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Demonetisation: A closer look

Scrapping high-value currency notes is unlikely to make a major dent in the black money problem unless accompanied by structural reforms in the rest of the economy

Gurbachan Singh 

The new Rs 2000 note issued after the government declared that existing Rs 500 and Rs 1000 notes were no longer legal tender
The new Rs 2000 note issued after the government declared that existing Rs 500 and Rs 1000 notes were no longer legal tender

Black money and white money are simplistic concepts; there is a grey area in between. In a country such as India, given the lack of financial inclusion, the financial and legal illiteracy, the history of tax laws and foreign exchange regulations, monetary and financial culture, nature of political funding, availability and use of insider information in the economic and political spheres, and so on, there is a need to handle matters in a sensitive manner. There is, of course, a need to do something about all the black money, even if parts of it are “grey”. The policy of of high denomination currency notes may be viewed as a step in the direction of adopting a policy of coordination so that the Indian economy shifts from what economists call a bad equilibrium to a good equilibrium.

In 1978, was carried out in India, but that policy did not end black money. In fact, black money possibly increased over time. So this time again the announced on November 8 may not make a major dent in black money, unless there are structural reforms in the rest of the economy on a sustained basis. There is a need for stricter collection of taxes and further simplification of tax laws, and reasonable regulations in areas such as real estate, foreign trade, remittances, political donations, mining and gold, so that incentives or even the compulsion to indulge in black money are minimised.

To see that demonetisation is not enough to eradicate black money, take, for example, the real estate sector. As a result of demonetisation, real estate prices can fall for two reasons. On the demand side, with less black money to support purchases, the demand for property falls and so real estate prices can fall and the quantity can fall as well. On the supply side, many honest, educated and hard-working people were previously finding it hard to carry out business in the real estate sector. It can be relatively easy now with less black money in circulation. With their greater participation, the sector can become more efficient, productivity rises, the supply curve shifts out, prices fall, and the quantity rises.

So, while prices can fall due to both demand and supply side reasons, the effect on quantity is ambiguous. If it has a tendency to go up, it may face a different hurdle. There is a licence-permit raj in real estate; the liberalisation of the 1990s and the Real Estate Development and Regulation Act, 2016 left licensing in the sector by and large untouched. That may come in the way of expansion of the industry as licences carry a high price, which can only be paid in black money. So, we may be back to square one.

Suppose demonetisation is implemented, but other supporting policy measures are not adopted on a sustained basis. This can lead to a loss of confidence in anonymous high-value rupee notes and a shift to substitutes such as gold coins, gold bars and foreign currency notes. That will be a change of form and not substance. It will be a case of much ado about nothing except that the government would have, as shown later, mobilised a large amount of additional seigniorage (the difference between the value of money and the cost of producing it) on a one-time basis at the cost of future seigniorage.

Suppose demonetisation is indeed supplemented by other policies and the black economy truly contracts. The demand for currency as a proportion of the demand for money is expected to come down (and the role of banks will increase). This will, in the long run, lower the time path of future seigniorage for the Reserve Bank of India and the government. However, demonetisation has another effect too. Though the old currency notes can be exchanged for new ones, some of the old notes will not be returned, because that is where the hard core monetary part of the black economy is. If, say, a quarter of the old high-denomination notes are not returned and if in the short term the demand for currency stays unchanged, then the RBI can and will need to issue additional currency to make up for the old currency that went out of circulation.

This implies additional seigniorage for the RBI/government. The total value of high-denomination notes is Rs 14.17 trillion. A quarter of this amount is Rs 3.54 trillion, which is roughly what can accrue to the RBI or the government due to the additional seigniorage. This is more than ten times the tax collected through the Income Declaration Scheme 2016; the exact amount was Rs 0.29362 trillion. So, the government can gain considerably and a section of the public loses. This is a case of redistribution from the public to the government. If the government supplements demonetisation with other policies, then the overall possible welfare gain from demonetisation is as follows.

First, a good proportion of the black money tends to be used for consumption and other unproductive or less productive purposes. So a curb on black money can increase the long-term savings rate in general and the long-term financial savings rate in particular. This can increase the rate of economic growth. Second, the use of electronic or digital money goes up at the expense of currency, which can improve efficiency in payments. Third, as black money falls, productivity may rise in the economy, the ease of doing business improves, and more honest, hard-working and innovative people can enter business.

Unless there is an indirect effect through a change in the political and financial culture in India, demonetisation has hardly any direct effect on political funding. After demonetisation is fully implemented, political parties can continue to claim that they receive small sums (in high-denomination notes) and then deposit that money in banks. It then becomes white money. So, demonetisation can, by itself, hardly change the nature of funding of political parties.


The writer is an independent economist and adjunct faculty, Indian Statistical Institute. Published with permission from Ideas For India (www.ideasforindia.in), an economics and policy portal

First Published: Sun, November 13 2016. 09:30 IST
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