<b>Sarmistha Pal:</b> Why Demonetisation?

Sarmistha Pal examines whether the current government's stance in tackling black money has significantly differed from its predecessor

In India, black money refers to the money earned in the black market on which no taxes (income and others) have been paid. While a part of it is held in the form of domestic currency, it is alleged that a substantial amount is held as real estate, gold and also in foreign accounts abroad. In February 2012, the director of India's Central Bureau of Investigation (CBI) said that Indians have $500 billion of illegal funds in foreign tax havens - more than any other country. According to McKinsey, the share of the black economy was about a quarter of Indian (gross domestic product) GDP in 2013.

In response to a writ petition, in January 2011, the Supreme Court of India (SC) asked the government why the names of those who have hidden money in the Liechtenstein Bank have not been disclosed. On 4 July 2011, the SC ordered the appointment of a Special Investigating Team (SIT) headed by former SC judge B.P. Jeevan Reddy to act as a watchdog and monitor investigations dealing with black money, to be reported back to the SC directly. The two-judge bench observed that the failure of the government to control the phenomenon of black money is an indication of weakness and softness of the government. In 2016, the Panama Papers that included information on 214,000 offshore entities over a 40-year period exposed the names of 500 Indians, who scoffed government rules and regulations to build their empires abroad. The close nexus between businesses and the government is a reflection of crony capitalism. It may be exhibited by favouritism in the distribution of legal permits, government grants and loans, or other forms of State support to big businesses (not linked to their productivity) in return for generous donations, which unfortunately remain undisclosed in India (unlike in the US for example).

In May 2014, PM Narendra Modi rose to power on the big promise of curbing corruption, tax evasion and black money, and is very keen to be acknowledged as a pioneer in this respect. Surely, no one disagrees with the government about the dire need to tackle black money. But the question raised here is whether the government’s stance to tackle black money has really differed from its predecessors, and how far the government is willing to go in this respect. 

In December 2014, SIT asked the investigation agencies - Enforcement Directorate (ED) and Directorate of Revenue Intelligence - to take action against companies claiming duty drawback without repatriating export proceeds. It also asked the Reserve Bank of India (RBI) to develop an institutional mechanism and IT (information technology) system to red-flag those cases where exports have been outstanding in violation of the 1999 Foreign Exchange Management Act (FEMA) guidelines. Further, in early 2015, SIT asked the capital markets regulator Securities and Exchange Board of India (SEBI) to have an effective monitoring mechanism to study the unusual rise in stock prices of companies, and to regulate participatory notes issued by registered foreign institutional investors to overseas investors who wish to invest in the Indian stock markets without registering themselves with SEBI, especially those from Cayman Islands, Mauritius, and Bermuda. In 2016, SIT also recommended a ban on cash transactions above Rs. 300,000 and sought a cap on cash holdings of companies and individuals at Rs. 1,500,000. Further, the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act was introduced in May 2015 to bring back illegal money stashed abroad. 

Given the complex nature of corruption, direct measures are often preferred and as such these measures recommended by SIT are likely to be effective and beneficial. But the big question is about the government’s resolve to enforce them. SIT pressed the government in September 2015 for its responses to earlier SIT recommendations. However, the Attorney General, Mukul Rohtagi said: “I cannot say anything now. I have no instructions.” The Black Money and Imposition of Tax Act of 2015 too failed to elicit the kind of response the government was expecting. As such regulations alone are unlikely to help if these are not enforced fairly.

Instead, on 8 November 2016, PM Modi introduced demonetisation as he announced - in a broadcast to the nation - that Rs. 1,000 and 500 currency notes (constituting about 86% of total currency in circulation) would no longer be recognised legally as currency. While the policy was initially hailed as a major breakthrough to tackle black money in some quarters, there are now growing concerns about its effectiveness and implementation. Most importantly, only a small proportion of black money is estimated to be held in cash (about 6%, as evident from income tax raids), and there are loopholes in the implementation of the law, example, it exempts hundis offered to temples, which may help specific religious groups to convert black money into white (this can be regarded as unconstitutional, given secular nature of the State). As such, it is unlikely to have a significant effect on existing black money held domestically. Further demonetisation cannot block future black-money generation. Its implementation has also proved challenging: only about 53% of Indian people have bank accounts and 40% of Indian villages (where 68% of Indians reside) do not have access to banking services, as per 2011 Census. The problem has been exacerbated by the government’s failure to ensure timely and sufficient supply of new currency notes. As such, it caused a sudden contraction of India’s money supply affecting all aspects of economic activity, squeeze of the sizeable cash-based informal sector, disrupted the long-standing trade and tourism with immediate neighbours, hurt investor sentiment and above all, caused serious harassment and suffering of law-abiding citizens (who are supposed to benefit from the policy) in accessing their hard-earned money due to the mess created by the rich and powerful. 

Yet, under the watchful eye of the government, there is another crisis unfolding - it is the rising volume of non-performing loans (NPAs) in the banking sector, especially prevalent among State-controlled banks. In a speech on 22 June 2016, the then RBI Governor Raghuram Rajan argued that the slowdown of credit growth has largely been because of the stress of the public sector banking and not because of the high interest rate. A loan is classified as non-performing when the borrower stops making interest or principal payments, which was underestimated previously. The identification process for NPAs changed following the RBI’s directive to banks on asset quality review (AQR) in December 2015. In September 2015, the top 100 borrowers accounted for 2.9% of the NPAs. Six months later, they accounted for 19.3% of the bad loans. The total NPAs of 29 State-controlled banks stood at Rs.  1,140 billion at the beginning of 2016. 

There has, however, been no apparent effort to tighten the source of bad loans despite warning issued by Raghuram Rajan in June 2016: “The stress in the banking sector, which mirrors the stress in the corporate sector, has to be dealt with in order to revive credit growth.” Rajan’s futile fight against crony capitalism was also reiterated by Luigi Zingales of Harvard University. As such, the rising NPAs in the banking sector, especially in State-controlled banks, is likely to be linked to the persistence of crony capitalism that typically characterises the Indian economy. In fact, the Financial Stability Report of the RBI suggests that the size of the NPAs has increased significantly during the current government’s regime: NPAs of Indian banks jumped to 7.6% of their total assets in March 2016, up from 5.1% six months ago. The much-publicised case of Vijay Mallya case is a pointer in this direction. A group of 17 Indian banks including State Bank of India (SBI) are trying to recover approximately Rs. 90 billion ($1.3 billion) in loans given to Mallya. Using data on a list of world billionaires and the size of their wealth published by Forbes, The Economist labels each individual as crony or not based on the source of their income. This shows that India is ranked 9th in both 2015 and 2016 Crony Capitalism index, thus the ranking remaining unchanged. The size of the NPAs of State-controlled Indian banks suggests that Mallya was not alone and there is little success in recovering these bad loans. 

Instead, the government chose to adopt a one-off demonetisation policy, a costly measure that is unlikely to have any significant effect either on existing domestic black money or future black-money generation. In fact, given the infrastructural deficiencies and regulatory loopholes, novel mechanisms of evading the rules have already been in place. Data released by the RBI in 2016 shows that about 86% of the currency in circulation is in the form of Rs. 1,000 and 500 notes, which comes to about Rs. 13 trillion. Some may argue that cleaning up the cash part of the black money induced by demonetisation may boost the economy. This would depend on how much of the ‘lost’ currency notes plus all the idle cash held by all sorts of people will return as deposits into the banking system. While no one has a good estimate about the amount of idle cash (both legal and illegal) held by people outside the banking system, it is fair to assume that a substantial amount of this money would come back as commercial bank deposit (even allowing for the tax penalty for depositing cash over Rs. 250,000 per person). Indeed, newspaper reports confirm that about Rs. 8.5 trillion were raised from cash deposits (though no one knows what proportion of it is black money) in the first 17 days of demonetisation, a significant proportion of which will be held in various State-controlled banks. However, SBI itself has written off Rs. 480 billion worth of bad loans, as of 30 June 2016. If ‘increasing the bank deposits via demonetisation’ policy is directed towards balancing books of bankrupt State-controlled banks with huge bad debts, its potential productivity benefit is likely to be rather limited.

Since the government has failed to recover much black money and is widely perceived as being soft on corporate defaulters and Swiss Bank/Panama Papers bigwigs, it felt the need to signal that it is serious about black money by purporting to shake the system. The result was the introduction of demonetisation that is hard to implement not only because of infrastructural deficiencies, but also regulatory loopholes. The government’s anti-corruption rhetoric thus appears to be more like tall talk rather than effective action. 

The author is grateful to Maitreesh Ghatak, Parikshit Ghosh, Sugata Ghosh, Udayan Roy and Bibhas Saha for helpful discussions and comments on an earlier draft. 

Sarmistha Pal is chair in Financial Economics at the University of Surrey. 
Published with permission from Ideas For India (www.ideasforindia.in), an economics and policy portal.