governance, political economy, institutional development and economic regulation

Deep freezing India

deep_freezer

Terminally ill people are opting to deep freeze their body hoping for a cure some day which would make them come miraculously alive and be well. But would you opt to temporarily freeze 85 per cent of your bodily functions merely because you cannot compete with the explosive, short burst speed of Usain Bolt but are running well ahead of Haile Gebresellaise  – the Ethiopian long distance champ? Not likely, given the huge risks and the meagre reward.

Shockingly, the Government of India chose to do just that on November 8, by de-legalising notes of Rs 500 and Rs 1,000, which comprise 85 per cent of the Indian currency in circulation. This deep froze the world’s third (or fourth?) largest economy which was ticking over happily at a growth rate of just under 7 percent. It also irreversibly, hit the sentiments and the pockets of its most ardent supporters – the 400 million citizens who comprise the middle class earning between Rs 2.5 to 50 lakhs (US$ 3,500 to 73,500) per year.

Exit “old”black money enter “new” black money

If the government’s actual objective was to destroy black money, estimated at 25% of the US$ 2 trillion economy, think again. A widely dispersed “new black money” machine has already mushroomed, exchanging the frozen Rs 500 and Rs 1,000 notes into new legal tender at a cost of between 20 to 40 per cent of their face value. Many people prefer this route rather than declare their hoarded stocks and lose 33 per cent to tax -if the amount is the current year’s income- or 100 per cent as tax and penalty if it is undeclared income from previous years.

But not all sellers are owners of undeclared wealth. Many are ordinary people who got caught short on cash and are desperate to buy things they need — medicines, food or pay for transport to get home. The banks are inaccessible for exchanging currency and ATMs are by and large not operative. This mess will take at least till the end of the year to be straightened out.

In the meantime, scores of small establishments and workers will accumulate debts to pay daily expenses while the economy loses potential value added over this period. The direct economic cost for a two month deep freeze is at least 1% of GDP foregone. The loss of individual credibility from contracts not honoured because of a cash shortage; loss of savings or atleast the interest on it; the permanent shut down of small businesses due to bankruptcy and the consequential loss of self-respect even for hard working people. is far more permanent and immpossible to tabulate.

No to Black Money – but focus on its sources. 

gold

Who would oppose hunkering down systematically on black money? Surely not more than 15 percent of the “black” wealth  (undeclared to tax) is held as cash in Indin Rupees mostly to transact, not as store of wealth. Much of it is held abroad; invested in real estate bought partly in cash to save tax and invested in gold and diamonds. Going after the cash component, whilst neglecting the other “black” assets, is like impounding the fuel in the tank of a highly polluting car, in the hope it will reduce smog. So long as the car exists it will  find the fuel; smog will result and new black money will be generated.

Prime Minister Narendra Modi has targeted election financing and corruption as the root of the black economy. But we are a long way from doing anything substantive. Even the accounts of political parties are not yet open to public scrutiny under the Right to Information Act. As for bureaucratic corruption it is a long haul with patient , deep surgery needed to unclog the pipes of good governance. There are no quick wins here.

High minded objective but low tech implementation

The declared objective is noble. But did we choose the optimum implementation mechanism? What have we achieved by the secrecy; the haste and the resulting action without adequate preparation – all of which are reminiscent of the anti hoarding drives against food grain traders of yore. Why not, instead, have given adequate notice of the government’s intention to crack down, specifying a future date? The efficacy of the step would not have been diluted. If anything, it would have been enhanced. Brandishing a big stick is better than using it.

stick

A notice period would have allowed better logistics to be in place — sufficient new notes; working ATMs and mobile exchange units for the unbanked. Ordinary people could have been educated and prepared for accessing the new currency. There was nothing to stop the tax authorities and the police from clamping down, during the notice period, on the activities of potential black money aggregators to dissuade leakages — just as they are doing today. After all social media and electronic surveillance has vastly increased the powers of government to monitor the activities of citizens.

Leakages are inevitable in any currency exchange programme. Around 53 per cent of our 400 million bank accounts are dormant. Many may be multiple or “benami” accounts of the same person. These accounts are viable vehicles to launder black money by paying the nominal holder of the account a small fee.

The government says it will not scrutinise deposits up to Rs 2.5 lakhs in each account. But even an average deposit of Rs 40,000 in each of the 200 million dormant accounts can convert Rs 8 trillion of black money in old notes into temporarily white money, in new notes. Other avenues are for small businesses to deposit their old notes as an advance in the accounts of their suppliers. Employers can similarly deposit advance salaries in the accounts of their employees.

The math of who holds how much currency

Thirty per cent of the Rs 14.5 trillion currency in the high denomination notes is held legitimately in banks and other government agencies as working capital. Another 30 per cent could be the legitimate savings in cash of around 170 million households, after excluding the poor households, and the cash working capital of the 10 million registered businesses in India.

This leaves 40 per cent, or Rs 6 trillion, as the potentially unaccounted wealth held as cash. The expectation is that the “black money” component, held in cash, will not be deposited for exchange because the depositors would then become liable to tax.  But don’t hold your breath — it would be very surprising if the amount extinguished is more than just 15 per cent or Rs 1 trillion. After all, the government’s tax amnesty scheme which closed in September 2016 required a sacrifice of 45 per cent of the amount as tax and penalty. It netted just Rs 0.65 trillion in undeclared money. In the late 1970s, when gold was smuggled into India because legal import was prohibited, a small proportion was regularly and ritually “caught” and confiscated by the customs authorities — a “nazarana” for retaining the “izzat” of the “sarkar”.

Much the same may happen now. Around Rs 1 trillion may fail to be deposited in the banks. This is the amount the RBI can write off from its liabilities, enabling the government to declare victory, while individual hoarders of black money take a haircut. With inflation at historic lows already, the two month economic deep freeze will push it down even further. The windfall in RBI resources could be useful in FY 2017-18 to boost the economy, which would still be reeling from the internal shock and disruption. But caution on stoking inflation is fiscally and politically advisable.

Fix whats broken  

Recapitalising public sector banks and waiving the debt burden of state governments can give decent economic returns if it kickstarts investment in projects or if it generates the necessary political capital to implement GST on schedule. Using some of this largesse to reduce the tax rate for low and middle income earners in FY 2017-18, particularly for senior citizens, may compensate them for the pain unnecessarily inflicted on them. Some significant salve is necessary to restore the credibility of the government as an efficient protector of the aam aadmi. There are two lesson from the mess. First, never fix what isn’t broken? Second, think before you deep freeze tomorrow’s lunch.

Adapted from the authors article in Asian Age, November 20, 2016 http://www.asianage.com/opinion/columnists/191116/a-noble-objective-but-the-execution-is-faulty.html

 

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Comments on: "Deep freezing India" (1)

  1. Great article Ahlu – well researched and reasoned. I agree with your viewpoint about this being a bad idea that is being very shoddily implemented, causing needless and widespread harm that is likely to far exceed the benefits. I’m thinking the Modi govt. will probably (and deservedly) take a hit in future elections as well.

    There are folks on the other side with a different viewpoint, with BJP supporters vociferously justifying the move. They talk of short public memory, change in banking and transaction habits, and the aam admi swayed by ideological rhetoric and promises. There’s also an aspect of significant transfer of wealth from holders of black money to the “commissions” earned by poorer people who are helping to convert it (temporarily) into white by depositing it into their bank accounts, standing in lines in banks on behalf of others, etc. I still anticipate that the pain far exceeds the gain. Let’s see.

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