biggest driver of GDP growth— also fell. Data showed that private consumption as a percentage of GDP fell to 58.7% in January- March this year ( the quarter after demonetisation), from 59.1% a year earlier. However, even worrying statistics like these do not measure the full pain of demonetisation. The informal sector— till recently comprised of small units operating almost solely on cash, serving lakhs, if not crores of Indians— suffered a devastating blow. “The GDP numbers reflect the activity in the formal sector. When the informal sector is taken into account, the growth numbers will be much lower, for the next two quarters at least,” says a Mumbai- based economist. As many as 1.5 million jobs in this sector were lost in the first four months of 2017, likely due to demonetisation and the knock on effect on the continuing fall in new investments to this sector, said the Centre for Monitoring Indian Economy.
Some economists say we are looking at the economy the wrong way. Cash is only a tiny percentage of the entire black economy, and all major economies operate with a fair bit of cash in their systems. Maybe this explains why, according to cash drawdown data, that cash in the system is back at pre- demonetisation levels. However, as a Mumbai- based economist asks, “Part of the slowdown was because of demonetisation— and cash is back. Was it worth the trouble?” As the experts say, those looking for a clear answer to this question might have to wait a year or two.