Prime Minister Narendra Modi's surprise move to demonetise Rs 500 and Rs 1,000 notes in circulation to bring out black money is a laudable move. Whether it will have the desired effect will be known in a few months. It is a blunt instrument and it is likely to have some collateral damage as well. There are also a few things that are a bit puzzling, but these could become clearer over time.
1.Was bringing out black money the objective or stamping out forged notes?
The prime minister mentioned both in his speech, even though Finance Minister Arun Jaitley and the finance and revenue secretaries have focused largely on the black money portion in subsequent press conferences. While no one obviously knows the exact amount of forged notes in circulation, the estimates are that 250 out of 10 lakh currency notes of that denomination are forged. Therefore, the total amount is of forged notes is likely to be in the Rs 350 crore to Rs 450 crore range. That is a huge amount but probably not as significant as the total estimates of the black money in the country.
However, as I said, the demonetisation is likely to be a blunt instrument because it tackles the amount of unaccountable cash held, not money that has been over time converted to assets like gold, silver or even property, or even sent overseas using shell companies and parked in accounts in places like Panama and Cayman Islands. The money held in those assets is likely to be far higher than anything held in cash. We will have to wait and see if there is further investigation into other asset classes. Demonetisation will inflict a one-time shock only for people who have unaccounted cash on that day, not those who have already moved to other asset classes.
2. Is the objective to fetch tax revenues on black money held in cash or to just extinguish it?
From the press conference utterances, it seems the government would rather extinguish the money rather than try to collect additional revenues. Unaccounted money, under the income tax laws, will be taxed at full rate (30 per cent), plus attract a penalty of 200 per cent, plus interest of 12 per cent per annum for the number of years the money was not declared. This would amount to an effective taxation rate of 95 to 99 per cent. That is, a person would get back Rs 1,000 if he deposited previously undeclared cash of Rs 1 lakh. Plus, he/she would face the possibility of going to jail. Hence, the incentive to declare would not be great. The current measures seem to be designed to hurt the black money hoarders to the maximum extent, not necessarily fetch maximum tax revenues for the government.
Of course, what the government loses out, it also gets back to an extent. In the last demo-netisation drive, 25 per cent of the notes in circulation were never deposited to the banks. If a similar trend happens this time as well, the currency liability of the RBI will come down sharply, points out an SBI research report, adding that the RBI can then pass on the benefits to the government resulting in a fiscal bonanza. This may actually outweigh the tax revenues the government is foregoing by setting the tax penalties too high.
3. Why was the high-value denomination supply going up right up to the announcement?
A lot of kudos have been heaped on the prime minister and his team for keeping the move secret. However, certain problems have also cropped up because ATMs were doling out Rs 500 and Rs 1,000 notes right till the announcement. In fact, that was the bulk of the denomination that was being spewed out by the banks. At the moment, about 84 per cent of the notes in circulation currently are the old high-denomination notes. That is, as much as Rs 14.93 lakh crore worth notes are old high-denomination in the total Rs 17.77 lakh crore worth notes in circulation. Lower denomination notes were in short supply. Much of the chaos in banks being seen is because the amount of Rs 100 and lower notes are in short supply, apart from the new notes. If the government had been thinking about this for some time, perhaps it could have started reducing the supply of high denomination notes subtly. It would be hard to believe someone who is hoarding big sums of undeclared cash would keep them in small denomination notes. On the other hand, it could have created less of a panic if the number of old high-denomination notes in circulation were not so common.
4. Did the government think of the immediate slowdown in a range of industries?
From accounts trickling in, the real estate brokers are in a shock and this is going to lead to a massive correction of rates and big drop in secondary sales immediately. Similarly, consumer durables have been affected as well. Cash on delivery of e-commerce companies have been stopped temporarily and since this accounted for two-thirds of the total sales, this could have a pretty grim effect in the short run. Restaurants have been hit as well. There might be others but the accepted view seems to be that a range of consumption will be affected for between two and four months, and for property and others, maybe even longer. This could lead to a temporary slowdown in economic activity when the government would like to actually accelerate it.
5. Is the government actually trying to move to a cashless economy?
This is not very clear at the moment. Sure, we have seen huge ads by the wallet and other fintech companies, but the government thinking on the issue is still to be understood. From the information that has come out so far, Rs 2,000 and new Rs 500 notes will be in circulation in sufficient numbers within a few days. In a few months, even new Rs 1,000 notes will be added. So far, the government has not indicated whether the supply of new notes will be less than the amount that was in circulation earlier. If not, there is no way the cash economy is going to get any smaller. Some people may move to online and mobile payment systems, but a huge chunk of the cash economy will continue. And over a period of time, fresh supplies of new notes will only add to the problem.