Bold move, wrong target

It’s the season of metaphors, be it to describe the attack on terrorist camps or on black money. When the rot is deep, you need drastic surgery to remove the cancer. The surprise announcement of Prime Minister Narendra Modi that high value notes would cease to be legal tender immediately was also described as a surgical attack on black money.

The 500 and 1,000 rupee notes constitute 85 per cent of the 17 trillion rupees in circulation. Imagine removing them at one go, and replacing with new notes. We are yet to see how the aftermath is handled, and how quickly is the short term hardship removed, especially for ordinary folk, and those in remote locations.

The more appropriate metaphor however is the nuclear blast of Pokhran of 1998. India conducted a nuclear test, which stunned the world. Just as it was then, the present move to impose an immediate ban on 500 and 1,000 rupee notes too needed months of preparation under utmost secrecy. The rapid re-stocking of nearly fifty billion new notes in bank branches and ATMs across the country also had to be planned meticulously but secretly.  Just like the nuclear test, this too was an almost unthinkable line of control, or rather a lakshman rekha that India crossed. The sheer audacity is admirable. Indeed, effective reform is not possible without such boldness and without taking a huge political risk. Prime Minister Modi deserves high praise for taking this huge gamble.

The 500 and 1,000 rupee notes constitute 85 per cent of the 17 trillion rupees in circulation. Imagine removing them at one go, and replacing with new notes. We are yet to see how the aftermath is handled, and how quickly is the short term hardship removed, especially for ordinary folk, and those in remote locations. Initial stories suggest lot of privations, long lines at banks, truckers strike and stock outs.

But was the idea of demonetisation really so unthinkable? Various people including this author have been advocating the removal of high value notes from circulation, as a deterrent for black money, for several years. Notably Baba Ramdev and the Pune/Nashik based group called Arthakranti have been advocating this for years. Former Chief Economist of the IMF, Ken Rogoff, is a strong advocate. The logic is that smaller denomination notes are used mostly for transactions while higher notes are for storage of value. So only those who want to hide their wealth from the authorities stock hoards of high value notes. These are typically tax evaders and money launderers, and much worse, include terrorist financiers and drug dealers. High value notes offer anonymity, ease of carriage, storage and liquidity and are difficult to trace. Most ordinary people in India never use a 1,000-rupee note in their daily transactions.  Hence to make it inconvenient to handle black money, high value notes must be removed from circulation.

Most stock of accumulated illegal wealth tends to be in the form of benaami land or gold and much less in cash. Hence focus on stock alone and ignoring the future flow is misguided. Indeed if you factor in the cost of hardship imposed on legitimate folk, small businesses, daily wage earners who have to wait for hours to exchange their old notes, then the net benefit of destroying old stock is lesser.

Unfortunately that’s not exactly the intent of the PM’s current blockbuster initiative. Since high value notes are only being discontinued, to be replaced by new ones, this is not demonetisation. In fact, another higher denomination of Rs.2,000 is being introduced. Hence this measure only attacks the current stock of black money, not the future flow. Assuming around 30 per cent of the high value notes today is “black money”, this stock will become worthless. That is roughly three lakh crore rupees. But much of it will find ways to enter the “white world” through sheer ingenuity of the hoarders.

For instance, this can be done by recycling through poor income households (by offering them a commission) or by back-dating invoices and by claiming the notes as old revenue. So the stock that actually gets “nuked” is much less than the estimated 30 per cent. Of course, the new notes have better counterfeit protection, so that is an improvement too. If the PM wanted to attack the existing stock only, there are several other ways to get at it, apart from discontinuing old notes. The just concluded Income Declaration Scheme was one such method. Most stock of accumulated illegal wealth tends to be in the form of benaami land or gold and much less in cash. Hence focus on stock alone and ignoring the future flow is misguided. Indeed if you factor in the cost of hardship imposed on legitimate folk, small businesses, daily wage earners who have to wait for hours to exchange their old notes, then the net benefit of destroying old stock is lesser.

By ignoring the problem of future flow of black money, the government has missed a big opportunity. Until black money gets converted into immovable assets like land, it needs to move around. It’s here that high value notes are most convenient. If banned, they can’t be replaced with gold coins, since someone has to check authenticity of the gold content.  Hence that creates a great inconvenience. This is what the government should have done – a planned removal of high value notes completely, say over a period of the next 12 months.

India is at an inflection point where the use of electronic money, mobile wallets, online banking is all taking off in a big way. The national rollout of the Unified Payment Interface, the direct benefit scheme, the Jan Dhan Yojana bank account will all help the digital, less cash economy. Hence we really needed to plan for removing the high value notes (at least the Rs.1,000 and Rs.2,000 denomination) from circulation. To that extent, this is a missed opportunity.

This is the age of disruption, be it in boardrooms which remove Chairmen, or democracies which elect a person with zero political experience as President, or the third largest economy which discontinues 85 per cent of its currency overnight. The churn will be good but in this case it will require careful handling so that public anger does not spill and the hardship faced by the common citizen, which is now visible in long queues at banks, is minimised.

(The writer is a senior economist based in Mumbai)