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Demonetisation: Counting the cost of an economic risk

It is unclear that the likely impact on the black economy would justify the costs that the economy would have to pay.

analysis Updated: Nov 14, 2016 17:09 IST
Demonetisation,currency ban,Narendra Modi government
People exchange their old 500 and 1000 rupee notes at special camp organised by a public sector bank in Chennai on Saturday. (PTI)

The PM’s announcement that high denomination currency notes will soon be worthless paper caught everyone unawares. Even the government departments did not know of it and would have to prepare for its implementation after the TV announcement. It is an attack against the black economy no doubt but questions will be asked about how effective it would be and at what cost to the economy? There will be an immediate impact and also over time as many unforeseen consequences emerge. It is so complex that analysts in the government or outside will be discovering new aspects of it for some time.

Do we have any experience of such a move in the past from which we can learn? In 1978, the Rs 5,000 and Rs 10,000 currency notes were demonetised. Of the Rs 165 crores of such notes that had been issued, Rs 135 crores were returned with little impact on the black economy. Not only that, the black economy continued to grow after that. The move did not touch the lives of the average citizens. The economy was small and the income of the average citizen was tiny compared to now. People carried mostly Rs.10 notes and hardly any Rs 100 notes. So, trade was not affected. So, it did not touch the lives of the average person. There were no queues at the banks.

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The high denomination notes now constitute around 80% of the Rs. 16 lakh crore currency in circulation. Most of this is with business and not individuals. Even if it is held mostly by the well off with black incomes, say, the top 3% of the population, it would not amount to more than Rs.3 lakh per person and if businesses hold most of it then the average amount may not be more than Rs 1 lakh per person. Only a part of this would be black money saved out of the black incomes which cannot be accounted for. These are averages but some may hold crores in black money. But, black savings in cash may not be more than a few lakh crores.

Of the current size of the black economy of about Rs.90 lakh crores this may be only a few per cent. But clever rich and businessmen will find ways to circumvent the new regulations and convert a part of their black into white. The black economy in India is not parallel but intertwined with the white economy. So, just as in 1978, a very tiny part of the black economy would be demolished. The real worry ought to be that the mechanisms of generation of black incomes in different sectors would be unaffected by this move and black income generation would continue as before.

At what cost to the economy? Household, business and industry would be adversely affected as transactions would become difficult in the coming months. Large part of the economy does not use plastic money or cheques. Small businesses will be hit hard and that is the BJP’s core constituency. There would be long queues at banks and a black market may emerge in the currency notes for exchange and for smaller currency notes. There would be premium for gold and foreign currency - this was the case in the 1980s with the Bearer Bonds. Jan Dhan accounts are likely to be used for converting black into white. Havala may become more active. Demand for discretionary items would drop sharply in the coming months. But sales in Malls and from e-commerce based on plastic money may rise. However, in the net, dislocation of trade and commerce is likely leading to a hit for industry which has hardly been growing recently.

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Our poorly performing and leaky bureaucracy would be unable to handle such a complex operation at such a short notice. Remember the wheat trade nationalization in early 1970s which had to be reversed in a few months time because of the havoc it created. But the present move cannot now be reversed even if it fails. The government has taken a big risk. Why? Recent steps to control it via the foreign money bill and the Income Declaration Schemes failed. It wants to show that it is serious about the black economy after its promises during the 2014 election. In conclusion, it is unclear that the likely impact on the black economy would justify the costs that the economy would have to pay.

(The author is a retired professor of economics, JNU, and the author of The Black Economy in India. The views expressed are personal.)

First Published: Nov 14, 2016 17:09 IST