The Silver Linings of Demonetisation

Businessworld's Neeta Misra catches up with Dr. Arvind Virmani at the Demonetisation roundtable held at the Metropolitan Hotel in New Delhi on what he thinks about the measure.

Two weeks have passed since 8 November announcement by the prime minister on demonetisation. What is your assessment?
Demonetization of 500 & 1000 notes was a risky move given that corporate sector has still not fully recovered, international headwinds remain strong and private investment remains below par. Demonetization of 86% of the total currency, compared to <2 per cent in the previous such episode in India, can be viewed as an incredibly bold decision or a gamble, depending on your point of view. It must however be analysed in the context of other actions against black money taken by the govt.

1) Black money abroad: Black money bill, cooperation with United States, European Union who have introduced corruption and tax evasion laws, International co-operation on Tax havens

(2) Domestic Reforms: Transparent auction systems for natural resources (telecom spectrum, coal, minerals); Real Estate Regulation Bill, Goods Services Tax (GST), Corporate Income Tax (CIT) reform (25 per cent by 2019), measure to ease payment of PIT, mobile wallets, Aadhar & bank accts for poor (Jan Dhan), Rupay credit/debit card;

(3) Policy Reforms Needed for sustained decrease in the share of black economy in GDP and national wealth: PIT simplification & rate reduction, stamp, end of tax terrorism, duty reduction, lower circle rates, promotion of mobile wallet; State financing of elections, rigorous auditing of accounts, penalties for non-compliance including eventual de-registration (all to be implemented/supervised by Election Commission), criminal justice system reform (law-police-judicial).

What does the success of demonetisation in your view hinge on?
Let's come back to the economics; what is the economic problem and what is the pain. Currency has two components, one is transaction demand and the other is the stock demand ie. Storage and large transactions. Success of demonetisation in the next month is critically dependent on replenishing the stock of money in the economy. Retail trade in goods and services (including daily labour) will collapse in the first few weeks with the rural areas being worse hit as the usage of cash is higher relative cheques and cards, than in urban areas. The speed/slowness of retail recovery is directly related to the speed/slowness with which the transaction demand for currency by users of retail services is met, in each geography (city, district, block, Panchayat). RBI must ensure supply of new notes in every geography and of liquidity more generally. In the absence of Rs. 500 and Rs. 1000 notes, the need/demand for Rs 100 notes increases manifold and must be met. New Rs. 500/- notes need to be introduced quickly as Rs. 2000 notes are not even a pale substitute for the de-monetised 500 & 1000 notes for the purpose of transactions/trade.

What are the silver linings?
On the positive side, it's a blow to cross border counterfeiters, corrupt politician-bureaucrat-police, and to operators of the 60-40 land-real estate system. The demonetization will make it impossible to use undeclared income, and thus put severe downward pressure on prices. It's conceivable that almost the entire black component of price is eliminated, bringing down prices by up to 50 per cent. But this cannot happen if government rules like high "circle rates" make it impossible. State Governments must quickly eliminate rules and procedures which can keep real estate prices from falling and reduce stamp duties an outdated transaction tax that discourages transparent deceleration.

The other channels for holding black wealth such as jewellery and foreign currency Hawala, will also be reduced, but the effect will be mostly on volumes, not much on prices, as these are set by international markets. Conspicuous consumption in the form of extravagant wedding ceremonies is also likely to be moderated. However, the effect on these items will not last beyond 3-5 years, unless complementary measures are taken to reduce new generation of black money.
Tax compliance & collection will increase dramatically in the current year, independent of how GDP growth is affected, because undeclared cash is being deposited in bank accounts and these will have to be declared as income in current year. This provides a great opportunity for tax reduction, so that better voluntary tax compliance is incentivized and sustained in future years. Union and State Governments should plan to use part of increased revenue to increase construction oriented infrastructure spending to offset lower real estate activity due to elimination of black money.

What is your big take away?
Overall the money supply will pivot from black to white economy and the ratio of white to black economy will rise, with corresponding changes in their ratios to GDP. It's harder to determine what will happen to measured GDP as the % of the two types of flows in it is not known. My guess is a fraction of a per cent point reduction in growth rate in 2016-17 from that projected by me in March 2016. However if the authorities are unable to supply the transaction demand for currency within a month of the demonetization, the negative effects will begin to mount and spread in the under-supplied areas, and could become serious after two months.