Black Money

Demonetisation: How Black Money Has Become White

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Yesterday in a press conference after the monetary policy, R Gandhi, one of the deputy governors of the Reserve Bank of India, said that Rs 11.55 lakh crore of demonetised notes had made it back to the banks.

This essentially amounts to close to 75 per cent of the total value of the demonetised notes. With this, it is safe to say that by December 30, 2016, the last date of submitting demonetised notes, most of the demonetised notes will make it back to the banks.

This goes against the initial logic that the black money would form a certain portion of the demonetised notes and that won’t make it back to the banks. Black money is essentially money which has been earned through legal and illegal means, but on which tax has not been paid.

People who had black money in the form of cash would not submit it to the banks for the fear of generation of an audit trail. And this is how black money would be destroyed.

But we Indians have turned out to be smarter than that. Various ways have been used to convert old demonetised notes into new ones. This is something that the brains beyond the current demonetisation process had not bargained for. Here are a few ways which I have come across, through which black money is being converted into white.

a) I have come across a number of stories where daily wage labourers are still being paid in old demonetised notes. It is a case of either take it or leave it, for them. They have no other option but to take these old notes and then go to a bank to submit these notes into their bank accounts. They then need to stand in another line to withdraw notes which continue to be legal tender.

b) Another story that I have come across is that merchants with black money are forcing their employees to deposit old demonetised notes in their bank accounts. So, the way this works is that the merchant hands Rs 50,000 to his employee and asks him to go and deposit the money into the bank account. He then tells the employee that this money will be deducted from the salary over the next few months. In the process, this becomes an interest free loan for the employee and the merchant’s black money gets converted into white.

c) Another interesting story that I have heard is of those with black money buying dollars with it, at a very good rate. This clearly is a play against the rupee. People buying dollars don’t want to take any further risk of holding their black wealth in the form of rupees.

It is then the responsibility of the person selling the dollars to go and deposit the money in the bank and ensure that it continues to have purchasing power. This is another way through which black money has been converted into white.

d) Then there have been cases of many households finding a lot of cash in their homes, which the women folk had saved up over the years. This money has been spread across various bank accounts that the household has and deposited into banks.

e) There have also been stories of black money being converted into white, by depositing it into Jan Dhan accounts.

Of course, the thing is that none of these methods are fool-proof. As revenue secretary Hasmukh Adhia told The Indian Express: “No black money hoarder will be spared. If someone has deposited Rs 50,000 in the accounts of 500 people each, he will also be caught.”

With information technology, things can easily be tracked. If someone suddenly deposits Rs 1 lakh into an account, in which he normally does not deposit more than Rs 10,000 every month, this can easily be flagged by the information technology system. The income tax department can then enquire into this.

Of course, people who are depositing money into bank accounts and converting black to white in various ways, understand this. What they are essentially backing on is, how many people can the income tax department go after? There is a limitation to that. Also, how easy will it be prove things, if things do end up in court? Further, the more notices that are sent out, the more unpopular the demonetisation decision is likely to get.

And all this is something worth thinking about.

The column originally appeared in The 5 Minute Wrapup on November 9, 2016

Demonetisation is Dead — Long Live Demonetisation

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When the Facts Change, I Change My Mind. What Do You Do, Sir? – often wrongly attributed to John Maynard Keynes.

In the press conference that followed today’s monetary policy, one data point and one clarification, has essentially made clear that Narendra Modi’s big demonetisation plan is not going the way it was expected to.

When the plan was announced a month back on November 8, the one big aim of the plan was to tackle black money along with fake currency notes. Black money is essentially money that has been earned through legitimate or illegitimate means, but on which taxes have not been paid.

As on November 8, 2016, 685.80 crore Rs 1,000 notes were in circulation. Over and above this, 1716.50 crore of Rs 500 notes were in circulation. The total value of demonetised notes amounted to Rs 15.44 lakh crore.

These notes were demonetised and suddenly had no value. These notes can be deposited in banks and post offices, up to December 30, 2016 and the money will be credited in the bank account or the post office savings account.

The Reserve Bank of India (RBI) in a press release dated November 28, 2016, had said that Rs 8,11,033 crore worth of demonetised notes had been deposited back with the banks. Over and above this, Rs 33,948 crore worth of demonetised notes were exchanged for new notes as well as notes that continued to be legal tender. Initially, notes of up to Rs 4,000 could be exchanged. This was increased to Rs 4,500. Then decreased to Rs 2,000 and finally done away with.

By value the demonetised notes of Rs 500 and Rs 1,000 formed more than 86 per cent of the currency in circulation. The hope was that a certain portion of this currency would be black money held in the form of cash. And this black money would not be deposited into banks, for the fear of generating an audit trail.

In the process, black money would be destroyed. QED.

This logic seemed flawless that almost everybody bought it initially, including yours truly. The belief was that almost 20 per cent of the high denomination notes are black money. (I am yet to figure out how experts writing on the issue arrived at this figure. But once they did, almost everyone seemed to use it).

The total value of the demonetised notes stood at Rs 15.44 lakh crore. Given this, 20 per cent of Rs 15.44 lakh crore worked out to around Rs 3 lakh crore. It was then said that this amount will not make it to the banks. The assumption was that those with black money will not manage to get their old demonetised notes exchanged for the new or the currently legal ones.

Thankfully, I did not fall for this totally. In the letter dated November 11, 2016 (Modi’s Next Shot on Black Money Should…) I had worked with the assumption that around one-third of the black money won’t get converted and hence, close to Rs 1.1 lakh crore of currency will get destroyed.

In fact, almost every other analyst and economist talked about close to Rs 3 lakh crore being destroyed. It was rather amateurish of them to assume that the Indian public won’t be able to convert their black money into white. There are various ways through which this has happened, which I will discuss in a separate piece.

As mentioned earlier up to November 27, 2016, Rs 8.11 lakh crore of demonetised notes had made it back to the banks. Since then, the RBI hasn’t put out any new data. Nevertheless, in the press conference that followed the monetary policy today, the deputy governor of RBI, R Gandhi, said that close to Rs 11.55 lakh crore of demonetised notes had made it back to the banks.

This means that around 75 per cent of the demonetised notes are already back with the banks. (Rs 11.55 lakh crore divided by Rs 15.44 lakh crore of demonetised notes). With 24 days still to go until December 30, the last day of depositing demonetised notes, chances are almost all the demonetised money will come back to the banks.

This is something that the Revenue Secretary Hasmukh Adhia told The Indian Express: “The government expects the entire money in circulation in the form of currency notes of Rs 500 and Rs 1,000 which have been scrapped to come back to the banking system.”

Given this, the question of black money being destroyed does not exist. What this means is that the black money in the system has been exchanged for new notes in various ways.

There is another angle here which was the subject of multiple WhatsApp forwards. And this is how it went. Every rupee out (except Re 1 notes) there in the financial system is essentially a liability for the RBI. (If you look at the Rs 100 note carefully, you will see the RBI governor saying, I promise to pay the bearer the sum of one hundred rupees, for example).

The hope was that with Rs 3 lakh crore not coming back to the banks, the liabilities of the RBI will shrink. To that extent, the asset side of the balance sheet of the RBI would also need to shrink and that would lead to the RBI giving the government a special dividend of Rs 3 lakh crore.

Other than being a subject of many WhatsApp forwards this was something that many economists also wrote about in their research reports. Those against this logic said that, just because the notes don’t land up with the banks, does not mean that the RBI’s liabilities come down.

Today at the press conference, the RBI governor Urjit Patel was asked about this and he said: “They still carry the RBI’s liability as long as only the legal tender characteristic is withdrawn.” This basically meant in simple English that the RBI balance sheet wasn’t going to shrink and there was no question of a special dividend.

So where does that leave the Modi government? Revenue Secretary explained this to The Indian Express when he said: “Do you think that by simply depositing money in the bank account makes black money into white? It doesn’t. It will become white when we charge taxes, when the Income Tax department can reach up to them by issuing a notice and questioning them.”

The question is how many people will the Income Tax department go after, given their limited resources. Also, is this the way a government should go about raising revenue, by disrupting the entire economy?

Further, many people who have put money into banks are prepared to litigate and take this to court. As noted journalist Sucheta Dalal recently wrote: “Tax experts and retired income-tax commissioners have been confidently encouraging people to deposit their unaccounted money as this year’s income under Sections 68 and 69 of the Income-tax Act and get away by paying 30% tax. While there is a good chance that this may lead to litigation, case law from the two previous instances of currency demonetisation in India (1946 and 1978) may support this stand.”

All this brings us to the question whether demonetisation was really required? Will the tax that the government manages to collect through this effort, be more than enough to make up for the slowdown in economic growth that demonetisation is likely to cause?

Also, I really don’t like the idea of the income tax department being allowed a free run.

The column was originally published in Vivek Kaul’s Diary on December 7, 2016

Only if Modi had read Hayek…

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Almost one month back prime minister Narendra Modi announced the decision to demonetise Rs 500 and Rs 1,000 notes. In the initial communication, the nation was told that the objective of this decision was twofold—to tackle fake currency notes as well as black money.

Somewhere down the line the communication changed and we are now being told that the objective of demonetisation is to help the country where 98 per cent of consumer transactions happen in cash, go cashless. Why did this objective suddenly change?

As on November 8, 2016, 685.80 crore Rs 1,000 notes were in circulation. Over and above this, 1716.50 crore of Rs 500 notes were in circulation. These notes were demonetised and suddenly had no value.

These demonetised notes have to be submitted with banks and post offices, by December 30, 2016. The amount will be credited into the bank
or the post office savings account. This is where things get interesting.

The hope was that many people would not deposit their black money held in the form of cash into bank accounts because it would generate an audit trail for the income tax department. In the process, black money held in the form of cash would be destroyed. Many experts suggested that black money to the extent of Rs 3,00,000 crore would be destroyed. This is what caught the attention of the people and they largely supported the decision, and to some extent still are.

But the way things are going, chances are that nothing of this sort will eventually happen. The question is why? Between November 10 and November 27, almost 53 per cent of the demonetised currency had already been deposited with banks. No new numbers have been declared since then, but media reports suggest that more than Rs 11 lakh crore has already made it back to the banking system, three weeks before the last date of depositing.

The more the money that comes back to the banks, the lesser will be the black money destroyed. The lesser is the black money destroyed, more the demonetisation plan will look like an ill-thought out decision on part of the government, which it already is to some extent.

The question is what happened? The government became a victim of what the economist Friedrich Hayek has called the knowledge problem. As he wrote in a seminal article called The Use of Knowledge in Society  “The economic problem of society…is a problem of the utilization of knowledge which is not given to anyone in its totality.”

This basically means that whenever the government makes a big decision like demonetisation, it thinks that it has all the knowledge required. But it never does. As Matt Ridely writes in The Evolution of Everything: “The knowledge required to organise human society is bafflingly voluminous. It cannot be held in a single human head”.

This is precisely where the government got caught out. It didn’t realise that the people will figure out various ways of turning their black money into white. This is the knowledge that Hayek talked about. Smaller merchants simply handed over their black money to their employees and asked them to deposit it, into their bank accounts. The merchants will adjust this against the salaries of their employees in the months to come.

Some black money has made it into Jan Dhan accounts.  The hope here is that even if all this generates an audit trail, how many people can the Income Tax department really go after.

The bigger ones, who have black money, have been actively helped by our banking system in converting it into white. With a spate of bank managers being dismissed across banks, there is enough evidence of the same.

Still others, have been encouraged by former tax officials as well as chartered accounts, to deposit their black money into their bank accounts, show it as the income for the current year, and pay tax on it. If the income tax department has a problem with it, they can litigate. And we all know the speed at which our judicial system works.

Now only if Mr Modi had read Hayek. It would have saved all of us from so much trouble.

The column originally appeared in the Bangalore Mirror on December 7, 2016

 

If Nation is Expected to Go Cashless, Stop Political Parties from Taking Cash Donations

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In the November 27, 2016, mann ki baat address to the nation, prime minister Narendra Modi talked about India moving towards a cashless society. As he said: “The great task that the country wants to accomplish today is the realisation of our dream of a ‘Cashless Society’. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a ‘less-cash society’? Once we embark on our journey to create a ‘less-cash society’, the goal of ‘cashless society’ will not remain very far.”

A very noble thought indeed, the practical part of implementing it, notwithstanding. The interesting thing is that the mention of this dream of India moving towards a cashless society wasn’t made in Modi’s November 8, 2016, address to the nation. In this address Modi announced the decision to demonetise the high denomination notes of Rs 500 and Rs 1,000.

Neither was it a part of the ministry of finance press release that accompanied the decision. The primary goal of demonetisation was to tackle fake currency notes and black money. As the press release pointed out: “With a view to curb financing of terrorism through the proceeds of Fake Indian Currency Notes
(FICN) and use of such funds for subversive activities such as espionage, smuggling of arms, drugs and other contrabands into India, and for eliminating Black Money which casts a long shadow of parallel economy on our real economy, it has been decided to cancel the legal tender character of the High Denomination bank notes of Rs.500 and Rs.1000 denominations issued by RBI till now.”

Of course, it can be said that the dream towards a cashless society goes hand in hand with the dream of eliminating black money. So, to that extent they are connected. Nevertheless, with the way the entire issue of demonetisation has been handled up until now, it is safe to say that this was not something that the government had thought about originally. They are making it up as they go along.

It is worth asking how feasible this dream is. A PwC report titled Disrupting cash: Accelerating electronic payments in India points out that 98 per cent of volume of consumer transactions in India are still in cash. The number is 96 per cent in case of Mexico, 94 per cent in case of South Africa, 90 per cent in case of China and 86 per cent in case of Japan. While this figure can be brought down, there is no way India is moving towards becoming a cashless society any time soon.

Then there are other issues. Smart phones are not a universal phenomenon. The moment one goes beyond the big cities, internet speeds both on mobile and broadband, tend to crash. There is a large portion of the population which is barely literate. So, yes there are many issues. Some structural and some cultural.

But given that the prime minister wants India to move towards a cashless society, there is one thing that he should do to tell the nation how serious he is about the cashless dream. If the nation is expected to go cashless, why are political parties still allowed to take cash donations? This is something that the prime minister and the Bhartiya Janata Party (BJP) can work towards eliminating .

Let’s look at this issue in a little more detail. As Sandip Sukhtankar and Milan Vaishnav write in a research paper titled Corruption in India: Bridging Research Evidence and Policy Options: “On the expenditure side, candidates face strict limits on spending once elections have been announced, but election authorities struggle to properly verify their reported expenditure since a substantial portion typically occurs “in the black.”” Hence, black money which mostly finances political parties and in the process elections in India.

The laws are also structured to help this. As Sukhtankar and Vaishnav point out: “For instance, corporations and parties are only legally required to publicly disclose political contributions in excess of Rs. 20,000. This rule allows contributors to package unlimited political contributions just below this threshold value completely free of disclosure.”

And this is where things get really interesting. As the National Election Watch-Association for Democratic Reforms point out in a report titled Analysis of Income & Expenditure of National Political Parties for FY- 2014-2015: “A comparison of total donations declared by the parties in their IT returns (both above and below Rs 20,000) and that declared in the donations report shows that only 45% of the total donations of the parties came from voluntary contributions above Rs 20,000.”

It needs to be pointed out upfront that this analysis does not take the Congress Party into account because the Party had not submitted its accounts for 2014-2015 to the Election Commission at the time of writing the report.

The report makes multiple points.

1) Only 45 per cent of the total donations of the parties came from voluntary contributions above Rs 20,000. This means that 55 per cent of the donations came from those making donations of Rs 20,000 or lower. Hence, the donors are unknown. A total of Rs 582.72 crores (55% of total donations) of the total donations to National Parties was collected during FY 2014-15 from donors whose details are not available in the public domain. There are six national political parties: BJP, Congress, BSP, NCP, CPI(M) and CPI.

2) NCP is only party which has not received donation below Rs 20,000 during FY 2014-15. Thus all voluntary contributions are available in the public domain. It is to be noted that BSP claims not having received any donation above Rs 20,000 hence no donations details of the party are in public domain.

3) How do things look for the BJP? BJP, which declared the highest total income and highest income from donations above Rs 20,000 amongst the National Parties, had collected Rs 434.67 crores (50% of total donations) from donors whose details are unavailable.

4) The “unknown sources include ‘sale of coupons’, ‘relief fund’, ‘miscellaneous income’, ‘voluntary contributions’, ‘contribution from meetings/ morchas’ etc. The details of donors of such voluntary contributions are not available in the public domain.”

If Narendra Modi is serious about his fight against black money and moving India towards a cashless society, this needs to stop. If you, I and everybody else, are being encouraged to go cashless, why are political parties still allowed to take donations in cash and not declare the source of funds.

Since the entire demonetisation issue is more about making a political point, the BJP can take a step forward on this front and promote the usage of Unified Payment Interface for cash donations that are made to a political party. In fact, the BJP should make all donations of less than Rs 20,000 compulsorily to be made through the Unified Payment Interface.

This will work at multiple levels. The BJP will score political points over its rivals and allow Modi to take a moral high ground again. The economy will become more cashless. Further, there will be less infiltration of black money in political parties, given that those making a donation of Rs 20,000 or lesser can be identified as well.

The column originally appeared on November 30, 2016, in Vivek Kaul’s Diary.

 

Why the New Rs 500 Note is Missing from Your Pocket

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Yesterday, the Reserve Bank of India, put out an interesting set of numbers. Between November 10, 2016 and November 27, 2016, the banks reported deposits of Rs 8,11,033 crore. Over and above this, Rs 33,948 crore of exchange of notes was carried out.

The deposits and exchange became necessary in the aftermath of the Narendra Modi government deciding to demonetise notes of Rs 500 and Rs 1,000, respectively. People have time till December 30, 2016, to deposit these demonetised notes into their bank accounts or their post office accounts. Earlier a certain amount of money could also be exchanged for new notes or notes which continue to be legal tender, but that has since been stopped.

Data from the Reserve Bank of India(RBI) shows that in 2015-2016 the total amount of paper notes in circulation amounted to Rs 16.4 lakh crore. Of this, the high denomination notes of Rs 500 and Rs 1,000 amounted to Rs 14.2 lakh crore. The Rs 500 notes amounted to Rs 7.9 lakh crore whereas Rs 1,000 notes amounted to Rs 6.3 lakh crore.

Between March 2016 and November 2016, the number of Rs 500 and Rs 1,000 notes would have gone up. Using “econometric model factoring in inter alia, real GDP growth prospects, rate of inflation and denomination-wise disposal rate of soiled notes,” the RBI places orders for new notes every year. But given that we don’t have exact numbers for the number of Rs 500 and Rs 1,000 notes printed between April 2016 and November 8, 2016, when these notes were demonetised, it is best to stick to the March end numbers.

Hence, Rs 500 and Rs 1,000 notes, forming 86 per cent of the total currency by value have been demonetised. Against the Rs 14.2 lakh crore worth notes that were demonetised, Rs 2,16,617 crore has made it back into the financial system between November 10, 2016 and November 27, 2016. People have withdrawn this money from their bank accounts as well as ATMs.

What this means that withdrawals of Rs 2,16,617 crore from banks and ATMs have replaced the Rs 14.2 lakh crore of currency that has been rendered useless due to demonetisation. Of course, some portion of the currency that has been demonetised may have been hoarded in the form of black money.

The estimates of this black money in the form of cash that I have seen, vary anywhere from 6-20 per cent. Hence, even at the upper end of 20 per cent, more than Rs 11 lakh crore of currency (Rs 11.36 lakh crore to be very precise. Rs 14.2 lakh crore minus 20 per cent of Rs 14.2 lakh crore) was out there in the economy, helping people carry out transactions.

Hence, around 19.1 per cent, or a little under one fifth, of the demonetised currency which was in circulation, has been replaced. This best explains why transactions across markets in the country have collapsed. People just don’t have enough currency going around.

It is easy to ask that why are they not moving towards wallets and netbanking. The point is that more than 80 per cent of the transactions in India by value are still carried in cash and that number cannot disappear overnight. This is an economic reality and needs to be taken into account in the political decision making process.

Assurances have been made about banks having enough new notes, both by politicians as well as the RBI. But that as we all know by now is really not true. The reason for that is straightforward. There aren’t enough new Rs 500 notes going around simply because they haven’t been printed. Some basic maths tells us that it will take at least another five to six months to print enough new Rs 500 notes and get them out there.

I had first discussed this issue in the November 25, 2016, edition of The Vivek Kaul Letter. But given the importance of this issue, the whole point is worth repeating here.

The question is why is the rate of currency replacement been so slow? The simple explanation for this lies in the fact that the government hasn’t printed enough new notes to replace the old ones. There is only so much printing capacity going around at the printing presses of the government.

In total, around 1571 crore 500 rupee notes have become useless due to the demonetisation. Media reports suggest that the capacity of the government is to churn out around 300 crore notes per month. It is interesting to see how they have arrived at this number. In the last three years, the printing presses have supplied around 2200 crore notes a year, on an average. This number can be arrived at by looking at data in the RBI annual report.

A Mint newsreport points out that the total capacity of the printing presses is around 2400 crore notes per year. This is achieved by running two shifts. Adding a third shift can increase production by 50 per cent to 3600 crore notes per year. This essentially means a production of 300 crore notes per month.

What if we work with the supply number of 2200 notes per year? A third shift would lead to a jump of 50 per cent to 3300 crore notes per year. This would mean a production of 275 crore notes per month.

To get back to the point, around 1571 crore 500 rupee notes need to be exchanged. At 300 crore notes per month, this will take around 5.2 months to print, the new Rs 500 notes to replace the old ones. At 275 crore per month, it will take around 5.7 months.

So, just to replace Rs 500 notes can take a period of up to five months. Over and above this, there is the Rs 1,000 note that also needs to be replaced. In total, around 633 crore, 1000 rupee notes have become useless due to the demonetisation.

Assuming the new Rs 2,000 notes directly replace the Rs 1,000 note, then that would mean printing 316.5 crore new notes of Rs 2,000 (633 crore divided by 2). At the rate of 275 crore or 300 crore notes a month, this would mean a little over a month. If all the currency is printed, it will take a little over six months to print it.

Also, we can clearly see that the problem is with the Rs 500 note and not the Rs 2,000 note. Further, media reports suggest that most of Rs 2,000 notes that need to be printed have already been printed. There are a reasonable number of Rs 2,000 notes going around but they are of no use because nobody has enough change to return. They become useful only if a purchase of more than Rs 1,500 is to be made. Only then is it possible to get change from the merchants.

Of course, all this currency may not have to be printed given that all of it may not make it the banks, given that some of it is black money held in the form of cash. And some people may prefer letting their money become useless pieces of paper than generate an audit trail for the bank. That part of the detail will come clear only after December 30, 2016, the last date for depositing old notes to banks.

Current assumptions on black money held in the form of notes are in the range of 6-20 per cent. If, the total amount of black money held in the form notes is 20 per cent, then at least one-fifth of the demonetised notes will not make it to the banks. This would mean around a month less of printing new notes.

This one month less of printing new notes is nullified by the fact that we are considering Rs 500 notes in existence only until March 31, 2016. In 2016-2017, the RBI had asked the printing presses to print 572.5 crore of old Rs 500 notes to be printed, during the course of the year.

Assuming that half of the lot has already been printed, it would mean that close to 300 crore old Rs 500 notes would have been printed during the course of this financial year. These notes are over and above the 1,571 crore Rs 500 notes in existence as on March 31, 2016. They will also have to be replaced by the new Rs 500 notes and this would mean an extra one month of work, given the printing capacity of 300 crore notes per month. This would in effect neutralise the impact of around 20 per cent of the old Rs 500 notes not making it back to banks or post offices.

Taking these factors into account, it is likely to take at least five months for the situation to get back to normal, when there will be enough new notes going around in the financial system. And this with the assumption that all Rs 1,000 notes are replaced by Rs 2,000 notes.

If that is not the case, and Rs 500 notes also replace Rs 1,000 notes, then it will take even longer. Of course, all this comes with the assumption that during this period the low denomination notes of Rs 10, Rs 50 and Rs 100 are not printed at all. I don’t know how feasible that is.

Also, we are assuming here that the government printing presses are working full steam here. Now that as well know is an unrealistic assumption. A report in the Quint points out that only 1 crore Rs 500 notes have been printed up until now. That is less than 0.1 per cent of the total number of Rs 500 notes that need to be printed. Further, I don’t know whether the government printing presses are in a positon to run a third shift.

Other than printing the new notes, they should also reach the different parts of the country, quickly enough.

To cut a long story short, this mess will take some time to sort out.

(The column originally appeared on November 29,2016, on Vivek Kaul’s Diary)