Mr Modi, Here’s What to Do Next in Fight Against Black Money


Prime Minister Narendra Modi’s address to the nation on the New Year’s Eve turned out to be a damp squib. While people were looking for specific answers on demonetisation, what they got instead was a long list of generalities.

Sample this: “Over the last ten to twelve years, 500 and 1000 rupee currency notes were used less for legitimate transactions, and more for a parallel economy.” This is something that the ministry of finance press release accompanying the demonetisation decision had also pointed out.

As the press release said: “Use of high denomination notes for storage of unaccounted wealth has been evident from cash recoveries made by law enforcement agencies from time to time. High denomination notes are known to facilitate generation of black money.” The term unaccounted wealth essentially means black money. Black money is income which has been earned through legal or illegal means but on which tax has not been paid.

Both Modi and the ministry of finance were essentially saying the same thing. High denomination notes facilitate the black economy. Take the case of a real estate transaction. A home is sold. The buyer and the seller carry out a part of the transaction in cheque and the rest is carried out in cash.

There is no record of the transaction being carried out in cash. Hence, the buyer does not pay a stamp duty on that part of the transaction and the seller does not pay a capital gains tax. The cash that is paid, is in high denomination notes. Hence, high denomination notes facilitate a black economy transaction on which taxes are not paid.

Further, individuals keep a part of the black money they have earned, in the form of high denomination notes. Demonetisation was supposed to hurt them by rendering the Rs 500 and Rs 1,000 notes useless overnight. That hasn’t happened. But we will not get into that.

The idea that high denomination notes facilitate the black economy is well accepted internationally. Take the case of the United States. The highest denomination note is $100. In Britain, the highest denomination note is £ 50. Hence, the highest denomination note in United States is 100 times the lowest denomination note of $1. In Britain, it is 50 times. In India, up until demonetisation happened, the highest denomination note was Rs 1,000, which was 1,000 times in value the lowest denomination note of Re 1.

Given this, one would have appreciated the decision to demonetise Rs 500 and Rs 1,000 notes, if a new note of Rs 2,000 wouldn’t have been issued. If Rs 500 and Rs 1,000 were facilitating black market transactions, so will Rs 2,000.

As on November 8, 2016, 685.80 crore Rs 1,000 notes were in circulation. These notes have been replaced by the Rs 2,000 note. As on November 8, 2016, the RBI had printed and kept around 247 crore Rs 2,000 notes in its kitty. Since then it would have printed more. 247 crore Rs 2,000 notes can replace 494 crore Rs 1,000 notes. It is safe to say that more than 72 per cent of the Rs 1,000 notes have already been replaced by Rs 2,000 notes.

Now these notes can be used for facilitating the black economy transactions like Rs 1,000 notes were. So, what is the way out of this? Some economic commentators have suggested that in the time to come the Rs 2,000 note should be demonetised as well. As we have come to know by now demonetisation is very disruptive.

The best way to go about this is to phase out Rs 2,000 notes gradually. This idea has been suggested by the economist Kenneth Rogoff in his new book The Curse of Cash in a different context. Paper money has a limited shelf life. As Rs 2,000 notes run through their lifecycle, they need to be replaced by Rs 500 notes and not by new Rs 2,000 notes.

This won’t happen overnight and will take time. Meanwhile, the government, unlike this time around, can be ready for it, and print enough Rs 500 notes in advance. It will take four 500 rupee notes to replace a Rs 2,000 note. Over a period of few years, the Rs 2,000 notes can be replaced by Rs 500.

Of course, all this is subject to the condition that the government genuinely wants to attack black money and not just talk about it.

The column originally appeared in the Bangalore Mirror on January 4, 2017