The Money Trap

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Narendra Modi has declared war on black money. And how

DESPERATE TIMES CALL for desperate measures, if not tough ones. The current Government deserves praise for doing more than mere lip service to fight ‘black money’—which fuels, among other dangers, terrorism. It was a move as bold as it was therapeutic to the country’s economy. With the ‘neutralisation’ of existing Rs 500 and Rs 1,000 currency notes, the Modi Government has imposed a huge wealth tax on the black economy. It will be some time, perhaps some months, before a reliable estimate will be available of how many of these large value notes were ‘black’—unaccounted for. Not all persons and entities who have these notes will exchange them for new ones; only those who have lawful sources are likely to do so. Which explains why, in one fell swoop, the existing stock of black money has been purged.

Let’s put the text in context. In theory, the demand for cash rises in tandem with economic growth. That the need for holding cash balances goes up as economic activity increases has been known at least since the time of John Maynard Keynes, if not earlier. The Indian economy is a good example of this process of change. One decade after the economic liberalisation that began in 1991, the circulation of high denomination notes took off. Data released by the Reserve Bank of India (RBI) shows this very clearly. For example, in 2001, the share of Rs 500 notes as a total of the currency in circulation was 25 per cent; that of Rs 1,000 notes was barely 1 per cent. In contrast, the share of Rs 100 notes was close to 50 per cent. By 2015, the share of Rs 500 and Rs 1,000 notes had risen dramatically to 83 per cent, with that of Rs 100 notes falling to around 12 per cent.

Among other factors, this had to do with two important facts about the Indian economy. One, the growth in rural wages after 2006 steadily raised the demand for cash as rural consumers began chasing goods and services that had either been out of their reach. Two, over this period inflation also reduced the value of money, leading to greater demand for high-denomination notes. These processes are ‘natural’ in any developing country undergoing an economic transition.

But along with economic growth and rise in incomes came another development: the spread of the underground (or ‘black’) economy operating illegally. The spread of large-denomination notes helped in its spread. A 2010 World Bank study of 151 countries found the size of this underground economy to be around 10 per cent of India’s Gross Domestic Product (GDP). A rough estimate in 2014 pegged this number much higher. Centred on speculative investments in the real estate sector, this phenomenon corroded Indian politics as well.

The use of huge sums of money to contest elections, in contrast with an earlier era of Indian politics (from 1970 to 1990) has had a significant impact. In those decades, electoral violence and booth capturing were not only widespread but also a regular feature. In states such as Bihar and Uttar Pradesh, violence was the currency that lubricated elections; in the next 25 years, it was actual paper currency that moved electoral politics. One could say the money substituted violence, but the effect remained the same: the devaluation of positive politics based on governance achievements. In spite of vigorous efforts by the Election Commission to check the flow of large sums during elections, the process has continued unabated. The EC can only check money at polling sites; it cannot do anything if transactions take place elsewhere.

The Government deserves praise for doing more than lip service to fight ‘black money’. It was a move as bold as it was therapeutic to the country’s economy

With the Government’s dramatic announcement on November 8th, this is set to change. The criticism against the step—unfounded for the most part—has two parts. One, put forth rather frivolously, is that it will mean hardship for people with a ‘genuine need’ for holding large volumes of cash—for marriages, hospital expenses and other such uses. The Government has already announced the steps it plans to take to prevent any such inconvenience. Barring panic reactions and related misgivings, the effect on such spending is unlikely to be a serious matter of concern.

The second criticism, that the scheme will prove futile, is worth considering, even if it too is unfounded. This claim rests on the experience of the last demonetisation move made in India on January 16-17th, 1978. It has been argued that things soon returned to ‘business as usual’ with corruption fuelled by black money coming back with a bang in the years that followed. Critics at that time said that illegally-held money could over time be ‘converted’ by paid agents who would go and exchange the money ‘tucked under pillowcases’ with legal tender. It was also argued that people seldom keep ill- gotten money in the form of cash.

None of these criticisms hold water in the India of 2016. For one, the Government’s ability to track cash flows through payment systems and channels is far better than it was in the 1970s. The combination of the PAN, Know Your Client (KYC) and Aadhaar systems is like a grid that fortifies the banking system now. For another, several changes have been made over time to create an ecosystem that makes it costly to keep black money, thus steadily squeezing it.

Consider the sequence of events over the past two years. First, under the Jan Dhan scheme, a huge number of bank accounts were opened for the poor, vastly expanding the network of banking. Unlike the 1970s, this is not ‘pen and notebook banking’: all these accounts, down to the last account at the remotest bank branch, are integrated via computer networks within the banking system, and data can now be monitored as never before. Second, from June 1st to October 30th, the Government had announced an amnesty scheme for tax evaders, the first since 1997. In repeated messages put out by the Government and the Prime Minister himself, holders of black money were urged to pay up their share of taxes. Modi’s warning of no-amnesty after October 30th was apparently not enough for many shadow operators, inured as they were to such threats (many made in the past had little credibility).

Finally, the demonetisation step of November 10th—which had been in the works for a long time—was implemented with secrecy and ruthlessness unprecedented in modern Indian history. Viewed in isolation, these three steps in themselves would have been ineffective; in combination, they promise to be lethal.

The criticism that black money is being tackled but not the process that creates it, too, loses some of its bite in this context. Once the financial monitoring grid is fully in place and an increasing number of Indians are brought into it, killing the existing stock of black money will definitely slow the process of its generation. It takes a political leader with an unusual degree of assurance and élan to take such a step. One does not recall the last time when even a half-hearted attempt was made in India to check black money and corruption.