Modi's surgical strike on the Indian people

Prime Minister Narendra Modi's drastic action to combat 'black money' in India has caused needless misery to the poor without really effectively tackling the problem. Jayati Ghosh explains.

THE audacious move by Indian Prime Minister Narendra Modi to demonetise currency notes of 500 and 1,000 rupees at one stroke is supposed to indicate his government's resolve to root out black money. Unfortunately, it will barely touch the problem of generation of black money, while both design and implementation have flaws that have left the mass of people reeling.  

The demonetisation of bank notes per se is not the problem. It has occurred periodically in India and many other countries, both to reduce concerns about counterfeiting and to stem the use of cash-based illegal transactions. But it has typically been done gradually, allowing adequate time for people to replace the old notes with new ones. This overnight shock, by contrast, is hugely destabilising and disruptive of normal economic activity.

Government spokespersons argue that secrecy and speed were essential, because otherwise, those hoarding black money would simply turn their cash 'white' through buying other assets. But this argument will not hold. Suppose the government had announced that (say) from 1 December the old notes would no longer be valid. It could then start tracking all large sales of likely assets (such as land, houses and gold) and foreign exchange transactions, to follow up with those who had made them. This would have provided the government with all the information it needs to ensure legal and tax compliance from such individuals, while involving no cost to the ordinary law-abiding citizen.

As it happens, the secrecy and suddenness have created completely unnecessary problems which have hugely affected ordinary people across the country. In addition, the government clearly failed to recognise that, given the rise in prices over the years, it is absurd to treat Rs 500 as a 'high-denomination' note that poor and middle-class people are not likely to use. Given the prices prevailing for many essentials like food items and medicines (with some dals costing nearly Rs 200 per kg for example), it is absurd to consider that Rs 500 would be used only by rich people or black marketeers. The two cancelled notes account for 86% of the notes in circulation, and removing them at one stroke inevitably has had huge repercussions on liquidity, markets, production and consumption across the country.

In terms of implementation, what has been even more surprising than the design is the apparent lack of preparation on the part of the administration for such a major move, even though the Prime Minister claims that this was planned over nine months. The chaos evident in the week after the announcement is partly because not enough notes have been made available to banks and ATMs, and arrangements to deal with what should surely have been an expected rush to exchange notes were completely insufficient. Since the new cash notes have not become readily available, economic activity in the heavily cash-based Indian economy (where well above 90% of transactions are in cash) has been hugely affected.

The choice to introduce first the Rs 2,000 note rather than the Rs 500 note is also mystifying. If the idea is to eliminate black money, then why introduce even-higher-value notes that are even easier to store for those holding large quantities of undeclared cash? Obviously, this is not an effective liquidity substitute for the Rs 500 note, yet government representatives are surprised when people cannot find anyone to give them change for the higher-value note. The shortage of other, lower-value notes, inevitable when only higher-value notes are introduced, was also not anticipated.

It beggars belief that simple matters like ensuring that the central bank, the Reserve Bank of India (RBI), had sufficient notes to replace the ones that have been demonetised, or that ATMs are appropriately configured, were not taken care of before going through with this. Indeed, these implementation problems appear to have been unexpected: the government began by claiming that things would be sorted out in a matter of days, then weeks, and most recently 50 days, during which time the Prime Minister has asked the people of the country to bear with him.

Still, all this would have been justified if it would eliminate all black money in the country. But in fact, it will do little more than scrape the surface of the problem, despite all the hyperbole about this being a holy war on corruption.

The nature of 'black money'

One mistake is to see 'black money' as a stock of cash or pile of accumulated assets, because it is not about stocks at all, but about flows or transactions that are concealed from authorities or under-reported to avoid taxes and various other regulations. These include bribery and other corruption, as well as under-invoicing and over-invoicing by companies of all sizes, under-reporting of the values of sales of goods and services by individual providers, overstating of costs, reporting false or non-existent transactions and, of course, criminal activities of various kinds. Many of these do not necessarily require cash transfers at all but can be just as easily (and more speedily) done through electronic means. Also, money does not acquire a particular colour and keep it; as it flows through different transactions, it can move through white, black and grey hues.

For all these reasons, estimates of the exact amount of 'black money' in the system at any given time are necessarily problematic, since they rely on assumptions about both the number and the value of unrecorded and tax-evading transactions. A recent estimate by a private agency has claimed that black money amounts to 20% of total gross domestic product (GDP) or 25% of recorded GDP, which would make this one of the lowest in the world already. However, a report by the National Institute of Public Finance and Policy (NIPFP) on the incidence of black money in India (which was submitted in December 2013 but has still not been made public or even submitted in Parliament) is reported to have suggested that the black economy amounts to as much as 75% of the recorded GDP.

Most of this is not - and indeed cannot be - held in the form of local currency. Those engaged in such activities would speedily seek to transfer them into other assets, like land and other real estate property, gold and jewellery, benami accounts in banks, holdings of dollars and other global reserve currencies, holdings of stocks and shares through the anonymous vehicle of Participatory Notes and, most of all, sending the money abroad through various means.

Consider what proportion of the money in circulation is black money that could be flushed out by this new measure. We know that currency in circulation currently amounts to 12% of GDP, and 86% of this currency is in the form of Rs 500 and Rs 1,000 notes. But around half of GDP is produced in the informal sector, on which 85% of the population rely. This is unrecorded income, even though it is estimated in the GDP, but it is predominantly not 'black' because incomes here are generally too small to fall into the direct tax net and are anyway subject to indirect taxes of various kinds.  These include incomes of farmers (which are not taxed), the returns of small traders and micro entrepreneurs, the incomes of daily wage workers, the incomes of small service providers, and many more such incomes.

This informal economy in India is hugely, if not completely, dependent upon cash. Probably anywhere from half to all of informal GDP is in the form of cash transactions. Since estimated cash balances amount to 12% of GDP, the cash equivalent of anything between 3-6% of GDP is involved in such informal activity, which is completely legal.

A move to demonetise larger-denomination notes of Rs 500 and Rs 1,000 would be successful only to the extent that it flushes out the part of black money that is held in cash, which would then be equivalent to 2.3-5.2% of GDP. In terms of the available estimates of black money, this comes to only 3.4-6.8% of the NIPFP estimate of black money or 10-20% of the smaller private estimate. So only a tiny or at most a small proportion of black money (or rather, of the assets acquired through illegal or unrecorded transactions) would be captured through this move.

The impact of sudden demonetisation

Even revealing this small amount would still be an unmitigated benefit, if the move did not simultaneously cause so much grief to innocent citizens. But the insensitive design and shoddy implementation of this move have already caused massive economic distress and the pain is likely to linger for some time. The immediate impacts - in the form of drastic cash shortages leading to immense hardship especially among less privileged groups; long and tedious waiting times in queues that often prove to be fruitless because banks and ATMs are unable to provide the required cash; breakdown of payments and settlements systems across India - have been widely portrayed in the media.

It is true that these are essentially temporary disruptions, which should be eased over the coming weeks, and the government and its supporters argue that this temporary pain is worth it to ensure the greater common gain of eliminating black money. And in some sectors like real estate where cash payments were rampant, this  may  serve  to  make property more affordable, at least for the moment. But other effects are very damaging for the economy and especially for the poor. And it will put a brake on economic activity, with medium-term effects that may be even worse than the immediate dislocation.

The biggest negative effect is the massive loss of liquidity for the informal economy. This has affected production systems, as moneylenders providing working capital to small producers are unable to provide the new notes. There are already reports of daily wage labourers unable to find work because employers cannot pay them with the new money and are only able to offer old notes, which are now without value. It has led to breakdowns in payments systems and has drastically affected trading. People hoard their slender cash holdings and do not shop; this affects large and small retailers who rely on cash sales; this affects their own demand for purchase of goods in the wholesale markets; and so on. Even in megacities like Delhi, there are reports of shopkeepers simply shutting their shops because of the lack of buyers, while traders in wholesale markets have been caught with huge amounts of unsellable stock of perishable items like fruits and vegetables because of lack of cash purchasers. This has permeated down the distribution chain to the small vendors and street hawkers. And the predominantly cash-based road transport sector has been very badly hit.

All this is worsened by the impact that the cash shortage has on consumption, as people cut down on purchases of non-essentials and even of food and other essentials, because of the lack of liquidity with which to purchase these items. Consumption squeezes have been especially dreadful for those facing medical emergencies who do not have new notes to pay for private hospitals or medicines. Stories abound of individual tragedies resulting from this mess.

As always happens in capitalism, the market quickly responded to these needs, in the form of intermediaries who offer to collect the old notes and exchange them for a discount. The prevailing rates in Delhi are at 20% discount: Rs 400 for a Rs 500 note and Rs 800 for a Rs 1,000 note. Similar rates were also being offered by market vendors for their goods. Those who are desperate to get hold of some cash quickly for whatever reason, or who cannot afford to lose a day's wages for standing in the queue at the bank, are then forced to take these rates. This amounts to an attack on the already low incomes of the poor. This has  been  made  worse  by  the recent  clampdown  on  exchange  of old notes for new ones - the limit for this  has  now  been  set  at  Rs 2,000 in total, with indelible ink being used to prevent multiple transactions. So the poor who do not have bank accounts will now have no option but to exchange their old notes at a discounted rate, further impoverishing them.

In rural areas, matters are even worse. The number of rural bank branches has declined in past years, and these branches are now few and far between. Banking activities are supposed to be conducted through ATMs and through the Banking Correspondents (BCs), most of whom have been largely dormant for a while now. These systems have proved completely inadequate to the task of ensuring the supply of new notes.

Farmers are in a particularly difficult condition. Across much of India, farmers have recently harvested the kharif crop (monsoon crop) and are now about to begin sowing the rabi crop (winter crop). Many of them had saved up the cash proceeds of their kharif sales to buy inputs for the next sowing season. They need money to buy seeds and fertilisers, and to hire tractors and other equipment - and they need it now, because the agricultural season does not wait upon humans. Even a day's delay can be critical in some cases depending upon weather conditions, but these farmers have already been waiting nearly a week. The timing of this move is really terrible for them because it affects their incomes over two agricultural seasons.

There are also gendered consequences. Policy-makers persist in seeing India in terms of households, not recognising that men and women can have very different requirements and relationships to banking. Around 80% of women do not have access to the banking system, and even when they do, it is often in the form of joint accounts with their husbands. So it is common for many women to save some money in cash hoards to guard it from abusive husbands who would use it for drink, or to ensure some savings for children's future needs, or to provide for medicines in case of illness.

Many women now do not know what to do with these hard-won and carefully stored notes, and have neither the time nor the capacity and autonomy to go and stand in those endless queues to exchange the money. Revealing the existence of such money can infuriate the adult men in the house, with potentially violent consequences. It is extraordinary that those who introduce such a policy could have such little awareness of Indian society that they do not stop to think of such consequences.

The cashless society?

It is not as if at least some of these aspects are not known to those in the ruling Bharatiya Janata Party (BJP) who are currently singing paeans to what they describe as this 'historic move', supposedly a game changer in the reform process. In fact, in January 2014 when the previous government had tried to phase out old currency notes printed before 2005, BJP spokesperson Meenakshi Lekhi described the move as 'an attempt to obfuscate the issue of black money stashed outside the country ... This measure is strongly anti-poor - those who are illiterate and have no access to banking facilities will be the ones to be hit by such diversionary measures'.

So what has differed over the past three years to make BJP leaders change their tune? They say that there is now much greater coverage of banking services through the Jan Dhan Yojana financial inclusion scheme. Indeed, the official website of the scheme notes that on 1 July 2016, 254.5 million accounts had been opened, with only around a quarter of them with zero balance and an average of Rs 1,780 per account. This has led to the claim that almost all households in the country are now covered by banking.

But actually, around one-third of the adult population do not have any bank account, even of the no-frills variety. Others may have an account but the distance from and sheer difficulty of getting to the nearest bank has meant that the account lies dormant and that institutional banking plays no role in their lives. They rely on intermediaries - the BCs created by the banks themselves, or local middlemen who spring up in response to these gaps. The logistical issues involved in exchanging the old money for the new would be huge in any circumstances, let alone the strained and overstretched conditions of today.

The Reserve Bank of India - which surely should know better than any of us the true state of the penetration of e-banking and digital transactions in the economy - had its own Marie Antoinette moment in a press release of 12 November 2016: 'public are encouraged to switch over to alternative modes of payment, such as pre-paid cards, Rupay/Credit/Debit cards, mobile banking, internet banking. All those for whom banking accounts under Jan Dhan Yojana are opened and cards are issued are urged to put them to use. Such usage will alleviate the pressure on the physical currency and also enhance the experience of living in the digital world.' Statements like this make one wonder whether the RBI is living only in the digital world.

In fact, e-banking has been increasing in India, but the shares are still very small: cash is still estimated to account for more than 90% of all transactions, and the remainder is approximately equally split between cheques and e-payments. Most bank accounts do not have a chequebook facility. The facile assumption that moving to e-banking is just a matter of personal choice is completely mistaken.

Of course, it is desirable to move to less reliance on currency, but it cannot be done in this abrupt and coercive manner, especially when most bank accounts are still not e-enabled, when basic infrastructure for this (such as secure Internet connections or even electricity) is not accessible everywhere, and when levels of education for a very large section of the population do not allow for easy e-banking. This must occur as a smooth and gradual process because of the greater ease and facility of such transactions. Disrupting currency transactions is a painful and ultimately much less effective way to push the population towards greater e-banking.

In any case, even opening bank accounts or getting them enabled for e-transactions is not something people can just do immediately. Just now the pressures on banks are so intense that they are in no condition to handle these new requests.

So what can be done to control black money?


This government has so far done very little to deal with the problem of black money, even in terms of the more obvious moves, none of which would cause hardship to common people. To prevent the generation of black money, what is required is a more effective, clean and accountable tax administration that uses all the information at its disposal to go after those who are evading the law in various ways. For companies, it is possible to identify practices such as over- or under-invoicing, false transactions and attempts to use loopholes in the laws. For individuals, it is now easily possible to uncover undisclosed incomes by tracking payments and following suspiciously large purchases, and put them under scrutiny. Obviously, movements of funds abroad are a major avenue which needs to be monitored much more closely. Indeed, this is what most countries that are known to have relatively 'clean' economic systems do as regular practice, without making a great song and dance about it.

It is also possible to deal with the assets held from such undisclosed incomes. It is not just land deals and gold and jewellery purchases that can be monitored, precisely as the government is trying to do now in the middle of this cash crunch. The completely uncalled for possibility of buying securities through Participatory Notes in the stock market, which do not require the buyer to reveal his/her identity, is an obvious means of parking illicit funds. These should obviously be done away with - yet both the previous government and this supposedly anti-corruption BJP government have been curiously reluctant to do so.       

The most obvious thing to do - something Mr Modi continually roared about in his electoral campaign speeches - is to go after those who have stashed away their undisclosed funds in bank accounts and other assets abroad. He had promised to 'bring back' all this money, to the point that many holders of Jan Dhan Yojana accounts today still fondly believe that they will each receive around Rs 1.5 million as their share of the returned money! Yet his government has steadfastly refused even to divulge the names of such individuals, much less take any action against them.           

Overall, this ill-conceived and even more poorly executed move appears to be an attempt by the government to display a lot of sound and fury, but signifying very little. It may be a smart (if temporary) success in terms of confounding public perceptions. But it is unfortunate that in the process it has inflicted such damage on ordinary people and on the economy to the point that even the Supreme Court of India said it was not a surgical strike so much as carpet bombing.                                                

Jayati Ghosh is an economics professor at Jawaharlal Nehru University in New Delhi.

*Third World Resurgence No. 314/315, October/November 2016, pp 6-9