Thursday, November 17, 2016

Demonitization: Will it work?

I hear lot of criticism launched against Demonitization.  I cite some of them here.

‘Poor people are suffering’

‘It is the common man who is hurt.  Look at the long lines at each ATM.  They are standing there for hours’.

And yet the narrative is not as simple as it sounds.  When these people standing in line at ATM are asked if they are facing trouble, almost all of them say, ‘Yes’.  But when asked if this move is good, they all say, ‘Yes’.  Then they add, ‘This is an inconvenience, but in the larger good, this is OK.  On the whole, we support this initiative from Prime Minister Modi’.

So, it all depends on what part of narrative you want to hear.  If you hear only the first part, it does clearly say that people are inconvenienced to a great extent.  But if you hear the second part, common man endorses Modi’s demonitization. 

Did Government bungle up its implementation?

Yes. 

First, it did not prepare itself with enough new rupee notes it wanted to introduce.   It should have had enough stock with it before announcing the demonitization of old notes.   The paucity of new notes is creating lot of trouble to many businesses, including the common man.

Second.  Why did they not create 500 and 2000 rupee notes the same size as old 500 and 1000 rupee note? That would not have required the calibration of ATMs which is currently underway, and is causing the impediment in delivering cash to people.

It definitely looks like Indian economy has come to a standstill.  However, given few more days, with more new notes brought into circulation, the problem of paucity of notes will fade away and normalcy will be restored.  

‘We will not get the black money into the banks’

‘Most hoarders will not return the money to the banks.  They will either find methods to convert it, or just throw the cash away’.

Actually, the government doesn’t need the hoarders to return the black money.  The fact that such money doesn’t exist, and will never come into circulation, is good enough for the government to print notes in excess to compensate for the loss.  That is in fact better than getting that money back as bank deposit – because when it is deposited, it is with the banks (and not necessarily with the government).  However, if the hoarders don’t return the old notes, the difference that is printed is in the hands of government to fund its schemes and projects.

In summary: there is no necessity for hoarders to return the black money.  The fact that those old notes don’t exist anymore is good enough.

Coming to the second point.  The hoarders cannot convert their entire cash using other people’s accounts.  Just look at the math.  To convert 14 Lakh Crores of black money, one would need 7 Crore peoples’ accounts.  That is just not humanely possible.  Therefore, the best a black money hoarder would be able to convert is 1 Crore of his money using 50 of his known associates.  Even that is on the higher side.

‘The actual black money is in the name of benaami lands and jewellery’

Yes, but that is not what the current initiative aims at.  The current initiatives starts with attacking the physical black money, which forms the base of the pyramid of illegal transactions.  The benaami lands and unaccounted jewellery could be the next target, which come above the base of the pyramid.   Unless the physical black money is attacked, addressing benaami lands and jewellery does not make sense.  Therefore, the current move can be seen as the first move.  And there are good reasons to believe there are more steps in the offing.  So, let’s not despair.

‘What about the lull in the economy? Who is going to fix that?’

There is definitely lull in the economy.  Transactions have stopped.  State Governments are not making money.  Businesses have stopped buying and selling.  Traders have stopped trading.

But this is not going to be forever.  Very soon, once enough cash is in circulation, the economy will kick in and business will be as usual once again.

Hmm... Not really.  Let me pause there.  The reason why I endorse this initiative so strongly is because it changes exactly that.  Business will not be as usual after this.

What were our old habits?

For a very long time, most of our business was done in cash, and the advantage of that has been that the buyer and seller didn’t pay tax.  The employer gave employee his salary in cash, once again not paying the tax. This accumulated black money, the money that is unaccounted.  Over a period of time the accumulation was so much, that it could fund political parties to win elections, and entire real estate market turned out to be based on false reporting.  This also made land acquisition by the government quite impossible.

Jewellers traded in cash, their transaction values running into crores of rupees per day, and yet they didn’t pay any tax, so is the case with cloth merchants, real estate contractors, commodity traders, and even the wholesale merchants of fruits, vegetables and flowers.  They all traded in cash.  Even the movie producers traded in cash, so did, many small manufacturers. 

But that will change. 

What is going to change?

What is already changing is the attitude.  Attitude towards how we go about doing business, and how we are going to trade, how we are going to pay salaries. 

Unlike most other pundits who do not believe that legislation helps in changing the culture of a nation, I tend to believe that a legislation indeed is a very powerful tool, and it can change the attitude and culture of people of a nation, and that it can also alter its course in history. 

Take for example, Hindu Code Bill, which reformed our age-old traditions, with respect to how many kids we have, towards contraception, towards family, towards marriage, towards treatment of women.   Or for example, Right to Information Act, which changed the way we look at facts given by the government and how we use the information.   Take TS-iPASS bill passed by Telangana State to give clearances in 15 days.  The change is fundamental, and has dramatically transformed the way government dealt with investors.  No amount of coaxing would have achieved that.  But one law brought a sea change. 

Looking at examples of South Korea, Taiwan, Malaysia, it becomes obvious that certain fundamental legislations have transformed their cultures and economies.

This demonitization is one such step.   It is going to bring in fundamental change, and may alter our DNA.

A generation is a nation in itself.
Thomas Jefferson

The upcoming generation in this country will not believe that there was a time when almost all our business transactions was done only with cash, and most of it without paying tax. 

We are already witnessing change in attitudes.  Many business people are ready to streamline their processes so that they are never caught with their pants down like this ever again.  The businesses will stop doing cash-only transactions and instead use checks, banks, credit cards, e-transactions, whereby the government actually taxes these transactions.

What is the positive outcome?

In the first 3 days after demonitiziation, banks received 3 lakh crores of deposits.  The banks expect a total of 10 Lakh crores of deposits in the next month.  That is approximately 12% increase in the total deposits, equal to 10% of India’s GDP.   This will have a profound effect on our banking.  For a starter, the interest rates would go down, borrowing becomes easy, and more loans will be available.  In short, the cost of capital, which has always been very high in India, is going to drastically reduce.  And that will spur the economy in many ways.  More infrastructure projects can be funded. States can negotiate for a higher ceiling on their borrowing capacity.  Industry can raise capital to scale their business. 

And now for more interesting aspect.  The tax revenue is going to drastically increase.  For all these years, most business transactions were unaccounted for, and it was loss of taxes to the government.  Now, these transactions will yield substantial increase in tax revenue, so that the government has more money to spend.  This could even result in decrease in personal income tax and corporate taxes, which will further improve the economy, industry, and employment in this country.

‘Why issue 2000 rupee note when it is clear that higher denomination leads to black money hoarding?’

Well, I fundamentally differ with the premise itself. Some people believe that having a higher denomination allows for black money hoarding.  That is patently wrong.  A higher denomination just makes it easier. It is not a cause. It is just one of the possible methods.  The black money hoarders can hoard their wealth in the form of diamonds, or gold, or iron ore.  Just because we get to know that people are hoarding gold, we don’t put a ban on gold.  In the same way, banning higher denomination is not the solution, not even close. 

In fact, India needs higher denomination.  For its size of economy, it cannot trade in just 100 rupee notes, which is equivalent to $1.3.  Imagine US de-notifies all it currency except $1 and asks everyone to trade using that – that would be insane.  

‘People will now hoard 2000 rupee notes, makes it even easier’

Yes.  In theory.

But in practise, people are afraid that there could be another demonitization in future.  The mere threat or fear that there could be another demonitization in the next few years stops most business people from hoarding cash anymore, and pushes them to go for white transactions.

Summary

For now, the chaos and confusion will continue to torment the common men and businesses for the next few weeks.   But the good news is that demonitization is already working.  The real success will become obvious over a longer period of time. 

3 comments:

  1. Do you know 33 people died, while standing in the ATM queue? What is your take on that?

    ReplyDelete
  2. What about the deaths that have occurred so far... 45 and still counting?

    ReplyDelete
  3. Hi Sujai,

    If we excuse the short term pain for common man, this could cause few long term effects based on where the government policies go from here.

    1. Collected Unaccounted money and the result of taxes from going Cashless: This will beef up the government coffers and PSB's deposits. If they use these for meaningful policies like healthcare and education, infrastructure development to remote places, it is good. But if they rather choose to give loans to big fish like vijay malya, or increase defense spending, it will be waste of purpose.

    2. Real Estate prices, if PSBs and govt choose to recapitalize the problematic real estate companies, it will be bigger fraud and inexcusable.

    3. Controlling the Banks. Going cashless makes financial institutions too big to control, there by too big to fail as 2008 crisis in US. If Indian banks go that way, it is a pain on tax payer. There should be some mechanism to control evil banks whose moto is be reckless to make money, pay a fraction of profits if caught or get bailed out if the risk is messed up.

    ReplyDelete

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