Black Money

On Nov 8th Prime Minister Narendra Modi dropped a bombshell on the people of India. High value currency notes of INR 500 and 1000 would cease to be legal tender with effect from midnight. The aim was two fold to flush out black money – money earned through illegal activities or money obtained through bribery and corruption; and to neutralise counterfeit notes often said to be used to fund terrorism, and often alleged to be manufactured with the connivance of Pakistan.

There’s a lot of ill-informed, politically -motivated misconceptions being put about on social media about the possible effects of this policy move. In this blog I focus mainly on black money. I haven’t seen reliable estimates of the scale of the counterfeit money problem; and in any case I dont believe,  given the access to all those US dollars flowing into Pakistan, and the earnings from opium in the border areas,  that funding will prove much of a problem for determined terrorist networks.

I think the effect on black money will be marginal and the impact on ordinary people immense for the following reasons:

  1. Only 6% of illegal assets are held as currency notes. Lets assume this is the target amount that it is hoped will be netted by the 500/1000 note ban. But creative ways are being found of converting these notes into the new notes (by using proxies to stand in line and change them for new notes) or depositing them into valid bank accounts often using a large number of poor people as ’bank mules’. These poor people opened nominal bank accounts under Jan Dhan Yojana and had just a few rupees in them. These accounts can now be credited with up to 2,50,000 each of cash from rich people who may have stocks of the now defunct notes that for whatever reason they wish to hide. Of course the mules will be paid a fee for the use of their bank accounts and so to that extent the money will be spread around a bit; that’s good but the poor guys may not realise that they risk losing the BPL – ‘Below Poverty Line’ – status.
  2. Black money, in terms of its characteristics, is like any other money, including white money. It is never static but a flow. Fiat money is after all a medium of exchange and a (very temporary) store of value. As it is created by illegal activities (bribes, smuggling, prostitution, drugs, gun-running, extortion, fraud etc) it is held as cash for as short a time as possible if only because of the hassle of holding even smallish quantities of liquid cash. It is used to buy up more tangible assets or to finance a lavish lifestyle – cars, jewellery, homes, flats foreign trips etc) To the extent that that such expenditure re-introduces the money into the real economy its a useful thing – ( I disregard the morals of this for now). But it can also also be used to do deals with politicians to buy favourable treatment, and with judges and police to avoid prosecution. That nexus is the single most corrosive feature of black money because it embeds the culture into the very core of society. But lets also note that the same corrosive effect is also possible with perfectly legal white money.  All political parties are involved; the biggest culprits though, are the BJP and the Congress. ( See here) There is a difference between the two uses of black money. Buying goods and services is a useful economic activity, bribing officials or politicians is bad because it merely transfers the black money from one owner to another – it stays black. of course white money can also be used to bribe officials or buy special treatment. In fact almost all petty bribery by citizens of venal officlais is white money. The bribe to the traffic cop, to the clerk in some goverment office to keep your file moving, the payment to jail official to avoid rough treatment of an undertrial remand prisoner, the backhander to the customs official.. all these are usually if not always paid in perfectly legitimate ‘white’ money.
  3. How much black money potentially can this notes ban flush out? According to the PM himself 90% of all black wealth is out of the country – Swiss banks and Panama come to mind. Of the 10% that is inside the country, only about 5% is at any one time in the form of cash. So taking black wealth – as opposed just to black money as our target, the notes ban if totally successful will flush out just 0.5 percent of all black wealth. These figures are uncertain and based on best estimates. But you’ll have to revise them hugely before the conclusion changes that its only a small or smallish proportion of black wealth that can even potentially be flushed out.

So any notion that this currency notes ban will solve the black money problem is mistaken. It may temporarily stop some transactions but the source of black money – illegal activities that one cannot own up to if only to avoid prosecution, and bribery of politicians and policemen – will revive as fast as weeds grow back on a freshly mown lawn. And they will only be helped in the transport of the new black money from one asset class to another by the higher denomination note (2000) that has come in.

On the other hand the harm from the demonetisation move is definite and huge. How long the ill-effects last is a matter of debate. Consider

  1. Fully 86% by value of the 77 billion currency notes that were in circulation at end of 2014 (data from RBI) were in the form of either 500s (11.4 billion notes) or 1000s (5.081 billion notes). See for the detailed figures.
  2. Rural and semi-rural citizens in India are very cash dependent, lots of people depend on and regularly use cash for their transaction. Fewer than 20% of India’s approximately 2,15,000 ATMs for instance are in rural centres. [ See my chart here] So any idea of moving to cashless transactions any time soon is a pipe dream. Unfortunately many commentators live and work in urban areas and they can buy even 100 Rs worth of vegetables in a local supermarket and pay by credit card. Less than 5% of Indians have a credit card. In April 2015 there were only 21 million credit cards.
  3. A huge swathe of economic activity will therefore be disrupted. everything from marriages, funerals, festivals, purchases of essential goods, discretionary household consumption will be postponed and or cancelled.
  4. A great deal of the wholesale market in agricultural products is conducted in semirural markets where settlement is in cash. This is not black money. Its just that the people haven’t got around to using electronic payments partly because the infrastructure is not there. See for instance this report from The Hindu   – its a factual report; not a rabid anti-Govt slant
  5. An unknown number of the un-banked sector who may have sums of money stored away for a rainy day may be forced to travel to a nearby town to open a bank account to put the money in before March 2017. they will be subjected to harassment and exploitation by officials and touts. Some may even lose their money if they cant do it by 30 Dec. For them its more than a few thousand rupees; it may be their life-savings. As soon as they can they may well take their money out.

All this assumes that the transition to the new notes will be smooth. This is more forlorn hope than realistic expectation. The RBI has only now (Nov 14) announced the setting up of a task force to oversee the re-calibration of ATMs to dispense the new 2000 Rupee notes. The emergency meetings of senior ministers and bureuacrats are evidence that they have been caught unawares of the scale of the transition. I suspect that the RBI officials were not in the loop as to the timing of the announcement. The PM of course had a point about the need for secrecy but that merely goes to the heart of the problem – a culture of corruption at the highest level means that the PM cannot trust even his senior-most ministers and advisers for fear of leakage. Be that as it may, RBI and the Economic Affairs Ministry are having to play catch-up, announcing new rules on limits, indelible ink to avoid the same person turning up repeatedly to exchange his quota of 4000 Rupees worth of old notes, and so on.

7. Elementary maths shows the gap clearly. The data on currency notes in use are from the RBI website [here].  Assuming the existing 500s and 1000s are to be replaced like for like by value, we’ll need 11.4 billion new 500s and 2.54 billion (half of 5.08)to be printed distributed to banks and put into circulation (i.e peoples hands). Not to mention that there will also be a new 1000 note coming out soon.

8. Here’s the killer point: In 2014–15,- an entire year – the RBI had ordered from the printing presses the following numbers of currency notes:

INR 500s: 5.4 billion notes

INR 1000s: 1.5 billion notes

That means that even if all the printing press capacity was diverted to just 500s and 1000s it would take rather more than a year to replace the notes that have been trashed by the edict of Nov 8th. And you just cant print only high value notes because lower denomination notes (100s and 50s and 20s and 10s) are not only needed for everyday transactions but also need to be replaced faster for obvious reasons.

The point is that this is not just a temporary glitch for a few days. If the preparation had been better there would not have needed to be any temporary restrictions on the amount of currency you can draw out.

Bottom line. This was neither necessary to root out black money held as cash nor is it sufficient. In terms of its effect on total black money it will be at best marginal. In terms of the unintended consequences the effects will be major especially on the poorer less well educated un-banked, rural, cash-economy dependent citizens of India who are now queuing up not for love of country or ruler, but to salvage their own meagre savings.

At the very least, India deserves a Parliamentary enquiry into the decision making process, planning and execution of the policy, the results, the costs of implementing the policy and the adverse effects on peoples’ lives and on the economy.


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