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India’s demonetization: hits and misses

While the government continues to invest its political capital to ensure  demonetisation outcomes are positive, significant and enduring, the road ahead is bumpy,writes Monish Gulati for South Asia Monitor.

Mar 18, 2017
Monish Gulati
On November 8, 2016, the Narendra Modi government withdrew high denomination Rs 500 and Rs 1000 bank notes from circulation in a declared effort to tackle corruption and unaccounted wealth (black money). These were to be replaced with new Rs 500 and Rs 2000 notes. Indians were given until December 30 to deposit cash holdings into bank accounts, seen by some economists as a move to making assets more transparent as well as broadening the tax base. This action, popularly referred to as ‘demonetisation’, followed an amnesty scheme declared a few months earlier which allowed citizens to declare their unaccounted assets against payment of a percentage penalty. 
Since its declaration, the motives and stated aims of the demonetisation scheme have been a subject of much debate and criticism in the public space. The government too added to the discourse by ‘springing’ fresh objectives and purposes to the scheme, as it unfolded, though more than 50 notifications.  Ashutosh Varshney, Professor of International Studies and the Social Sciences at Brown University, emphatically argued that “all analytical roads lead to political motivations as the primary, or only, rationale for why Modi undertook demonetisation”. 
According to him economic theory and comparative historical experience point to three reasons that might provide legitimate justification for demonetisation -- the first being hyper-inflation as demonetisation, under such circumstances, is a way out of the economic crisis. Second, if a substantial part of the currency is counterfeit and third, as an attack on organised crime, wherein such high-denomination notes can be decommissioned without hurting law-abiding citizens. Varshney felt that none of these conditions obtained in India on November 8. The recent state assembly results may have provided the professor with a sense of vindication.
Current Situation
It is now over four months since the November 2016 surprise demonetisation of 86 per cent of India’s currency in circulation. By mid-February, the Reserve Bank of India (RBI) had reintroduced 55 per cent of the total value of demonetised notes(INR 12,00,00 billion have been remonetised so far). A degree of normality has been restored aided by the fact that the required cash-to-GDP ratio had fallen as many consumers had substituted cash with digital payments. Further the short-term costs of the measure are now somewhat clearer. Despite the accelerated pace of remonetisation India’s industrial production sector had been hit hard with negative growth in December 2016 and there is some consensus that the aggregate growth cost of the demonetisation measure could be up to 1 per cent of GDP. 
However, the situation was muddied recently after the government’s Central Statistical Organisation (CSO) claimed that it was an overestimation of the impact of demonetisation and since subsidies show a negative growth and indirect tax collections showed positive growth, the GDP growth has remained the same. Some industries such as intermediate goods and crop planting proved quite resilient. Truck movement showed a V-shaped recovery. The second advance estimates show the agriculture sector faring better than estimated in January with growth at 4.4 per cent. Similarly, the second advance estimates peg manufacturing growth for the full year at 7.7 per cent  compared with 7.4 per cent predicted by the first advance estimates. 
In a related development the Comptroller and Auditor General (CAG) of India has announced that his organisation will do a complete estimation of the cost of demonetisation. 
Despite official agencies insisting that costs are temporary, there is no denying that real human costs such as job losses were worsened by poor planning and implementation. In the continuing absence of official estimate of old notes deposited in the banking system, it is speculated that, including counterfeit notes, more than Rs 15.5 trillion ($231.7 billion) worth of notes have come back into the banking system. This suggests that the government did not only fail in its attempt to rid the system of black money, it will also lose out on the financial gain it was expecting from the notes that did not come back. 
Even though the central government still expects about Rs 6,000 billion in black money to be unearthed, there is also this realisation that demonetisation alone cannot make an appreciable dent in black money and corruption. But it can contribute as part of a sequence of related moves. 
Reassuringly the annual financial budget for the year, besides offering  a few tax cuts to worst affected lower income groups and small firms,  proposed initiatives for moving towards a formal economy with modern laws and regulation, suggesting that the government is focused on such a path. Measures such as clear property titles and lower stamp duties would reduce black money in the real estate market. But good results will depend on effectively linking different databases, including information sharing from G20 countries, while minimising the discretion of tax authorities. 
Positive Spinoffs
Notwithstanding the domestic rumblings on the initiative, the global financial institutions appear to give the move a ‘thumbs-up’.  World Bank CEO Kristalina Georgieva recently said that demonetisation will have a profound and positive impact on India’s economy as the government’s financial inclusion programme along with the move towards digital payments and direct transfer of subsidies will help the poor. In November last year, the International Monetary Fund too had supported India’s efforts to fight corruption through currency control measures. The OECD in its Economic Survey for India released recently said implementing demonetisation will have a transitory impact with short-term costs. 
On a positive note, tax compliance should increase because information on cash deposits will prompt greater number of filings. The number of tax returns filed in India is expected to double to 75 million, yielding about 1 per cent of GDP in tax revenue. In a population of over 1 billion people, fewer than 40 million currently file income tax returns. This is widely seen as unfair. India’s tax-to-GDP ratio of 16 per cent is among the lowest in the world and acts as a constraint on government expenditure. 
To give a decisive push, the government is expected to further simplify regulations and reduce tax rates even as it prods citizens to accept tax, surcharge and penalty totalling to 49.90 per cent on their undisclosed income under the Pradhan Mantri Garib Kalyan Yojana (PMGKY) by March 31. The income declared under PMGKY is not taxable under the Income Tax Act, 1961.
Demonetisation did provide a boost to the financial technology sector with companies like Paytm announcing investment of Rs 6 billion to expand its QR code-based payment network. Mobile wallet company MobiKwik recently announced an investment of Rs 3 billion for expansion aimed at growing its user base by deploying funds in loyalty initiatives, expanding its network, and launching other financial services such as loans and investments on its platform. Alibaba-backed Paytm, which claimed it had 150 million wallets before demonetization, recently announced that its wallet base had expanded to 200 million. MobiKwik, too, which currently has 50 million wallets, said it expects its user base to grow to 150 million during 2017. However, there are worrying signs. 
Worrying Signs
The central government, under an initiative of the National Institution for Transforming India (Niti) Aayog, gave out Rs 530 million in cash awards -- ranging from Rs 1,000 to Rs 1 lakh to about 100,000 people picked through lottery for going cashless in their daily business. The awardees had encouraging tales to tell about how digital payments changed their lives for the better. However, since then some have fallen back on cash transactions. 
In January 2017, the third month after high-value currency notes were delegitimised, electronic financial transactions declined over December. As per data released by the RBI, digital payments fell 10.2 per cent in volume terms and seven per cent in value terms during January 2017 compared with December 2016. February 2017 saw a month-on-month decline of 21.3 per cent in the volume of electronic transactions, higher than the 9.1 per cent fall seen in January 2017 over December 2016. Industry analysts believe that this decline could persist as cash supply in the economy normalises. 
The decline in digital transactions in successive months goes against the government’s stated objective of moving towards a “less cash” economy. The biggest fall in usage was seen for cheque payments, use of debit and credit cards at point of sale terminals and mobile banking that had emerged as preferred modes of payment  during the demonetisation period.
Government Initiatives
The central government recently launched a major training programme for more than 13,000 small and medium businesses on adopting digital payment modes. Under this, the National Institute of Electronics and Information Technology (NIELIT) will organise five regional workshops at Delhi, Jaipur, Kolkata, Mumbai, Chennai and 30 state workshops and 100 DigiDhan camps all over the country. These training programmes are meant to introduce digital payment mechanisms like UPI (Unified Payments Interface), USSD payment, BBPS (Bharat Bill Payment System), and AEPS (Aadhaar Enabled Payment System) to traders. 
Training on digital payment initiatives for traders will be mobilised by the Confederation of All India Traders (CAIT). These regional workshops would also serve as master training on digital payment modes for traders, who would be involved with further proliferation and promotion of digital payment initiatives among their fellow traders. 
While the government continues to invest its political capital to ensure that the demonetisation outcomes are positive, significant and enduring, the road ahead is bumpy as the current round of assembly elections have demonstrated that demonetisation failed to reduce the use of cash and, therefore, black money in elections.
(The author is Associate Director, SPS. Comments and suggestions on this article can be sent to

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