Friday, December 16, 2016

Understanding Demonetisation Debate

A lot has been said both for and against demonetization of high denomination currency notes in India. Nobel laureates Prof. Amartya Sen and Prof. Paul Krugman have denounced efficacy of the mechanism. On the other hand, Prof Jagdish Bhagwati has praised demonetisation as a bold move, and S. Gurumurthy, an idealogogue of RSS, has claimed demonetisation to be a paradigm shift. In the political front, former finance minister Mr. P Chidambaram has called demonitisation the biggest scam, while the current finance minister Mr. Arun Jaitley has enumerated numerous benefits of demonetization on the posterity.

It has been argued that demonetisation has put Indian poor people through extreme hardship. Forcing people to use digital methods of transaction, has the potential of compromising individual privacy. Besides, India lacks proper infrastructure for conducting transaction using electronic means. 

In a country, where a vast majority of people live below subsistence level, in a country where rich and powerful dupe poor illiterate population of their daily wage and other entitlements offered by government, should we debate about futility of electronic transaction? In a country where 70% population is young, what do we understand of demonetisation? Was it needed? Here is my understanding:

  • Indian economy is predominantly cash driven. Cash economy is not illegal provided cash is moved back into circulation.  A sizeable proportion of Indian cash is hoarded and used in parallel economy or black economy. It is believed that almost 30% of cash is circulating in parallel economy.

  • Cash - GDP ratio is an indicator of cash component in national goods and services. Simply put, cash - GDP ratio ascribes monetary value to goods and services a country produces. Generally, most of monetary value of GDP is in electronic form. World average of cash - GDP ratio is 4%. In India, this ratio is between 10 - 13%. This indicates, a lot of valuation of GDP is floating around in cash.

  • In a predominantly cash economy, government has no control over tax it collects. Tax is the source of revenue for government. In India hardly 2% people pay income tax. Most of taxpayers are salaried class. Tax is taken out, before their pay cheque is delivered. Rest, small businessmen, farmers, daily wage earners, vegetable vendors etc, may not have black money, do not pay tax. Many others with black money, obviously are not poor,  also do not pay tax on their unaccounted wealth.

  • Money that government misses out in the form of tax, deprives government of its revenue. Government has to raise tax or borrow money to fulfil its commitments to its people. Borrowed money when comes in circulation leads to inflation. Because excess money fuels demand. Too many people compete for fewer goods. Raising tax makes many citizens to hide their income, this results in generation of black money.

  • Money that is with rich in the form of unaccounted money also fuels inflation because of extravagant consumption of ill-gotten wealth by a small percentage of population. Most of the unaccounted money is invested in gold, real estate and stocks. 

  • As a result of inflation, value of money erodes. An evidence of this erosion of purchasing power of rupee is evident from the fact that when government demonetised its currency on Nov, 2016, 85% belonged to 500 and 1000 rupee notes. Had government avoided present step of demonetisation, in coming years as economy and inflation grow, who knows may be value of rupee would further erode and we would trade in 5000 rupee notes. 

  • It is important to note that black money can also be used for a variety of illegal activities like funding terror against the state. Instances of bank robbery in the state of Jammu and Kashmir, may indicate drying up of funds for terrorists due to demonetisation. It is being reported that naxalite movement and insurgency in north eastern states have also been affected by demonetisation.

One objective of demonetisation was to bring unaccounted money into circulation. There could have been two possibilities. First black money owners would destroy their tranche. In such a case, RBI will be relieved of its liability to pay for the lost currency. This may give government more fiscal room. Second scenario can be money is deposited in banking system. As of today, we have seen that more than expected amount of money has come back into the system. This, though not anticipated, may have advantage of bringing unaccounted money into main stream, increasing tax base and providing more revenue generation for government. 

It has been argued that money coming back to government may suggest that there was no black money in the country in the first place. Such a contention is absurd at its best. It is easier to understand that corrupt have found ways to convert their  unaccounted money using helpful and corrupt bank officials. A recent sting operation conducted by a television channel also confirm that many political parties have no problem converting their unaccounted money. An alternative approach involved using ordinary citizens to either exchange money or parking stash on behalf of black money holders. 

It is important for government to bring more people under tax net. Because higher the revenue, greater the amount government spend on social welfare, on healthcare, on education, on infrastructure development etc. The idea of digital transaction is an extension of demonetisation plan. As economic transactions become more and more transparent, business men, both Indian and foreign, may find it easier to do business in India. Employment opportunities for Indian youth may increase. For a country whose 70% population is young, it is important that there is sufficient opportunities. I think demonetisation, when followed by other steps, is likely to clean up Indian economy to some extent to the benefit of Indian population.

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