The governments claims about the fruits of demonetisation of

500 and 1,000 notes are analysed. The five claimsfighting

terrorism, black money, gaining fiscal space, reducing interest
rates, formalising informal economyare scrutinised from an
economics perspective.

On 8 November 2016, Prime Minister Narendra Modi announced the

demonetisation of `500 and `1,000 notes with effect from the next
day. Through the 50 days after 8 November, the government has
made a set of claims with regard to the objectives and outcomes of
the demonetisation scheme. In this note, we wish to examine the
economic rationale and logic behind a few of these claims.

The first claim is that demonetisation would plug terror financing.

The Prime Minister asked:

have you ever thought about how these terrorists get their
money? Enemies from across the border run their operations using
fake currency notesMany times, those using fake five hundred
and thousand rupee notes have been caught and many such notes
have been seized (PMO 2016).

The second claim is that demonetisation would help unearth black

money. Clearly, the Prime Minister was referring to black money
hoarded in cash; he asked: which honest citizen would not be
pained by reports of crore worth of currency notes stashed under
the beds of government officers? Or by reports of cash found in
gunny bags? (PMO 2016). There are two ways in which this is
supposed to happen: one, unaccounted cash is not returned to the
banking system due to fear of detection; and two, when
unaccounted cash that enters the banking system is either
detected by tax authorities or voluntarily disclosed by the
depositors.

The third claim is that the unearthed black money would expand
the fiscal space of the government. One, when unaccounted cash is
not returned to the banking system, the Reserve Bank of India (RBI)
can use the savings to pay the government a dividend. Two,
unaccounted cash that is voluntarily disclosed would be subjected
to a 50% tax as per the Taxation Laws (Second Amendment) Bill,
2016. Unaccounted cash not voluntarily disclosed but detected by
tax authorities would be subjected to a 75% tax. Further, the
declarant would have to deposit 25% of the undisclosed income
into the Pradhan Mantri Garib Kalyan Deposit Scheme (PMGKDS)
2016, which would be used to finance programmes of irrigation,
housing, toilets, infrastructure, primary education, primary health,
livelihood, etc.[i]

The fourth claim is that demonetisation would help reduce interest

rates in the banking system. According to Arun Jaitley, Minister of
Finance and Corporate Affairs, banks are now flushed with funds
and these low-cost funds are going to be lent at a much lower
rate.[ii] In his address to the nation on 31 December 2016, the
Prime Minister further claimed that demonetisation would reduce
inflation in the economy.
The fifth claim is that demonetisation would help formalise Indias
informal economy, reduce the extent of transactions in cash and
help create a less-cash economy. In fact, between November
2016 and December 2016, the slogan of demonetisation has shifted
from being an attack on black money into a facilitator of
transformation into digital transactions. A number of incentives
have been offered to induce people to use digital transactions.

Counterfeit Currency

The circulation of counterfeit currency in the economy is a fact.

However, there is no accurate estimate of the quantum of
circulation of counterfeit notes. There are two major sources of
data on Fake Indian Currency Notes (FICN): one, the data released
by the RBI on FICN detected by the banking system; and two, the
data released by the National Crime Records Bureau (NCRB) on
FICN seized by the police.

The share of FICN detected by banks in the total number of `500

notes in circulation was 0.000022% in 201314, 0.00002% in 2014
15 and 0.000016% in 201516. The share of FICN in the total number
of `1,000 notes in circulation was 0.000021% in 201314, 0.00002%
in 201415 and 0.00002% in 201516 (RBI 2016: ch 8).[iii]
The share of FICN seized by police in the total number of `500 notes
in circulation was 0.0037% in 2013, 0.0025% in 2014 and 0.0019% in
2015. The share of FICN seized in the total number of `1,000 notes
in circulation was 0.0038% in 2013, 0.0031% in 2014 and 0.0028% in
2015.[iv]

In 2012, the government had entrusted the Indian Statistical

Institute (ISI), Kolkata with a study on counterfeit notes. The results
of the study were reported in the written answer to a question in the
Rajya Sabha in August 2015.[v] According to the answer, the face
value of FICN in circulation was found to be about `400 crore and
the value remained constant for the last 4 years. Media reports
also quoted the ISI study as concluding that the existing systems
of seizure and detection are enough to flush out the quantum of
FICN being infused.[vi]

Thus, it is unclear if the quantum of FICN is significant to warrant

overarching measures like demonetisation.

Black Money

A crucial assumption in the demonetisation exercise is that black

money is hoarded as cash. Such a view is not just narrow, but
also serves to defeat the larger purpose of preventing illegal
creation and storage of unaccounted money. To begin with, it is
necessary to distinguish between three concepts: black
economy, black money, and what we may refer to as black
cash.

The term black economy may simply refer to a broad set of

economic activities that generate production and income flows that
are under-reported or unreported or result from economic illegality.
A portion of incomes generated in the black economy, when saved,
adds to the stock of black wealth or, what we may call, black
money. Because savings that financed the acquisition of black
money were themselves undisclosed, black money has been
defined officially as assets or resources that have neither been
reported to the public authorities at the time of their generation nor
disclosed at any point of time during their possession (GoI 2012a).

A part of the black money is held as black cash. According to

estimates in the National Institute of Public Finance and Policy
(NIPFP) (1985), cash was a very significant form of holding black
money in only less than 7% of the cases. The prominent forms of
holding black money were: (a) under-valued commercial and
residential real estate; (b) under-valued stocks in business; (c)
benami financial investment; (d) gold, silver, diamonds and other
precious metals; and (e) undisclosed holdings of foreign assets.
More recently, open economy policies, free-trade arrangements and
financial liberalisation policies have expanded the scope for
holding black money in newer forms.
However, the very concept of black money is nebulous (NIPFP
1985). This is because the same person who earns black income
also typically generates income in white. He may choose to declare
his savings by claiming them to be a portion of his legitimate
income. There may, in other words, be black incomes but little or
no black savings! No wonder then that economists are not very
fond of estimating the size of black money. In fact, we are not sure
if there could be any realistic estimate of black money in India. A
commonly cited estimate puts the size of the black economy
between 19% and 21% of the gross domestic product (GDP) (NIPFP
1985). Some other estimates note higher shares. According to
Kumar (2016), the size of the black economy amounted to about
62% of GDP in 2012.

In fact, the idea that only illegal holdings of cash lubricate the black
economy is itself misplaced. This presumption has not only
infiltrated the public discourse but has also seeped into some of
the academic work on the subject. In his much-quoted work on the
subterranean economy of the United States (US), Gutmann (1977)
chose a base period in which he considered the size of the black
economy to be negligible. The currency-to-deposit ratio of the base
period was then applied to the deposits in 1976. Such a method
gave him an estimate of the legitimate currency requirement in
1976. The ratio of GDP-to-legitimate money (legitimate currency
plus deposits) multiplied by the currency stock in excess of its
legitimate requirement, then, gave Gutmann his measure of black
income in the US.
The problem, however, is that transaction balances used for
generating black income need not be undeclared or illegal. For
example, a firm can declare cash in its balance sheet and then use
it to procure inputs at inflated prices from an associated firm that
operates from a low tax jurisdiction. The profits can then be
ploughed back into the firm, say, via the foreign investment route.
The expansion of liabilities that results may, at least temporarily,
cause the firm to hold even larger amounts of cash. In this case,
there is nothing illegal about the original holdings of cash or their
subsequent augmentation. In fact, since transaction balances are
held legally as cash, they could well be held as deposits. The
example, therefore, shows that bank deposits can also finance
black activities. This, of course, goes against the very grain of what
Gutmann suggests and what the current Indian government would
have us believe.

In the example we constructed above, black incomes are generated

in the country but received in a foreign land. But are not incomes
from corruption (and many other forms of illegalities) received as
cash within the country. Would not demonetisation reduce these to
worthless pieces of paper? It would, but only to the extent that the
recipients of such incomes were foolish enough to continue to hold
them as illicit cash. They could, in the first place, choose to
consume these incomes. But even when such incomes are saved,
they need not be held as cash. The savings can take the form of
land, gold/bullions or financial shares. Besides, there are ways to
launder illicit cash. For example, bill masters may be engaged to
sell fake bills to those firms that wish to inflate their expenses (GoI
2012b). Illicit cash can then be shown as a receipt for sales that
never took place and, in this manner, made perfectly legitimate.
Thus, only a small section, which stores cash in large amounts
either for future use or as revolving cash in business/trade
transactions, is adversely affected by demonetisation. As we
explained above, even here, a big portion of cash might actually be
legal or made legal through myriad innovative ways. The
assessment by I G Patel, the then Governor of the RBI, of the
demonetisation scheme of 1978 is as true for 2016 as it was for
1978:

such an exercise seldom produces striking results. Most people

who accept illegal gratification or are otherwise the recipients of
black money do not keep their ill-gotten earnings in the form of
currency for long. The idea that black money or wealth is held in
the form of notes tucked away in suit cases or pillow cases is
nave. And in any case, even those who are caught napping or
waiting will have the chance to convert the notes through paid
agents as some provision has to be made to convert at par notes
tendered in small amounts for which explanations cannot be
reasonably sought (Patel 2002: 159).

In sum, no significant unearthing of illegal cash may be expected

by demonetisation, even if it might halt or slow down illegal cash-
based operations for a while.
Fiscal Space

In the days soon after 8 November, the buzz in policy circles was
that demonetisation would extinguish close to `3 lakh crore of
RBIs currency liabilities. The enlarged net worth of the RBI, it was
hoped, could then be transferred to the government in the form of a
special dividend. The legal permissibility of such a transfer was a
matter of speculation for almost a month after the announcement.
However, two points may be noted in this context. First, the transfer
of extinguished currency as dividend to the government was ruled
out by the RBI itself. Urjit Patel, the RBI Governor, clarified on 7
December that the withdrawal of legal tender characteristic status
does not extinguish any of the RBI balance sheets ... They are still
the liability of the RBI. Secondly, as on 10 December, an amount of
`12.44 lakh crore in the old series of notes had already entered the
banking system. The public had time till 30 December to deposit
old notes with banks, and they could continue to submit old notes
to the RBI until around March 2017. In other words, there is likely to
be very little money left with the RBI to extinguish.

Given that the dividend route is closed, the government would bank
on the second version of the Income Disclosure Scheme (IDS) to
improve tax collections and enlarge the kitty of the PMGKDS 2016.
However, one wonders why such a scheme could not have been
announced without demonetisation. Perhaps, demonetisation has
armed the government with evidence on big ticket deposits that it
can use to confront tax evaders. Yet, why would anyone deposit a
large sum into a bank after 8 November and invite scrutiny from tax
authorities? According to news reports, people may have split their
large hoard of cash into smaller parcels before converting them
into deposits. The tax authorities now have the unenviable task of
establishing the trail from the original hoard of cash to multiple
small-ticket deposits in the millions of accounts spread across tens
of thousands of bank branches.

What is likely to be the net revenue gain from demonetisation? As

an illustration, let us assume that `1.6 lakh crore are voluntarily
disclosed (which is more than two and a half times the amount
disclosed in the first income disclosure scheme). A 50% tax on this
amount would result in an addition of `80,000 crore to
governments tax kitty. Besides, declarants are supposed to
provide an interest-free loan equal to one-fourth of the disclosed
amount to the government for a period of four years. Assuming a
6% interest rate on borrowings, the government would then save
`2,400 crore in each of the next four years. The present discounted
value of this income stream comes to `8,430 crore. The total
revenue gain is then `88,430 crore.

However, the government would also lose money. It will end up

spending about `17,000 crore on printing and distributing currency,
and conservatively, another `6,000 crore as the interest cost
(explained later) of managing the excess liquidity with banks. Let
us assume that 2% of the nominal GDP is shaved off due to
demand contraction; instead of growing at, say, 11.5% per annum,
the nominal GDP would grow at 9.5% per annum. Taking the
nominal GDP (at market prices) of `135 lakh crore in 201516 and a
tax-to-GDP ratio of 17%, the combined loss of tax revenue to the
centre and the states due to economic contraction would amount to
`45,900 crore.[vii] The total loss of revenues due to demonetisation
would then be about `68,900 crore. This does not include the
compensation that government may have to provide for toll
operators (about `922 crore, as per estimates in the media) and the
loss of revenue from the sops announced on digital payments. The
net revenue gain to the government would then be `19,530 crore.
Even if we are generous and assume that the government actually
gains `40,000 crore from the entire exercise, it would still work out
to just 1.3% of the combined revenue receipts of central and state
governments in 201516.

In other words, it is hard to think of demonetisation as a game

changer for government finances.

Interest Rates and Inflation

According to Arun Jaitley, and a few media commentators,

demonetisation would expand credit supply and reduce interest
rates in the economy. Such a claim betrays an incorrect
understanding, not only of Indias credit markets, but even more
worryingly, of the process of demonetisation itself.
Before dealing with this issue in detail, we need to, right at the
outset, dispel a claim made by the Prime Minister in his 31
December 2016 address. He had said: the excess of cash was
fuelling inflation and black-marketing. It was denying the poor, their
due. Lack of cash causes difficulty, but excess of cash is even
more troublesome.[viii] What may drive inflation, besides a
sustained escalation of costs, is an excess of demand over supply.
Demand, of course, is backed by access to a means of payment,
which may be held as cash or deposits. It is thus conceptually
erroneous to claim that a mere conversion of cash into deposits
will deprive economic agents of the means of payments to demand
commodities. As a matter of fact, after 8 November 2016, the poor,
who are underserved by banks and mostly receive and make
payments in cash, were forced to spend less due to the denial of
their rightful cash. The success in controlling prices, in other
words, was achieved by squeezing the consumption budget of the
poor.[ix]

The claim that demonetisation would result in lower interest rates

can be rationalised through a simple money multiplier process.
Suppose `10 of cash in the hands of the public is converted into
deposits. Let us further assume that out of every `10 that banks
issue as deposits, they are required to hold `1 as cash reserve. As a
result, banks will now have `9 worth of excess cash, which they
lend to public and, which, assuming that the public is discouraged
from holding cash, returns as deposits. The cycle would then start
afresh: deposits will increase by `9, cash reserves by `0.90 and
loans by `8.10. When all is said and done, deposits, reserves and
loans would have increased by `100, `10 and `90 respectively.
Another way to understand this process is to simply assume that
the banks hold no more than their required reserves by crediting
`90 to the deposit account of their borrowers. Of course, such an
expansion of credit cannot come without a reduction in its price
and demonetisation has raised hopes that the interest rate on loans
may fall in the near future.

There is, however, a fly in the ointment. What we are witnessing in

India today is not a permanent conversion of currency into
deposits but a temporary measure that would last only till the limits
on withdrawals exist. Once the convertibility of deposits into cash
is restored, the multiplier process sketched above would start
working in the reverse direction. As deposits worth `10 are
converted into cash, the banks, now holding less cash than they
are required to, would be compelled to extinguish loans worth `90
(and the corresponding sums in the deposit accounts of their
borrowers) from their balance sheets. Any increase in credit on
account of demonetisation would therefore be completely
temporary.

There is more. The textbook money multiplier mechanism assumes

that banks fix the overall quantity of credit and its price is
determined in the marketplace. In the real world, just the opposite
happens: banks fix the price of credit and its quantity is determined
in the marketplace by the activities of borrowers. To borrow
terminology developed by Polish economist Michal Kalecki, the
quantity of bank credit is demand-determined whereas its price is
cost-determined. Commercial banks can always expand their
lendable resources by borrowing funds from the RBI at the repo
rate fixed by the latter. The repo rate, in turn, sets the floor for
lending rates to various bank borrowers.[x] It is only when the
stock of eligible securities with banks, which the RBI requires as
collateral in repo transactions, begins to run thin that one can
realistically talk in terms of a quantity constraint on their credit-
creating capacity.

Surely, there was no quantity constraint for Indian banks before

demonetisation. As on 28 October 2016, the stock of government
and other approved securities with banks stood at `28,956 billion;
this was about 29% of the demand and time liabilities issued to the
non-bank public, a figure well in excess of the 20.75% Statutory
Liquidity Ratio (SLR) that the banks are required to maintain.[xi]
There was no constraint on the credit-creating capacity of banks to
begin with, and the finance ministers claim that demonetisation
would result in an expansion of credit appears grossly
exaggerated.

Since the RBI acts as a price fixer in money markets, it seeks to

mop up the enlarged cash reserves of banks either by activating its
reverse repo window or through the outright sale of government
securities.[xii] Between 30 November 2016 and 6 December 2016
alone, the RBI had mopped up more than `4 lakh crore from the
commercial banking system.[xiii] The impact of expanded deposit
base would, therefore, be not so much to enlarge credit to private
borrowers as to shift the ownership of Government securities (G-
Secs) and Tresury bills (T-Bills) from the RBIs balance sheet to that
of the banks.
It is hard, then, to see how interest rates in the banking system
would fall due to demonetisation; any decline in interest rates
would only be transient.

On the other hand, excess liquidity situation, while doing little to

improve credit supply, will actually have adverse fiscal
implications. This is because the RBI, a public institution whose
profits are transferred to the central government budget, will lose
its income earning assets to commercial banks. Moreover, to the
extent that market stabilisation bonds are used to mop up excess
reserves from the banking system, interest payments will have to
be made directly from the central government budget. The exact
magnitude of these costs is anybodys guess at the moment. But if
`12 lakh crore is mopped up by the RBI for a period of just one
month, assuming an annual interest rate of 6% paid over 12 equal
monthly instalments, the total interest outgo of the central
government would be about `6,000 crore.[xiv]

Less-cash Economy

Given the inordinate delay in the printing of new currency, the

government has begun a campaign for less-cash banking. It is
argued that less-cash banking would formalise a large share of
Indias informal economy by bringing more firms into the tax net.
To begin with, there is no clear relationship between the currency-
to-GDP ratio and what we call as the shadow economy, which is a
more appropriate concept to use than informal economy.[xv] India
had a currency-to-GDP ratio of 12.5% in 2015 (Rogoff 2016). The
size of Indias shadow economyusing one definitionis
estimated at about 21% of its GDP (Schneider et al 2010). Let us
take three countries where the currency-to-GDP ratio was either
higher or comparable to Indias: Japan at 18.6%, Hong Kong at
14.7% and Switzerland at 11.1%. The size of the shadow economy
relative to GDP in 2012 was only 8.8% in Japan, 15% in Hong Kong
and 7.6% in Switzerland (Schneider et al 2010; Schneider 2011).
Now, let us take five countries that had lower currency-to-GDP
ratios than India in 2015: South Africa and Brazil at 3.4%, Chile at
3.6%, Indonesia at 4.1% and Mexico at 5.7%. All these countries had
a large-sized shadow economy relative to GDP in the second half of
the 2000s: 26.8% in South Africa, 38.5% in Brazil, 18.5% in Chile,
19.1% in Indonesia and 28.5% in Mexico.

A higher share of cash in total payments does not necessarily

indicate a larger shadow economy. According to a Deutsche Banks
study in 2016,

surveys and estimations for different countries show that a high

share of cash in total payments does not always indicate a large
shadow sector: Germany and Austria are cash-intensive countries
with relatively small shadow economies. In Sweden, cash payments
have become rare but the country still has a mid-sized shadow
economy. However, in many cases the degree of cash usage and
the size of the shadow economy do seem to be related: Spain, Italy
and Greece are characterized by intense cash usage and large
shadow economies while countries with relatively low cash usage
tend to show low levels of shadow activity (Anglo-Saxon countries
as well as Switzerland, the Netherlands or France). Given these
diverse findings, it becomes clear that cash is scarcely the reason
for conducting shadow activities (Mai 2016: 78, emphasis added).

Similar, again, is the relationship between corruption and cash.

There are cash-intensive countries with lower perceived corruption
and less cash-intensive countries with higher perceived corruption.
The corruption perception index of Transparency International
represents the perceived level of public sector corruption on a
scale of 0 (highly corrupt) to 100 (very clean). In 2015, the index
was higher for many economies with higher currencyGDP ratios
(75 for Japan and Hong Kong; 86 for Switzerland; 81 for Germany;
76 for Austria) and lower for many economies with lower currency
GDP ratios (44 for South Africa; 38 for Brazil; 35 for Mexico; 36 for
Indonesia).[xvi]

There are also many reasons why cash is preferred by firms,

particularly small and micro-enterprises. Transaction costs in cash
transactions are low; in particular, costs of book-keeping are
minimised by relying on cash. The use of digital transactions is
expensive as each transaction invites a 2%3% tax. Cash
transactions may also be convenient because of the immediacy of
realisation without delays of bank transfers. In many cases,
informal credit is available to small and microenterprises only as
cash, and needs to be repaid too as cash. In other words, forcefully
formalising a fragile informal sector may actually end up
eliminating the minuscule margins on which these firms survive.
[xvii]

Finally, cash leaves no trail, while digital payments leave a trail. For
this reason, the potential for state surveillance, violation of privacy
and abuse of civil liberties rise significantly with the replacement of
cash payments with digital payments. New sources of metadata on
everyday transactions of citizens are emerging; big data analytics
is increasingly becoming big business. Such personal data of
citizens turn into commodities in the grey markets, resulting in a
breakdown of trust between the state and its citizens. While strong
laws on privacy and cyber-security exist in many Western
economies, Indian legal system is marked by the absence of such
legal safeguards. The introduction of Aadhaar, and its expansion
into the Orwellian idea of India Stack and the JAM (Jan Dhan
AadhaarMobile) trinity, present new threats to the freedoms of
Indian people that have not been adequately appreciated in the
public discourse on cashless transactions.

Conclusions

In this brief note, we tried to examine the governments claims on

the benefits of demonetisation. We argued that (i) the extent of
circulation of counterfeit notes in the Indian economy is
exaggerated;

(ii) the claims of unearthing large amounts of black money is

unfounded and based on a poorly informed view of what
constitutes black money; (iii) no improvement in government
finances may be expected due to demonetisation; (iv) it is unlikely
that interest rates in the economy may fall as a consequence of
demonetisation; and (v) the movement into a less-cash economy
may neither lead to the shrinkage of the shadow economy nor
reduce corruption, and, instead, may open up new spaces of
surveillance and assaults on the personal freedoms of citizens.

Thus, one finds it extremely difficult to locate any economic logic in

the conception and implementation of the demonetisation scheme.

REFERENCES

- See more at: http://www.epw.in/journal/2016/53/web-

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