Demonetisation: Inconvenience or Punishment?

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Governments’ decision to demonetize the current Rs 500 and Rs 1000 notes as legal tenders have taken everyone by surprise. So sudden was the announcement that while those in opposition could at the best harp on the inconvenience this will cause to the common man, experts are still fathoming what are likely to be the possible impacts. It was a brilliant coup pulled both in terms of secrecy and timing. While such a move was being contemplated for last six months, the fact that only a handful of individuals knew about it was extraordinary. To time it an evening before the US Presidential Election also meant that any adverse effect of this on the markets will get largely overshadowed by the US Elections, irrespective of the outcome of the latter. Whether this was as a surgical strike on black money or more akin to a carpet bombing   on all money, time will tell. Given, the uniqueness of the scheme, we no longer have the luxury of drawing experience from elsewhere. Amidst the criticisms and euphoria, it is very easy to start expecting wonders which this is not aimed at. Therefore, , I will only focus on two things that are trending most – (a) will this help India graduate to a cashless economy and (b) is this the beginning of the end for black money?

Move towards Cashless: The benefits to India as it moves more towards cashless is well documented. There is a tremendous scope for growth here. Currently less than 15% of all households use cashless payments amounting to less than 3% of all transaction values. Unless one inspects the reasons as to why India is still a predominantly cash based society, it will be erroneous to extrapolate the effects of demonetization on our journey to cashless. An earlier work[1] identifies two prominent reasons as to why India is a predominantly cash based society. The most important reason is not having a steady inflow into the account. An individual likes to make cashless payments for convenience it brings. Now, if she receives her payments in cash, it becomes an additional cost to convert the cash to cashless payments eroding away the convenience factor. The second reason is the low acceptability by the sellers. While most sellers do not have infrastructure setup to accept cashless payments, the ones who have, largely prefer cash to avoid paying various indirect taxes. What part of this problem will get solved by the demonetization? My guess is, hardly anything. The sudden demand for cashless instruments given this announcement is no indicator of what will happen in the steady state. This is a temporary shock. At best, individuals who were unaware of the benefits of cashless payments are now exposed to them. Many buyers and sellers would have now invested in the infrastructure. Whether they will use them in the future will depend upon how active their bank accounts are and can they get away yet again by not paying the taxes. That brings us to the second point. What effect will this surgical strike have on black money?

Black Money-Inconvenience versus Punishment: The current announcement is expected to have maximum impact on black money. Indeed it will have, and if early trends are to be believed, the signs are prominent. However, the moot issue is whether this is a onetime cleaning up or will it define how the black economy will work in the future. Not surprisingly, there is not much hard data as to how this massive black money is generated, nurtured and ploughed back although enough ‘know how’ already exists. However, what is fairly well established is a strong correlation between economies that have large cash transactions and corruption.[2] The current strategy if not adequately thought through may actually spike corruption. Let me argue why.

The demonetization is neither expected to nor does it actually address how we have ended up with huge corruption. However, demonetization can act as a deterrent only if there were effective punishments associated with those holding unaccounted cash. There is a subtle difference between inconvenience and punishment. Currently, any individual who has stocks of unaccounted money, but is unable to use them is at the worst, pushed back to status quo- life without these cash. This is inconvenience. However, an outcome that may mean jail terms or hefty fines that make him worse than the status quo is punishment. The developments over the last couple of days suggest that the demonetization exercise will merely be an inconvenience. Announcements that cash deposits exceeding certain limits will attract 200% penalty and/or attention from IT office would in all likelihood deter individuals from large deposits. Worse still they will find ways to convert the cash off the grid. Therefore, it would be extremely rare that any significant part of the black money holders will get detected and will pay any penalty. How does this influence the future? If there are no further steps to address the process of corruption, the ‘smart’ manipulators are now prepared that once in a while, the Government may demonetize again making large part of their unaccounted cash worthless. The best strategy for them will be to accumulate and spend as much as possible before the next demonetization takes place. This is the footprint for a spike in corruption.

What alternatives could we have explored? If punishing the black money holders was one of the key motives, under the current scenario, very few will get detected to begin with. Instead if identifying them was an objective, then perhaps an amnesty with minimum penalty and an advanced demonetization date would have been more effective. At the least, large part of the money would have fueled back in the banking system. However, given the current scenario, one should not be surprised if the same norms of cash transactions done in banking are also extended elsewhere. The starting point is to insist any individual or entity accepting cash more than 50,000 needs to produce the KYC. Using the unaccounted currency to buy high value assets are automatically discouraged. Coupled with the threat of demonetization, holding of unaccountable cash will suddenly appear far less lucrative.

Extra ordinary problems may need extra ordinary interventions and certainly the demonetization will count among the most innovative of them all. To keep a card so close to the chest and spring a surprise also indicates the ability of the Government to take risks and then very efficiently execute what it believes. It will no longer be surprising if the Government decides to announce the next attack on how to identify and then punish individuals who amassed black money. However, without any additional measures, this step may actually exacerbate the problem further. We need to wait and see, and hopefully get pleasantly surprised, yet again?

[1] Mukhopadhyay, B ,‘Promoting Cashless payments in India’, Social Science Research Network, 11 December 2015.  – See more at: http://www.ideasforindia.in/Article.aspx?article_id=1610#sthash.x6cbSmDi.dpuf

[2] https://mpra.ub.uni-muenchen.de/65934/1/MPRA_paper_65934.pdf