On the day when the Reserve Bank of India (RBI) finally reported that almost 99% of the proscribed currency notes of ₹500 and ₹1,000 denomination had returned to the banking system by 30 June 2017, the finance ministry also issued a formal statement seeking to explain how demonetisation has been “immensely beneficial to the Indian economy and people.”

The statement begins by enumerating the objectives of demonetisation: “(i) flushing out black money, (ii) eliminate Fake Indian Currency Notes (FICN), (iii) to strike at the root of financing of terrorism and left wing extremism, (iv) to convert non-formal economy into a formal economy to expand tax base and employment and (v) to give a big boost to digitalization of payments to make India a less cash economy.” The Prime Minister’s speech on 8 November 2016 needs to be recollected in this context:

So, in this fight against corruption, black money, fake notes and terrorism, in this movement for purifying our country, will our people not put up with difficulties for some days? I have full confidence that every citizen will stand up and participate in this ‘mahayagna’.

There was no mention of the words “non-formal” or “formal economy,” “expand tax base,” “digitalization,” and “less cash economy” either here or anywhere else in the Prime Minister’s speech.

Points (iii) and (iv) mentioned in the finance ministry’s statement, therefore, were clear afterthoughts, added as an attempted face-saver through shifting of the goalposts. Moreover, a closer examination shows that the ministry’s claims of meeting the above-mentioned objectives are mostly false and deceptive.

On Cash Returning to the Banking System

The statement says:

The Government had expected all the SBNs [specified bank notes] to come back to the Banking system to become effectively usable currency.

This, however, is not borne out by the actual sequence of events since 8 November 2016. In a signed article appearing on 14 November, the chief economic advisor of the State Bank of India (SBI) had argued that since 25% of the proscribed currency notes did not return to the banking system during the 1978 demonetisation episode, it is reasonable to assume that 25%–50% of the proscribed currencies will not be exchanged in the present instance. He wrote, “there would be around Rs 2,482–4,800 billion money that will not be converted and remain outside the banking system. To that extent, cash in the system may decline” (Ghosh 2016).

Defending the demonetisation decision in the Supreme Court, the then attorney general argued on 15 November 2016 that the government estimated black money size to be ₹15 to ₹16 lakh crore and expected people to deposit ₹10–₹11 lakh crore in banks. He said, "Rest Rs 4–5 lakh crore were being used in northeast and J&K to fuel trouble in India. That will be neutralised" (Times of India 2016).

On 23 November 2016, the chief economic advisor of the SBI once again wrote that there was no doubt over the fact that between ₹2.4 and ₹4.8 lakh crore would not return to the system and hence the RBI’s liabilities will “get extinguished” to that extent, and that differences were only on how the consequent capital gain by the RBI was to be handled. He argued: “We reiterate that the best possible move should be the first one and the government must spend the funds on activities like infrastructure development or as it deems fit. There is nothing wrong in it, as is being claimed in several circles” (Ghosh 2016a).

Following this, several former governors and deputy governors of the RBI publicly reacted, questioning the rationale of “extinguished liability” of the RBI and windfall gains. It was only on 7 December, that the RBI officially reported in a press conference that ₹11.55 lakh crore had already returned to the banking system, with the RBI governor ruling out the possibility of any part of the RBI’s liability getting “extinguished” or any special dividend being paid to the government. Even then, the SBI Research Division publicly questioned the veracity of the RBI’s data on currency notes which had returned to the system due to double counting (Times of India 2016a).

It is more than clear that the government’s demonetisation decision was motivated by expectations of a windfall, on the lines proposed by the chief economic advisor of the SBI. That is why the Prime Minister asked people to give him 50 days for the war against black money in his 13 November speech in Goa, after which he even offered to submit himself to punishment. Once those expectations were belied by subsequent events—with currency exchange and bank deposits surpassing official expectations—the government changed its narrative to the promotion of digital payments and formalising the informal economy.

This is further borne out by the severe shortage of new currency notes till the end of December 2016, which implies that the government initially expected the demand for new currency to be much less than it turned out to be, and new notes were therefore not printed in adequate numbers. For the finance ministry to now claim in an official statement that the government had expected 99% of the cash to return to the system at the very outset is both disingenuous and disgraceful, because the cash-using public had to undergo many travails in the post-demonetisation phase, with over a hundred people dying in bank queues.

“Flushing out Black Money”

The finance ministry’s statement, while acknowledging that a significant proportion of cash deposited in bank accounts post-demonetisation could be black money, also claims that a fiscal windfall will eventually come through the mining of big data by the income tax department, which could be collated because of demonetisation. However, the mention of 18 lakh accounts involving ₹2.89 lakh crore under the income tax department’s scrutiny is of little fiscal relevance, since neither does one know what the revenue outcome of that scrutiny may be, nor is there any time frame for its materialisation.

The finance ministry’s statement has reproduced the data on the increase in the number of income tax assessees following demonetisation in the recently released Economic Survey 2016–17 Volume–2. However, it fails to mention that while the number of income tax assessees in 2016–17 has grown by 5.4 lakhs over that of 2015–16, the average taxable income reported by the possible additional taxpayers is only around ₹2.7 lakh annually, barely above the ₹2.5 lakh income tax threshold. The Economic Survey has projected the possible additional revenue from this income tax base expansion to a modest ₹10,587 crore.

The data provided in the finance ministry’s statement also show that between November 2016 and May 2017, the total amount of undisclosed income unearthed is ₹17,526 crore, out of which only ₹1,003 crore was seized. The crackdown on benami transactions so far has yielded another ₹600 crore. Revenue department data show that since 2013–14, the income tax department has annually unearthed undisclosed income of around ₹10,000 to ₹11,000 crore, with seizures of around ₹700 to ₹800 crore. It is clear from the finance ministry’s statement that there has not been any significant rise in such seizures of illicit wealth, post-demonetisation.

The statement avoids mentioning the second income disclosure scheme of 2016–17 (Pradhan Mantri Garib Kalyan Yojana) announced after demonetisation, which has turned out to be damp squib, with declarations of unaccounted wealth barely touching ₹5,000 crore, half of which accrued as revenues to the government (Indian Express 2017). Taking this together with the revenue gains reported in the finance ministry’s statement, the concrete revenue gain of the government due to demonetisation has not exceeded ₹4,000 crore so far.

The projections of income tax collections in 2017–18 made in the last budget suggest a growth of around 25% over last year, compared to 22.7% tax collection growth in 2016–17. If this projection comes true, the income tax to gross domestic product (GDP) ratio will inch up from 2.3% in 2016–17 to 2.6% in 2017–18. Moreover, the finance ministry’s statement throws around figures of increased income tax returns and advance tax collections, but fails to clarify whether the projections would take income tax collections beyond the budget estimates for the current financial year, suggesting a mere 0.3 percentage points of GDP increase in income tax collections over the previous year.

Can this be construed as a tax bonanza in any sense? And is this touching even the tip of the iceberg as far as the stock of black money in the Indian economy is concerned, which by various estimates ranges from 20% to 50% of India’s GDP? More importantly, is all the pain undergone by the people worth an income tax collection gain of 0.3% of GDP?

To put things in perspective, the union government’s total expenditure in 2017–18 is projected to be around 12.7% of GDP and the fiscal deficit, 3.2% of GDP. The gross non-performing assets (NPAs) of 38 listed banks in India have crossed 4.6% of GDP by March 2017, and the public sector banks (PSBs) had written off NPAs worth 0.5% of GDP in 2016–17. Even if the post-demonetisation income tax projections for 2017–18 turn out to be accurate, it would imply nothing more than drawing out a few droplets from an ocean, let alone flushing out black money.

Elimination of Fake Currency and Terror Financing

The finance ministry’s statement claims:

As a result of demonetization of SBNs, terrorist and naxalite financing stopped almost entirely. No high quality FICN was found/seized by intelligence operations, including at the Indo-Bangladesh Border since demonetisation. Further, it also adversely affected the hawala operators and dabba trading venues.

Table 1: Fatalities in Terrorism Related Violence in India

Note: *Data till August 27, 2017.

C – Civilians, SP – Security Personnel, T – Terrorist

Source: South Asia Terrorism Portal

However, such assertions fly in the face of facts. Data from the South Asia Terrorism portal (Table 1) show that total fatalities in terrorism related violence in India have hardly seen any significant decline in 2017 (data till August 2017) compared to the two previous years, with violence in Jammu and Kashmir actually witnessing an escalation. While there are several complex reasons for the rise and fall in terrorism related violence anywhere, there is hardly any sign of a decline in such violence in major conflict zones in India, post-demonetisation. It can rather be argued that demonetisation has had no impact on the financing of terror, unless the finance ministry is suggesting (without evidence of course) that the perpetrators of such violence are now suddenly being able to carry on their activities free of any cost.

As far as fake currency is concerned, the evidence is even murkier. The affidavit filed by the government in the Supreme Court estimated ₹400 crore worth of fake currencies circulating in the Indian economy, on the basis of data from a 2016 study conducted by the Indian Statistical Institute (ISI) (commissioned by the Ministry of Home Affairs or MHA). The RBI annual report states that total counterfeit currency notes of ₹500 and ₹1,000 denomination detected till March 2017 were worth only ₹41.5 crore, which is around one-tenth of the ISI–MHA estimate for 2014–15. This implies that only a miniscule 0.003% of the ₹15.28 lakh crore worth currency notes returned to the banking system post-demonetisation, were found to be fake.

Therefore, the FICN estimates that drove the demonetisation decision were over-the-top and alarmist. There was absolutely no justification for nullifying 84% of the economy’s currency in circulation in one stroke just to neutralise ₹41.5 crore worth of fake currency. Moreover, the RBI’s annual report shows that ₹13.75 lakh worth of counterfeit in the newly issued ₹2,000 and ₹500 currency notes were detected by March 2017. Thus, the infrastructure of counterfeiting Indian currency notes appears to have remained untouched by demonetisation.

Impact on the Economy

The finance ministry’s statement defiantly observes:

Some people had expected a very large shock to economic growth on account of demonetization. Their expectations have been belied. India has continued to be on path of one of the strongest growths in the world.

This is yet another instance of the finance ministry’s state of denial. The quarterly growth rate of the economy (gross value added or GVA at basic prices) came down from 6.8% in the second quarter of 2016–17 (July–September) to 6.7% in the third quarter (October–December) and 5.6% in the fourth quarter (January–March). The recently released data on the first quarter of 2017–18 (April–June) show the growth rate of GVA at 5.6%, down from 7.6% from the first quarter of 2016–17 (Figure 1).

Figure 1: Quarterly Estimates of GVA at Basic Prices (at 2011–12 prices)

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Source: Central Statistics Office, Government of India

Not only has the overall economy slowed down considerably in the post-demonetisation period, growth in sectors like manufacturing, agriculture, mining and construction have fallen sharply. Had it not been for higher growth in service sectors like “public administration, defence and other services” and “trade, hotels, transport & communications” over the past two quarters, the economy would already have slid into a recession (Table 2).

Source: Central Statistics Office, Government of India

Two figures from the Economic Survey 2016–17 Volume–2, sharply bring out the adverse impact of demonetisation on economic activity. Figure 9 (p 12) shows how growth in real investment (gross fixed capital formation or GFCF growth) plummeted to negative territory in the fourth quarter (January–March) of 2016–17. Figure 22 (p 23) shows how manufacturing (Index of Industrial Production or IIP) growth and the real growth rate of industrial credit collapsed in the last two quarters (October to March) of 2016–17, following demonetisation. The latest data on the first quarter (April–June) of 2017–18 show continued deterioration in investment and manufacturing activity.

An analysis undertaken in Economic Survey 2016–17 Volume–2 based on data from 23 emerging economies has shown that no other such economy has experienced 7% growth rate in the last 25 years with such low levels of growth in investment, exports and credit that India has witnessed over the past two years. This raises fundamental questions regarding India’s GDP growth rate itself, which several economists have long held to be grossly overestimated. Even that overestimated growth data has shown a considerable slowdown following demonetisation, contrary to the assertions made in the finance ministry’s statement.

Digitisation of Payments

The finance ministry’s statement cites the decline in cash circulation in the economy and the increase in digital payments as the successes of demonetisation:

[T]he effective currency in circulation today is only 83% with full remonetisation having taken place ... Digital payments have increased by 56% from 71.27 crore transactions in October 2016 to 111.45 crore transaction till the end of May, 2017.

The Economic Survey 2016–17 Volume–2 had already noted the fall in the cash–GDP ratio from 11.3% in 2015–16 to 9.7% in 2016–17. However, two questions remain unanswered in this regard. First, whether “full remonetisation” has indeed taken place, in terms of currency supply being fully reflective of the demand for cash in the economy. Unlike the assertion made in the finance ministry’s statement, it is not possible to conclude on the basis of available data, how much of the shift to digital payments is a result of the currency shortage induced by demonetisation, and hence transient, rather than a permanent and voluntary shift to digital payments. Data on debit and credit card transactions at point of sale (POS) for both less affluent (RuPay card holders) and affluent consumers provided in the Economic Survey show a sudden spike in such transactions following demonetisation till December 2016, after which they fell significantly, although to levels higher than the pre-demonetisation period. It is too early to arrive at strong conclusions on that basis.

The more important issue, however, is whether a massive shock like demonetisation was at all necessary to shift cash-users to digital payments. While higher profits accruing to a handful of digital payment service providers are obvious, the gain to the larger economy and the people from such a shift should not be exaggerated. Digitisation may enhance the convenience and transparency of transactions, but it can also increase transaction costs as well as possibilities of misuse, given India’s abysmal levels of financial and digital literacy and the deeply unequal socio-economic structure. A case in point is the Pradhan Mantri Jan Dhan Yojana. The finance ministry’s statement says:

As on 16 August 2017, the number of Pradhan Mantri Jan Dhan Yojana (PMJDY) accounts stands at 29.52 crore with rural accounts comprising 60% of it. Thanks to demonetization led efforts, zero balance accounts under PMJDY declined from 76.81% in September 2014 to 21.41% in August 2017.

Several media reports suggested that the Jan Dhan Yojana (JDY) accounts were utilised across various states to launder illicit cash hordes (India Today 2016; Shankar 2016). The fact that 99% of demonetised currency found its way back into the banking system is itself proof that much of the black money stored in cash was deposited in the banks.

The search and seizure statistics of the revenue department data show that around 6%–8% of undisclosed income has been found to be stored in cash and other liquid assets. However, the rapid decline in zero-balance JDY accounts post-demonetisation, which the finance ministry’s statement has cited as a success story, may actually reflect their misuse for post-demonetisation money laundering. The decline in cash-use and the increase in digital payments after demonetisation had had no deterrent impact whatsoever on such money laundering channels.

Demonetisation Costs Exceeded Benefits

While the benefits of demonetisation as claimed in the finance ministry’s statement are either meagre or illusory, where the statement remains entirely silent is on the costs of demonetisation. Economic Survey 2016–17 Volume–1 (Chapter 3) recognised at least the following fiscal costs of demonetisation:

 Costs of printing new notes over and above normal replacement.

 The costs of sterilising the surge in liquidity into the banking system through the issuance of Market Stabilisation Scheme bonds.

 Loss in corporate and indirect tax revenues of the centre in the case of decline in economic growth.

The annual report of the RBI has informed that the surplus paid by the RBI to the central government came down from ₹65,876 crore in 2015–16 to ₹30,659 in 2016–17. The reduction in RBI’s surplus was because of reduced earnings and higher expenses in 2016–17, much of which were a direct outcome of demonetisation. The cost incurred on printing notes increased from ₹3,421 crore in 2015–16 to ₹7,965 crore in 2016–17, that is, an increase of ₹4,544 crore. This significant additional expense was incurred because supply of new currency notes rose by 37% over the previous year, with the supply of higher denomination notes rising by 160%, alongside higher freight and forwarding expenses. RBI suffered a whopping loss of ₹18,004 crore in 2016–17 compared to last year on account of interest payment expenditure due to absorption of surplus liquidity in the banking system post-demonetisation. Therefore, RBI lost ₹22,548 crore in 2016–17 compared to the previous year due to demonetisation related costs.

Even if we make a conservative estimate of a reduction in the real GVA growth rate in 2016–17 by 1% due to demonetisation, the loss in GVA comes to approximately ₹1 lakh crore. Assuming a tax–GVA ratio of 9% (same as Central Statistics Office’s estimates for 2016–17), the tax revenue loss of the government would amount to another ₹9,000 crore.

In sum, the central government lost at least ₹31,500 crore in revenues on account of demonetisation, by conservative estimates, while it has so far gained only around ₹4,000 crore in tax revenues in return, going by the information provided by the finance ministry. Therefore, there has been a net loss of ₹27,500 crore so far, to the government alone. There are of course other significant costs that were inflicted on the private sector, which led to losses in earnings and jobs in both the formal and informal segment of the economy.

The fact that the finance ministry has chosen to officially educate the Indian people on the “immensely beneficial” impact of demonetisation on the same day when the RBI reported that 99% of the currency notes has returned to the banking system, is symptomatic of the post-truth world that we live in today, where the establishment has turned its back towards the concerns of factual accuracy and credibility. Despite the smog of misleading official propaganda, however, the fact remains that even the fiscal costs of demonetisation have far surpassed its benefits, let alone its impact on the rest of the economy and the people.

References:

Ghosh, Soumya Kanti (2016): “Demonetisation and Note Burning,” Business Standard, 14 November.

–––––––– (2016a): “Grappling with Demonetisation Windfall,” Business Standard, 23 November.

Indian Express (2017): “Official Data for PMGKY: Unaccounted Funds at just Rs 5000 crore,” 2 June.

India Today (2016): “Exposed: Crooks Turning Kala Dhan into Jan Dhan,” 17 November.

Times of India (2016): “Supreme Court Refuses to Stay Ban on Rs 500, Rs 1000 Notes,” 15 November.

————–(2016a): “SBI Raises Doubts over Rs 11.5L-cr Deposit,” 8 December.

Shankar, V Shiva (2016): “Parallel Economy: Jan Dhan Accounts Used to Launder Money,” Times of India, 15 November.