Currency Recall – Modi’s Austerlitz Or Waterloo?

P R Srinivasan 

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I don’t think sudden currency recall will be Modi’s Austerlitz. But hopefully it may not be his Waterloo either. It may be a hard battle that teaches Modi to seriously upgrade talent in his Cabinet.

I became a Narendra Modi fan after his speech in Sri Ram College of Commerce, New Delhi when he coined the slogan, “Minimum Government, Maximum Governance”. I was ecstatic when Modi formed the first “non-socialist” single party majority government in India’s history. I strongly believe that India needs to be weaned from socialism and desperately needs market-oriented reforms that the Modi government can champion. For 30 months, I thought that Modi deserved more plaudits than brickbats. Now, I am wondering if the “abrupt currency recall without adequate replacement” announced on 8 November is going to be Modi’s crowning victory or historical blunder. I am probably not wise but I am full of doubts.

Searching Bags In School

Remember the headmaster marching into class and ordering a search of all students because something or other had gone missing and no student was confessing to stealing it? It may not have happened to you but you must have heard of incidents like that if you had been a school student in the 1970s like me. Students protested in vain but the headmaster couldn’t care less about niceties like feelings of the students, and everybody had to submit to a search.

Well, that is what is happening to Indian citizens, since 9 November. The government wants to catch tax cheats and corrupt crooks, who are using cash, so the Prime Minister has ordered that every citizen must go through agnipariksha, i.e. deposit their money in a bank account. If you make cash deposits that you can’t explain, then the taxman will be after you. If you are a credit card freak, like me, paying your petrol bills with a credit card with a 2.5 per cent surcharge, then you probably have no cash in hand to worry about.

Initially, the public experiencing schadenfreude (joy at the likely misery of black marketers) was euphoric and very supportive of the currency recall. However, as the reality dawns that the black marketers were not suffering the inconvenience of ATM queues and there could be economic hardship ahead, people are focusing on botched implementation!

However, let us focus on the idea. Even if we all are enthusiastic and not objecting to being subjected to agnipariksha, was it a good idea? Could it have been implemented without hardship, some inconvenience is okay? Will it be effective in catching the tax cheats? Neither good intentions nor botched implementation should distract us. Was it a good idea, is the sole focus of this article.

Cash As A Percentage Of Gross Domestic Product (GDP)

Source: Bank of International Settlements.

Currency with public in India is about 11-12 per cent of the country’s GDP, even as tax is about 10-11 per cent of GDP. Proponents of “demonetisation” are convinced that Indian economy does not need so much cash and there is a large cash hoard of black money (Rs 4 lakh crore if you believe the social media) idling away that needs to be seized from tax cheats. While cash in the Indian economy is large, it is not exceptionally large as seen in the graph, above. Japan with a 30 per cent tax to GDP ratio (OECD average is 33 per cent) also has a much higher cash to GDP ratio than India. China, Russia, Singapore, Hong Kong and Switzerland also have high cash to GDP ratios.

Secondly, investing black money in property is easy and very lucrative in India. Though it is more difficult, black marketers could also round-trip money through Mauritius and invest in the stock market. Black money in the form of cash is only required as working capital for black market transactions; there is no reason to use cash as a storage of value when you can make a return of greater than 10 per cent per annum by investing in property or in the stock market. Thirdly, data disclosed by Finance Ministry from over 24,000 income tax raids, indicate that on an average cash forms only 5 per cent of undisclosed income (curiously assets seized only form 10 per cent of undisclosed income).

Source: White paper on black money 2012.

Other than political rhetoric, there is no evidence to substantiate the opinion that Reserve Bank of India (RBI) is feeding cash to black money hoarders.

High Denomination Notes

Demonetisation of high denomination notes has never been advocated as a means to seize black money cash hoards or to (temporarily or otherwise) shut down the black economy. The purpose of demonetisation is to make it difficult for black marketers to use currency for settling transactions. Demonetisation is always announced months if not years in advance, and is executed with no economic hardship. An example would be the announcement in May 2016 to demonetise the euro 500 note, which will be effective in December 2018! Demonetising the euro 500 would make it difficult for black marketers; a million dollars in euro 500 notes weighs two pounds and can be hidden in a handbag as compared to $100 notes, which would weigh 22 pounds (Source: New York Times)!

Demonetisation by emerging economies faces one big challenge. Black marketers have the option of switching over to US dollar or euros. Wisely, the decision on 8 November was not demonetisation but currency recall; replace the 500 rupee and 1,000 rupee notes with new 2,000 rupee and 500 rupee notes of different size and security features.

Why the 500 rupee note was included in the currency recall is a mystery. The Rs 500 is only about $7 at the market rate. Even if you take the purchasing power parity rate of Rs 21 to a dollar, Rs 500 is only about $25. How in the world does $25 become a high denomination note? Also, RBI appears to have been well prepared with adequate replacement currency in denominations of 2,000 rupee notes that could have replaced all the 1,000 rupee notes that were in circulation. But RBI had absolutely no replacement for the 500 rupee note, so one wonders whether recalling 500 rupee notes was part of the plan or a last-minute inclusion in the currency recall?

According to its annual report, for the last three years, RBI printed about 20.9-23.9 billion notes a year for replacing about 14.2 to 16.4 billion soiled notes and to cater to fresh demand. RBI also reports that the printing presses were unable to supply intended demand for notes and the short fall is between 550 million (FY15) to 2.7 billion (FY16) notes. Given this record, how did they decide that 15 billion 500 rupee notes can be recalled without printing replacements in advance?

And was the currency recall planned for 8 November? Or was the date advanced because the news leaked? Please see picture, below, of Dainik Jagran dated 27 October 2016, widely shared on social media.

This image circulated in social media indicates that the news may have been leaked.

Components Of The Indian Economy

Before we proceed to assess the idea of an abrupt currency recall, let us understand the components of the Indian economy. The UN’s Standards for National Accounting (SNA) requires that GDP estimates include all economic activity, whether they are legal or not and whether they have been subject to tax or not. So, when you read that Indian GDP was slightly more than $2 trillion/Rs 135 lakh crore for FY16, you need to be aware that this measurement includes the following components:

(a) The formal economy – legal & properly taxed economic activity. The formal economy uses cash for small transactions and relies on the banking system for large transactions. By their nature, many economic actors are compelled to be part of the formal economy (for e.g. salaried employees). Also, use of the banking system, puts actors of the formal economy in the radar of taxation.

(b) The illegal economy – drugs, prostitution & other “cash driven” illegal activities are also components of Indian GDP. Because this part of the economy is small and these activities are too difficult to track, many governments ignore the illegal economy in their GDP estimates. However, criminals and tax cheats consume production from other parts of the economy; food grains, biscuits, cars and clothes.

(c) The (partially or fully) hidden economy – legal economic activity that fully or partially evades taxation falls in this category. Under invoicing and over invoicing of transactions straddles economic activity partly in the formal economy and partly in the hidden economy. For example, if a house is sold for Rs 70 lakh on paper and Rs 30 lakh in cash, then the transaction is partially hidden from tax authorities. Hidden economic activity may be settled by informally enforced credit, disguised transactions in the banking system or with cash. People who are part of this economy interact with rest of the economy as consumers, buying food grains, biscuits, clothes and cars.

(d) The informal economy – legal economic activity of people who are below the taxation limits, i.e. with income levels of less than Rs 2.5 lakh per annum (e.g. labourers who load/unload trucks, trains or ships) &/or transaction levels below Rs 10 lakh that don’t attract service tax or sectors that are exempt from excise (SMEs) or income tax (farming) etc. The informal economy includes retailing – over 10 million retail outlets of which only 15 per cent or so have card swipe point-of-sale or POS machines. Almost 90 per cent of the retailing is done with currency. Some of the actors in this economy may also have one foot in the hidden economy, viz they may qualify for indirect tax exemptions but may be evading income taxes or vice versa.

Actors in this economy suffer significant financial exclusion – their businesses are so small & their paperwork is so bad that they don’t qualify for bank credit (for eg their properties would be kutcha, their titles would not be mortgage able etc). Again, actors in this economy are uneducated and unsophisticated. Have you noticed cattle i.e. cows, bulls or bullocks being traded in a village fair – cattle costs a lot of money and the transactions are settled in cash; nobody uses card swipe machines or digital wallets in a village market fair. This part of the economy is also a big employer – capital constrained & labour centric business models are the mainstay of the informal economy. No surprise that this part of the economy uses cash for transactions. Per capita income in this part of the economy would be lower than national averages. Many Indians who are part of the informal economy, don’t have any savings or wealth; they need to earn every day to survive. Lastly, the informal economy also consumes production of other parts of the economy – biscuits, cars and clothes.

The hidden and the illegal economies together are called the black economy! You need to distinguish between the annual black GDP from black money that is wealth earned and saved from the black economy and stored in real estate, gold, in bank accounts of tax havens like Switzerland or Cayman, foreign currency and cash.

The informal, illegal and hidden economies together form the cash economy.

The relative percentages of the cash economy versus the formal economy are not measured and hence unknown. However, guestimates indicate that the formal economy may be about 40 per cent of GDP, black (primarily hidden) economy may be 20 per cent of GDP and the informal economy may be 40 per cent of GDP. These guestimates could be totally wrong but given the banking and payment infrastructure of India, the cash economy could range from 40 per cent to 60 per cent of the economy.

Bringing The Hidden Economy To Sunlight Or Shutdown?

Government agencies try to shut down the illegal economy every single day. However, no government, anywhere in the world, has tried to shut down the hidden economy. Economists advocate policies and enforcement that can bring the hidden economy to sunlight, disinfect them and let them join the mainstream formal economy. No economist recommends that a government simply shuts down the hidden economy.

Let us be clear. Without doubt, the most desired outcome would be to shift the hidden economy to the formal economy and collect taxes from them. However outraged we are by the tax cheating black money economic actors, we need them to survive and thrive, preferably as part of the formal economy or failing that as a second preference, to remain in the hidden economy. The least desirable outcome will be to shut down the hidden economy, which could be 10 per cent or 20 per cent of India’s GDP. We can’t shut down the hidden economy without significant repercussions in the formal economy. If the rest of the economy is deprived of consumption demand from the hidden economy, the whole country would hurt.

The hidden economy does not directly contribute to government coffers but it contributes directly to your pocket and mine; demand from the hidden economy contributed to our employers’ cash flow and was included in our salary. I understand how disgusting it feels but the reality of economics has no place for morality.

Having argued that we can’t shut down the hidden economy, I assume that I don’t have to argue that we can’t slow down the informal economy. A slowdown in the informal economy would mean loss of livelihood to marginalised sections of the society that need to earn for everyday consumption.

Abrupt Currency Recall With Adequate Replacement

Let us now discuss the currency recall idea. Let us assume that adequate replacement currency was available with RBI on the day of the announcement. Even then, an abrupt currency recall would have shut down or at least significantly impacted the black economy for a period, say a week or a month. During that period the black marketers try to figure out how they can launder their stock of currency, whether they can switch to new currency or foreign currency or they must come to the sunlight. For that period, whether it is a week or a month, the impact on the hidden economy creates a demand shock that is felt in all parts of the economy.

Let us say at the end of that period, the black marketers decide to come clean and start operating in white or they switch to foreign currency; provided the hidden economy starts functioning again, the demand shock is over and demand from the hidden economy is restored quickly. On the other hand, they could decide that they will keep their shops shut for six months or however long it takes for them to get adequate replacement currency (new Indian currency or foreign) before restarting their business. In such an event, the demand shock from the hidden economy would last for a much longer period and contribute to a recession.

How the black marketers respond depends on how good the government enforcement is against all forms of black money and will not depend solely on currency recall. Is the government acting effectively against black money in property, against black money in gold or foreign currency, against all forms of black money and tax evasion?

What happens to the informal economy in a currency recall with adequate replacement? Daily wage earners must choose between working for their daily consumption and going to the bank. Even if we ignore the inconvenience of a queue for the middle class, we need to worry about the livelihood of a daily wage earner. However, the government could operate banks in the night for the benefit of the daily wage earner. We would have some kind of slowdown but hopefully nothing major. But the consequences of a significantly impacted black economy and a slowdown of the informal economy may still be significant on the overall Indian GDP. Government needs to articulate significant and achievable goals to justify taking the risk.

Abrupt Currency Recall Without Replacement

Data tables on the economy make me yawn. However, the economy is a complex organism and impossible to explain or understand without tables. At a very high level, economists use the term, velocity of money, to assess the impact of money supply to support GDP growth. Money can be currency with public, narrow money (M1) or broad money (M3); for assessing currency recall without replacement, let us focus only on currency.

Source: RBI and Finance Ministry websites.

I have calculated velocity of money by dividing GDP per month by average currency available during the year. According to my calculations, Rs 1 lakh crore of currency with public supported a GDP of Rs 0.759 lakh crores per month or Rs 9.1 lakh crores per annum for FY16. My calculations also indicate that currency velocity was relatively stable for the last three years (it should have declined if cash hoards were growing). (Velocity of money calculated for M1 and M3 also were relatively stable but not reproduced here).

The Indian Union Budget has been prepared on the basis that the nominal GDP for the year FY 16-17 would be Rs 150.65 lakh crores i.e. monthly average GDP of Rs 12.55 lakh crores. After 8 November announcement recalling Rs 15.4 lakh crores of high denomination notes, currency with public fell dramatically from Rs 17 lakh crores. Recalled currency notes were not legal tender except in government hospitals, petrol pumps and other limited facilities. While the small denomination notes of Rs 1.61 lakh crore were legal tender, the actual currency with public is indeterminate because of permitted activities with recalled currency. As per RBI data released on 7 December, legal currency with public had increased to Rs 6 lakh crore but effective amount would still be indeterminate as a smaller list of economic activities were still permitted with recalled notes.

What kind of GDP per month would the restricted supply of currency support in the first 30 days after currency recall? What kind of GDP per month can we expect for the remaining five months of the current year (November to March) as we continue to experience currency shortage? Out of the Rs 62.75 lakh crore economic activity, we could have experienced for the five months, how much will we actually experience?

If average currency with the public for the first month after currency recall was effectively Rs 6 lakh crore, even if velocity of money miraculously speeded up from 0.759 in FY16 to 1.5 in November 2016, the GDP for the month would be only Rs 9 lakh crore (Rs 3.5 lakh crore below the required monthly average of Rs 12.55 lakh crores), which would be a significant economic shock. Even if you believe that Rs 4 lakh crore of the recalled high denomination notes were an idle zero velocity cash hoard, that will not translate into doubling of the velocity of money. I would suspect that even if there is a significant shift to cheques, cards and other payment mechanisms like NEFT, RTGS, IMPS and UPI, it can still not provide doubling of currency velocity.

Collecting Taxes From The Hidden Economy

Noted economist Surjit Bhalla has suggested that: 

Black marketers would deposit Rs 5 lakh crore in the banks in November/December 2016 and pay Rs 2.5 lakh crore in taxes for FY17. 

They would also pay Rs 1.5 lakh crore every year thereafter. 

Without doubt, this would be a bold and audacious goal and if achieved can be used to argue that the abrupt currency recall was a good move. I can only hope that this will not go the way of Bhalla’s “Clinton will sweep the US polls” prediction.

Bhalla concurs with former finance minister P Chidambaram that that loss of economic growth for FY17 will be about 1 per cent of GDP and I hope they are both right. But I can’t help but worry, how much of this loss of Rs 1.5 lakh crore is coming from poor and marginalised sections, and how much is coming from the black marketers? And for their prediction to come true, we need currency supply to be restored to Rs 10 lakh crore or more and currency velocity to be 1.0 or more. I would leave it to the reader to decide on the likelihood of those outcomes.

A final assessment of the 8 November announcement would boil down to whether a permanent expansion of tax base is realised and whether the net present value of taxes from this expansion was worth the economic disruption that we actually experience. However, this we are not going to know, for several years.

I don’t think abrupt currency recall will be Modi’s Austerlitz. But hopefully it may not be his Waterloo either. Abrupt currency recall may be a hard battle that teaches Modi to seriously upgrade talent in his Cabinet.