Why demonetisation is necessary though it doesn't tackle black money

It is a major fallacy to perceive demonetisation as a way to permanently end generation of black money. It can’t be for the simple reason that the impact of the drive on counterfeit currency can be gauged to a limited extent. It can have no effect on the future flow of black money in the form of new currency notes. 

However, some economists recommend slow replacement of high denomination notes by lower denomination ones to eliminate accumulation of black money in the future. This is meant to make hoarding of high value cash physically very difficult. But this again is no solution to black money woes.

The outgrowths of black money arguably stem from underlying roots of corruption, election finance, overburdening regulations, high tax rates resulting in large outgo of earnings, and so on.

Each policy objective requires specific targeted policy instruments or tools to tackle a targeted economic issue. In other words, demonetisation, which is a one-time taxing instrument on black money, cannot address either all the hoard of black money or tackle future flow of it.

To tackle such accruals and to eliminate the same, you require different reform tools which are not in the armory of the RBI. The RBI at best can be only be an economic regulator by following certain standard operating procedures to curb black money by withdrawing old notes and reissuing new notes, which is within its ken and the rest are beyond.

It perhaps requires reform measures such as lowering of stamp duty on property transactions, e-registration of real estate transactions and re-registration charges on existing ownership claims, to minimise black money generated through real estate dealings - to cite a particular example of real estate. Like this, there are specific measures to be taken for resolving each of the economic maladies plaguing the country.

The Goods and Services Tax (GST) is a major economic reform which requires a black money-free economy for producing the desired levels of growth and spurt in GDP. Otherwise it will result in diversion of economic activity to a parallel or grey market economy, which will undermine the revenue potential of the GST reform and the consequent tax burden will create spiralling of costs and a situation of cost-push inflation.

Let us also listen to the reactions of some previous governors of the RBI, who would have witnessed all kinds of jolts and changes to the economy.

YV Reddy, who served as RBI governor from 2003 to 2008, when the economy saw a massive boom, endorsed the decision taken by the Modi government. Reddy termed the timing of the move “perfect” as it comes right before GST is all set to be implemented. He called it a historic moment.

There is bound to be a paradigm shift in the economic and political system. With the GST on the anvil, the system is ripe for change. However, to take it forward, contract enforcement and judicial processes will have to play an active role. It is impossible to have a big change without some inconvenience and some temporary disruption.

C Rangarajan served as governor of RBI in the post-liberalisation era, from 1992 to 1997. He called the demonetisation move a “standard prescription” that was tried in the past, but he said that this time the government was targeting those who accumulated money, who issued fake currency and those financing terrorism. Rangarajan also called for measures so that black money doesn’t get generated in the future.

According to him, demonetisation would affect the retail trade the most as transactions are done using cash. There are some other sectors in the economy like real estate and jewellery where cash is a major player. Those will undergo a fundamental change.

D Subbarao, who was at the helm at the RBI post the 2008 financial crisis, has said that positives of the current demonetisation drive outweighed the negatives. However, he cautioned the RBI against treating the money not returned during the current drive as profit and handing it over to the government.

He sounded a hopeful note, that if you ride out the short-term pain, the positives will be substantial, be in terms of attracting investments, and also getting people to move from physical cash to electronic transactions.

The money being deposited in banks, as against having it in the pocket or under the pillow, was good for the economy. Banks will multiply the money when it is with them. It will encourage banks to get lending rates down, even if the RBI does not ease any further. The noteban is also expected to help improve financial inclusion and banks will be able to give out more credit.

Raghuram Rajan, the previous RBI governor, hasn’t commented on the current drive. But on an earlier occasion, he had raised doubts about the effectiveness of demonetisation as a way of cleaning the financial system of black money. Rajan had suggested that it is better to focus on making improvements in tracking tax data and ramping up tax administration.

He was sceptical, saying that even in the past demonetisation had been thought of as a way of getting black money out of circulation, because people then have to explain “how I have crores in cash sitting in my safe”. "It is often cited as a solution. Unfortunately, my sense is the clever find ways around it. They find ways to divide up their hoard into smaller pieces. You do find that people who haven’t thought of a way to convert black to white, throw it... (in) temples. I think there are ways around demonetisation. It is not that easy to flush out black money, he had said two years ago.

So far it is so good. Demonetisation has helped the economy leapfrog into a cashless state to a great extent.   

Hope the government plays a follow-on innings with more reforms to stockpile gains. Then it might just be declared a winner of this game-changing economic move.

Also read: Modi's solution to black money, demonetisation, as bad as the problem