DEMONETIZATION: KING’S GAMBIT ACCEPTED

BY: V Pattabhi Ram

When the history of modern India is written, Aadhar, GST, and Demonetization, will be looked upon as game-changers. On Aadhar and GST we will discuss another day. First up, DeMon.

In Jan 2015, Narendra Modi was still 21-months away from announcing the great cash switch. Speaking at a national conference, I had suggested that India must cashier its Rs 1000 note as a first step towards proving its sincerity of fighting black money. The following year, Modi unleashed the brahmastura by also banning the Rs 500 note. In chess parlance, it was classic King’s Gambit.  The amount involved was about Rs 15 lac crore.

Celebrated economists like former head of government Manmohan Singh and former RBI Guv Raghuram G Rajan looked askance at the move. In contrast, BJP ideologue S Gurumurthy gave his thumbs up.

Cut to Sep 2018. A full 22-months after Modi’s televised national address, Operation DeMon is spoken in hushed tones. The public posturing is of-course noisy. In a country that over the last five years has got dreadfully divided through a careful spread of malice and hatred, this is not surprising. But privately the tone is different.

So what was the cash-switch about, why was it put forth, who benefitted and how much, who lost and by what margin? Dr. Singh said it would shave 2% of GDP. He was proved right. Dr. Rajan indicated that long-term costs would outweigh short-term benefits. The jury is out on it. The government told the Supreme Court that India would have a windfall of Rs 3-4 lac crore: the cash that would not come back. As we will soon see, it turned out to be a vain claim.

If the initial expectations had materialized, India would have had several options. Like: the RBI would pay the government an additional dividend. Remember, the current practice is to retain nothing and give out everything. The government would then invest the money in infrastructure or social welfare projects. A second option was that to the extent money did not come back, it would be canceled out, and India could move towards a less-cash economy.  India believed, whatever it may say today, that it expected cash not to come back.

But we are getting ahead of the story. We need to get a few basics straight.

First up, we must understand that cash is an IOU, a liability.

Economics 101 tells us that money can take several forms. Cash is one form; a credit card is another. While cash is the predominant form, anything that is accepted as a medium of exchange and a measure of value can be called ‘money.’ Let me explain further.

Suppose you sign on a piece of paper saying you owe Rs 100 to the bearer of the note. I receive the note and proceed to the nearest shop to buy goods worth Rs 100. The shopkeeper accepts it and believes he can later purchase products or services worth Rs 100 by exchanging it. Now, for your chit to continuously move from hand to hand, everyone in the chain must trust you since anyone in possession of your note is deemed the owner. Basically, it’s a bearer-note, transferable by delivery.  Or as the economics teacher would say tongue firmly in cheek, the finder is the owner.

In an economy, this ‘you’ is the Reserve Bank of India. Mark it; the central bank is an organ of the government. The IOUs are the ‘currency.’ People trust the currency and believe that when push comes to shove the government would honor its liability. Essentially, for the RBI cash or currency is a liability. You will notice the RBI Governor signing, “I promise to pay the bearer the sum of Five Hundred rupees.”

I repeat ‘currency’ is all about trust. Without trust, it’s not worth the paper on which it is written. It is not backed by any tangible asset, such as gold, as it once was. It is supported only by trust.

The bottom line: the central bank issues cash. From its standpoint, cash is an IOU, a liability.

Second, we must appreciate what DeMon is.

In DeMon, the government asked people to exchange the IOUs with new ones. The idea was to find what who all have the about Rs 15 lac-crore value of IOUs. The government believed that those who had no business carrying parts of it (the difference between what they had and what they ought to have is black, and represents income on which tax is evaded) would be scared and so will not put it out for verification. To that extent, the liability will not be claimed, and won’t have to be paid, leading to windfall profit for the central bank.

Did things go as per plan? Fat chance. Cash poured into the banks like a rivulet. The banks had no means of verifying the genuineness of the currency. The RBI took its time to find out how much money had returned. 22-months later, at the end of Aug 2018, it announced through its 2017-18 annual report that it had completed the count and that 99.3% of the currency had come back. That is to say, almost all of the 15 lac-crore except for a small Rs 13,000 crore had returned. The so-called 3-4 lac crore which the government thought would not come too had come. If there were any tax cheats, they possibly slashed their money in other people’s account or quickly hid it in assets like gold or real estate.

The bottom line: Indian citizens had looked the government in the eye to either say, we-are-not-tax-cheats or to challenge them with a catch-me-if-you-can taunt. In chess parlance, it was classic King’s Gambit Accepted.

Third, we must accept there are a few things we will never get to know.

The prime minister had proudly announced in his televised speech that DeMon would arrest terror funding and kill fake notes. I thumbed him up on black money, but not on the other two. I am sorry to say I was proved right. After a brief calm, when the terrorists were testing waters, the India-fighters were back to business with more acts of terror. Truckloads of the new currency (Rs 2,000) were discovered in different parts of India, and quite a bit of it was fake No money in India has been copied so quickly and with such clinical efficiency.

Some part of the money that came in could also be black money getting officially declared and converted. The government gave the option to the citizens to come clean by paying the penalty. How much of this money that came back was of this variety, we may never get to know, if the sum was not significant. Some people suggest that the government planned this out to convert large tranches of black money into white. I am too naïve to accept that argument. Yet I am cut up with the government, which has amended the Act retrospectively to prohibit probe on all foreign funding to political parties with effect from 1976.

There is a lot of talk on the social media as to how tax collections have gone up, return filing has increased, etc., on account of demonetization. It depends on what you look at as the base and how you believe that anything that happens after an event is related to that event. After all, other triggers could have led to this surge. We need to appreciate the difference between correlation and nonsense correlation. For instance, I am sure no one believes that India’s Asian Games tally is on account of demonetization!

Does it mean that there has been no benefit?

I would be the last person to say that. One thing is sure. The original objective of cashing in on a windfall of Rs 3-4 lac crore did not happen. Whether it was because the government was unprepared or Indian citizens were up to take the challenge, no one will know. The prime minister was so cut up as to even upbraid the chartered accounting community for being responsible for the failure of DeMon. Yet there were good things that happened with DeMon.  For example, all money is now identified with a bank account. It means we can trace it back and check for its color. The government has indicated that Rs 2.7 lac crore in 18 lac accounts require scrutiny. That’s about Rs 15 lac per account. The challenge will be in getting enough proof to nail the culprits. There are layers of justice in our country that apparently take a lot of time.

I have two views. One is that if the objective of DeMon was unearthing black money, one needed to remember that the quantum of black cash is only 5% of the total black. People no longer keep their black money in bathrooms and under-the-pillow; irrespective of what the vice-president may like us to believe. Black is slashed in gold, in real estate, and abroad. Two is that black cash was a low hanging fruit. The move was as much political as it was economic. It was a message to the people of India that the government tried its best, and was an attempt to make them forget about the promise of bringing back the cash stashed outside India, which is supposedly the more significant and stricter chunk. To that extent, it succeeded.

Way forward

The people of India are either mostly clean with their cash or have challenged the government with a catch-me-if-you-can bait. The government should take up the challenge. The next logical thing to do is to tag every property with its Aadhar card because that’s where the black money lies.

As long we don’t have clean election funding, as long as the country is not linked electronically for every financial transaction, as long as we either lack sincerity or preparedness in arresting black, we will have a problem on hand. The cost of DeMon is the opportunity cost. Experts place the net loss at something around 2 lac crore. We need a less-cash economy, and we should create the climate and the infrastructure for it.

The bottom-line: the DeMon exercise failed. The topline: The DeMon exercise needed to be carried out.