The Demonetisation Decision

                                Demonetisation

On November 8th, government announced the decision to discontinue the legal tender status of Rs. 500 and Rs. 1000 notes. The original objectives were stated as: eliminating fake currency; inflicting losses on those with black money; and disrupting terror and criminal activities. Later, new objectives were tacked on: enabling growth in bank credit, turning India into a cashless economy. A  cost benefit analysis suggests that the benefits were relatively small when compared with the costs 

Expected impact on fake currency

A study by the National Investigation Agency and the Indian Statistical Institute, in 2016, estimated that fake Indian currency notes in circulation have a face value of Rs. 400 crore. This is an incidence of fake currency of 0.022%. The scale of counterfeiting of the Indian rupee is not out of line with what is seen in other countries, and the procedures adopted worldwide to address this include investigative actions against counterfeiters, phased replacement of old series of notes with new notes that have better security features, etc. De-monetisation is generally not seen as a tool for dealing with counterfeiting. We must also not forget that the counterfeiters will now get to work on the new 500/2000 rupee notes, while India will likely never do a de-monetisation again.

Expected impact on unaccounted wealth "black money"

The analysis presented in the Finance Ministry's White Paper on Black Money, 2012, shows (on page 47) that, on an average, the amount of cash seized during raids by income tax authorities is 4.88 percent of total undisclosed income admitted in those cases. This data is from more than 23 thousand warrants executed. Even if this decision inflicted a 100% loss upon holders of unaccounted cash, this would imply a loss of 4.88% of their total unaccounted wealth, which is not much of a shock for those with such wealth. If, as is more likely, the demonetisation has imposed a 40% loss upon holders of unaccounted wealth (who suffer a 40% discount when laundering the money), this implies a loss of about 2% of unaccounted wealth.

Who bears the costs?

While there is much talk about the GDP impact of this decision, a unique feature of this episode is that there may considerable other costs that fall disproportionately upon the poor. The rich have access to electronic payments, employees who will stand in queues to obtain cash, and savings that are used to cope with a decline in income. The poor lack all these. If a poor person suffers an income shock, or is not able to get medical treatment, the consequences are enormous for the individual, but the GDP impact may be negligible. In terms of welfare implications, these costs matter a lot more than the impact on GDP.

Approach to comparing benefits and costs

The benefits are primarily in the form of losses inflicted upon those with black money, while costs are imposed on legitimate economic and social activities. Ordinary people, going about their lives, have suddenly been asked to bear a burden associated with the project of imposing costs upon people who have unaccounted wealth. Some of the costs are incurred by poor people, whose welfare loss might be much more for a given level of Rupee cost incurred. Given this difference in the nature and incidence of benefits and costs, before comparing costs and benefits, each rupee of cost should be given a much higher weight than each rupee of benefit.

Small impact on the poor?

Two ideas have been offered in the claim that the adverse impact upon the poor will be small:

• Cash savings as predictors of impact on the poor: Estimates based on national surveys show that cash earnings of the poor are small, and they usually lack cash savings. So, it is argued, they are likely to seldom visit a bank branch or post office, and they are not particularly inconvenienced.

• Credit as a mitigant of the impact on the poor: It has been argued that since the rural economy is significantly credit-driven, the impact on rural poor will be small. If transacting parties know each other, they would be willing to extend credit, which would make short-term non-availability of cash less costly. Given the practices in rural markets, many commercial relationships are indeed credit-driven, and cash calls are only made periodically.

Conclusion

The original assumptions underlying the decision remain unclear, but it seems to be ca
using considerable harm. All this harm is likely to buy us only a small dent on the black money problem and the elimination of a few hundred crores of fake currency. This is not a good bargain, especially considering the long-term consequences. I am not sure the government intended this bargain. Still, at the moment, the decision is popular.

Government may have painted itself into a corner of righteousness. Since, this decision seems to have struck a chord with a larger number of citizens, political ambition might tempt the government to double down on this path, and take more "shock and awe" decisions. It would take considerable statesmanship to veer away from this path of temptation fraught with enormous risks but questionable benefits.