demonetisation

Dear RBI, It’s Not About Hoarding Notes, It’s About Shortage of Cash

RBI-Logo_8

In the press conference that followed the monetary policy on December 7, 2016, R Gandhi, one of the deputy governors of the Reserve Bank of India(RBI), said: “We reiterate that there is adequate supply of notes and hoarding of notes helps nobody’s cause.”

The impression that the RBI is trying to create is that all is well and that it is the hoarders are responsible for the mess that prevails on the cash front, all through the country. But is that really the case?

In a press release dated December 8, 2016, the RBI said: “During the period from November 10, 2016 and December 7, 2016, banks have reported that banknotes worth Rs 4,27,684 crore have been issued to public either over the counter or through ATMs.”

The total value of the Rs 500 and the Rs 1,000 demonetised notes amount to Rs 15.44 lakh crore. Hence, the notes replaced amount to close to 27.7 per cent of the demonetised notes. Before the notes had been demonetised the total value of currency stood at Rs 17.87 lakh crore. This basically means that around 23.9 per cent of the currency that was in circulation before demonetisation has been replaced.

Hence, around one-fourth of the currency is back in circulation. The question is why doesn’t it feel like one-fourth? Why does it continue to be difficult to carry out cash transactions? The answer is straightforward.

To replace the Rs 500 and Rs 1,000 demonetised notes, the government printed the Rs 2,000 note, first. This means that there is no note between Rs 100 and Rs 2,000. Hence, every time one tries to spend the Rs 2,000 note, it is tough going because the other party simply doesn’t have enough change going around.

This, despite the fact that the RBI has supplied: “lower denomination of the notes, that is Rs 100, Rs 50, Rs 20 and Rs 10… over its counters,” as well. In fact, it has supplied 19.1 billion pieces of denomination of these notes over the last one month. As deputy governor Gandhi put it “This is more than what the Reserve Bank had supplied to the public in the whole of the last three years.”

While the RBI said that a total of 19.1 billion pieces of notes of small denomination were printed, it doesn’t provide us with a breakdown of numbers. It doesn’t tell us how many Rs 100 notes were printed, how many Rs 50 notes were printed and so on. Hence, there is no way of finding out the total value of these notes that had been printed.

Nevertheless, it is safe to say that the total value of the lower denomination notes printed and pumped into the economy, would essentially amount to around 5-6 per cent of the total currency in circulation before demonetisation. Hence, the bulk of the notes printed have been Rs 2,000 notes. Given this, there isn’t enough change going around, which means even those who have Rs 2,000 notes are finding it very difficult to use it.

What this means is that the 23.9 per cent figure of the total amount of currency replaced in comparison to the currency in circulation before November 8, 2016, when demonetisation was carried out, is overstated to that extent.

There is another problem with the Rs 2,000 note. There is a huge rumour going around that it has been launched as a stop-gap arrangement and is likely to be demonetised soon. This rumour perhaps comes from what was mentioned in the press release accompanying the demonetisation decision. As the press release said: “High denomination notes are known to facilitate generation of black money… Infusion of Rs 2,000/- bank notes will be monitored and regulated by RBI.” It is well worth remembering that the original motive of demonetisation was to tackle black money and fake notes.

How will the situation play out in the days to come? Will things improve by the end of this month as the prime minister has repeatedly told the nation? As Urjit Patel said during the course of the monetary policy press conference: “What we have done over the last two weeks is recalibrated our production towards the 500 and the 100.” This is going to improve the situation a little, given that as more 500s hit the market, the chances of the 2000s being accepted will also go up, as more change becomes available.

Having said that it will take some time for the situation to get back to normal. With 500s and 100s being printed the rate of currency replacement will slow down. It takes four 500 rupee notes to replace the currency that one 2000 rupee could.

Further, it is worth remembering here that the capacity of the printing presses supplying RBI with notes is around 300 crore notes per month. This, when the presses work 24 hours a day and for the full month.

The total number of 500 rupee notes demonetised stand at 1716.5 crore. At 300 crore notes a month, it will easily take five to six months to replace the total lot. Even if all the notes are not printed, given the push towards cashless, it will be a while before there is enough cash going around in the economy.

Hence, the point is that people are not hoarding cash. There simply isn’t enough cash going around. But what about all the raids all across the country and the cash being found during these operations? Isn’t that hoarding cash? Yes. Nevertheless, these seizures at best amount to a few hundred crore, which is a minuscule part of the overall currency that has been printed and pumped into the economy. At times, one does get excited looking at absolute numbers, but to put things in a proper perspective, it always makes sense to look at percentages.

To conclude, currency or cash is not the only form of money going around. There are other forms as well. Nevertheless, for a country where 98 per cent of the consumer transactions happen in cash, cash remains the major form of money. How difficult it is to understand this basic fact?

The column originally appeared on Equitymaster on December 12, 2016

Demonetisation and the Mystery of Rs 3 Lakh Crore

rs-500
As soon as prime minister Narendra Modi announced the decision to demonetise Rs 500 and Rs 1,000 notes, the analysis of the decision started.

Any such analysis needed the total amount of black money held in the form of cash. Of course, no one knew the right answer to the total amount of black money held in the form of cash by Indians. So, assumptions were made. The one assumption that many analysts and economists ended up making was that 20 per cent of the demonetised notes were black money held in the form of cash.

The 20 per cent figure was just assumed. No explanations were offered for it. It was probably because it was not too big nor too small. And gradually almost everyone who was analysing the issue was using it. But where did the number come from? Or was it just a case of a case of circular mill of ants, where the analysts and economists writing later, just followed the assumptions of the ones who had already written on the topic.

Here is how the argument worked. The total value of demonetised notes stood at Rs 15.44 lakh crore. Let’s assume that 20 per cent of the demonetised notes are black money held in the form of cash. This implies that around Rs 3 lakh crore is black money held in the form of cash.

This money will not be deposited into banks because it is black money (which has turned out to be a totally naive assumption) because any black money deposited into banks would generate an audit trail for the income tax department. Further, every rupee out there is a liability for the Reserve Bank of India(RBI). If Rs 3 lakh crore of demonetised notes do not make it back to the banks, then the liability of RBI shrinks to that extent.

If the liability side of the balance sheet of the RBI shrinks by Rs 3 lakh crore, the asset side needs to shrink as well. And that implies that the RBI would give a special dividend of Rs 3 lakh crore to the central government.

Many economists wrote long reports on this. The long reports led to some editorials as well (including one by an editor who I tremendously respect). These reports were then turned into WhatsApp forwards and passionate discussions happened around it.

In the press conference following the monetary policy on December 7, 2016, the RBI governor Urjit Patel, put the special dividend theory to rest. He clarified that just because the notes don’t come back to the RBI, it does not mean that the liability of the RBI will come to an end. As he said: “They still carry the RBI’s liability as long as only the legal tender characteristic is withdrawn.”

But the question of where did the 20 per cent assumption come from, remains. Could a better assumption have been made?

In May 2012, the finance ministry released a White Paper on Black Money. And that had some very interesting data points. Take a look at the Table 1 below, which deals with the search and seizure operations carried out by the income tax department.

Table 1: Value of assets seized (in Rs. Crore)

YearCashJewelleryOther assetsTotal Undisclosed Income Admitted
(in Rs Crore)
2006-07187.4899.1977.963,612.89
2007-08206.35128.0793.394,160.58
2008-09339.86122.1888.194,613.06
2009-10300.97132.2530.338,101.35
2010-11440.28184.15150.5510,649.16
2011-12499.91271.4134.39,289.43

Source: White Paper on Black MoneyThe cash seized at the time the search and seizure operations were carried out by the income tax department, is a minuscule portion of the total undisclosed income. This becomes clear from Table 2.

Table 2:

YearCashTotal Undisclosed Income Admitted (in Rs Crore)Proportion of cash in total undisclosed wealth
2006-07187.483,612.895.2%
2007-08206.354,160.585.0%
2008-09339.864,613.067.4%
2009-10300.978,101.353.7%
2010-11440.2810,649.164.1%
2011-12499.919,289.435.4%
Total1,974.8540,426.474.9%

Source: Author calculationsIf we look at data for the period of six years of close to 24,000 seizure and search operations, cash formed around 5 per cent of the undisclosed wealth. Also, the proportion varied from 3.7 per cent to 7.4 per cent over the years.

There are multiple things that this data tells us. First, that people who have black money do not store it in the form of cash. There are better ways of storing that wealth. And more importantly, the government had this information. In fact, the government would have updated information on this and not just to 2011-12.

Second, assuming that 20 per cent of the demonetised notes were black money held in the form of cash, was a terribly wrong assumption to make. This also explains why so much demonetised money has already come into the banks.

In the press conference following the monetary policy of December 7, R Gandhi, one of the deputy governors of the RBI said that close to Rs 11.55 crore of demonetised notes had already made it back to the banks. This amounts to close to 75 per cent of the demonetised notes. Of course, some black money has been converted into white in the process as well. Nevertheless, what Table 2 tells us very clearly is that very little black money is held in the form of cash. Hence, what is coming back to the banks is largely white money.

What this clearly tells us is if the analysts and economists hadn’t worked with the 20 per cent figure of black money held in the form of cash, they would have never come up with the Rs 3 lakh crore special dividend that the RBI would pay the government.

If they had assumed a 5 per cent figure (as per the White Paper) they would have come up with a special dividend of around Rs 77,000 crore (5 per cent of Rs 15.44 lakh crore of demonetised notes). And Rs 77,000 crore sounds nowhere as sexy as Rs 3 lakh crore.

I guess that explains everything.

The column originally appeared on December 9, 2016.

Demonetisation: How Black Money Has Become White

rupee

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

rupee

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…

hayek

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