Partly good, partly bad

Mythili Bhusnurmath  

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THE RBI’s Annual Report 2016-17 released on August 30, 2017, has reignited the debate over the merits and demerits, the cost-benefit trade-off of what was undoubtedly one of the boldest moves of the Modi government: demonetisation of Rs 1,000 and Rs 500 notes with effect from November 8, 2016.

Almost nine months later, the fallout of a measure that, in one ‘fell stroke’ destroyed the value of 86 per cent of the total currency then in circulation, remains contentious. And unfortunately, as with most debates on macro-economic policies that have a strong under-current of political economy considerations, is condemned to be coloured by political ideologies. So while BJP loyalists see demonetisation as an unmitigated success, never mind what hard data tell us, Congress loyalists see it as a complete disaster. The truth, from the economic perspective, is that demonetisation, like the curate’s egg, has been ‘good in parts’.

So what are the good parts? The first is that almost all demonetised currency — 99 per cent of it — has come into the banking system. To the extent that some (not all) of it was unaccounted or black money, yes, black money has been converted into white. But to the extent that it is now part of the formal system, all those who held their wealth in the form of currency earlier, can no longer escape the tax net.

Not only will they have to pay tax on cash holdings they deposited in banks, but they will also have to pay tax on future earnings since they are now within the tax net. The income tax department estimates that as many as 9.1 million taxpayers have entered the tax net for the first time. How much of this is due to demonetisation is debatable but there’s no denying that it would have been a factor.

To be sure, the fact that virtually all the demonetised currency has been surrendered has put paid to any hope of a windfall profit for the RBI that could be transferred to the government. But that was an ill-informed hope to begin with! As anyone familiar with the RBI’s balance sheet could have clarified, a reduction in RBI’s liabilities due to demonetisation is not the same as an increase in income or in profits of the central bank that can be transferred to government. Hence the lack of ‘windfall profits’ cannot be taken as a measure of the success or failure of demonetisation.

The second good part is that the share of currency in the system has come down. According to the RBI’s annual report, the share of currency in the system is now 87 per cent of what it was in pre-November 8. As re-monetisation gathers pace, that number could increase. But demonetisation has sent a powerful signal that holding excessive cash could be unwise. Cash transactions are notoriously difficult to track. Hence any reduction in the share of cash transactions contributes to increasing transparency and accountability in the system.

Third, there is a noticeable shift to digital transactions. To be sure, some of this is due to the proliferation of smart wallets and related apps but there is no doubt that demonetisation gave digitisation an extra push. Of course, the sharp increase in the number of electronic transactions in the months immediately following demonetisation was partly on account of the low base. Also, the pace of increase has since plateaued. Nonetheless, there is no mistaking the directional shift towards more digital transactions.    

On counterfeiting, the answer to the question whether demonetisation succeeded in weeding out counterfeit notes is more complicated. True, the RBI reports only a very small increase in the number of counterfeit notes detected. But it stands to reason that those who are (knowingly) in possession of counterfeit notes will not surrender them to banks and run the risk of being caught by the long arm of the law. Consequently, the only honest answer to that question is, we really don’t know.

Now to the not-so-good parts. The most important is the disruption in economic activity. Demonetisation hit the informal sector, which tends to be much more cash-dependent, hard. The construction sector, for instance, contracted 3.7 per cent in the period January-March 2017, down from 3.4 per cent growth in the previous quarter. To the extent that the informal sector accounts for roughly 50 per cent of GDP and close to 90 per cent of the labour force is engaged in this sector, the disruption and genuine human distress is undeniable. Sadly, there is no way to quantify the loss.  

The Parliamentary Standing Committee on Finance, headed by Congress party veteran, Veerappa Moily, has estimated the loss at 1 per cent of GDP.  However, given the complexity of GDP computation it would be naive to treat this as anything more than a guesstimate, with little or no sanctity. As the chief statistician, TCA Anant, pointed out, it is impossible to isolate the impact of any one measure, least of all one whose ramifications are still unfolding, on economic activity.   

The second consequence is the sharp fall in the RBI’s profit and hence in the amount it transfers to the exchequer. Thanks, in large part to demonetisation, RBI’s income declined, even as its expenditure, both on printing notes and on mopping up surplus liquidity created as a result of demonetisation, increased dramatically. As a result, RBI’s dividend to government for 2016-17 has more than halved to Rs 30,659 crore, down from Rs 65,876  crore the previous year. This is bound to upset the government’s fiscal math and jeopardise its ability to adhere to its fiscal deficit target for the year.

 On balance therefore, there is no neat answer to the question whether demonetisation was a success or failure. The problem is compounded by the fact that any answer must distinguish between the immediate costs, which are undeniable though difficult to quantify, and the medium-to-long- term benefits (greater formalisation of the economy, more taxpayers, more digitisation, greater transparency and so on). Also since there is no discrete break between the short, medium and long term or, indeed, the agreement on what constitutes ‘short’, ‘medium’ and ‘long’ term, it is hard to reach a definite conclusion. Much like Zhou Enlai’s famed response when quizzed about the impact of the French Revolution, when it comes to assessing the impact of demonetisation, it will always be ‘too early to say’!  

The writer is a senior consultant at National Council of Applied Economic Research