Currency demonetization is a bad or at best no impact idea

The recent decision by PM Modi government to take out Rs 500/1000 notes out of circulation has caught the media and the whole country into a frenzy. The policy seems to be the government antidote against the issue of black money in the economy. It particularly resonates among those who have white income and they seem to be gloating over the misery of those “others”, who had cheated the system by not paying their taxes.

The main reason behind this demonetization decision is to cut down the black economy in the country and dry up the illegal funds of those who have collected it over the years. So if you have large unaccounted cash, it is as good as piece of paper beginning November 8. Since GoI has declared that all income above 2.5 lakhs will be reported to the IT department and investigated, this essentially means that people with black money have no amnesty and their cash holdings are as good as dead.

The government is acting on the premise that there is large amounts of black money in India and it is held in cash. This gives us two scenarios in the wake of this decision-

1) There is really large amount of black money in the economy. So if you take this money out of economy, it will hit the economy hard post this decision, thus making demonetization a bad decision

or

2) There is no large amount of black money in the economy and there would be no impact on the economy. If this is the case, then it hardly makes sense to demonetize.

Having seen how an average medium sized business operates in India, one should lean towards the first scenario that economy will be hit hard by this decision. There are large number of inefficient and unseen taxes on businesses, which makes them less productive and also makes it essential for them to engage into unlawful activities to keep the business running. This is the legacy of the “License Raj” India inherited from the crooked governments of the past which gave large discretionary powers to the babus to harass the businesses. And demonetization in no way hits at the laws which generate black money in the first place.

So who might have large amounts of cash sitting at their place? Just think of any neighbourhood shop which does not give a receipt for your purchase, the owner there might have generated some amount of black money. And if the amount of black money hoarded by them is really high, expect them to fire their employees and shut shops in the wake of this decision. Since all businesses need operational capital, for day to day operations, and if black money formed a significant part of their operational capital it is not too difficult to guess how these businesses will be hit by this demonetization.

One of the sectors which is supposedly flushed with large amounts of black money is the real estate sector. The real estate sector has not done well for the past two years and it might get hit even more post this decision. And those of you who think that only those with black money have to lose in this scenario are factually incorrect. There might be many people with white money, who have invested in unfinished projects, and they would lose all their investment because the real estate company cannot complete the project now. This would create a cycle of busts in the real estate sector in the short to medium term. Since the real estate firms cannot complete the existing projects, they cannot raise money from the market for new projects, and since they cannot raise money for new projects, they cannot complete the old projects. This will create a vicious cycle with unfinished projects and depressed market.

There are many who would say- “But real estate was so expensive that anyway common man cannot afford it, so I don’t care”. Well it is true that the real estate values needed some correction but not the big jolt that they might face in the near future. And common man has to be equally worried because real estate sector provides jobs to a large number of people, so if it goes bust then all those jobs are gone. Plus the economy is inter-connected and shocks from one sector impact other sectors. So brace yourself for a slump if the amount of black money in real estate sector was really huge. Not to forget that banks are under-capitalized and under huge financial stress right now, so any shock which can lead to large number of defaults on loans will make their balance-sheet even worse. And real estate loans form a big part of bank balance sheets.

Also, the whole exercise seems a bit futile once you take into account that the government has decided to reissue new Rs 2000 notes. The rules of the game i.e. the discretionary power with the babus, have not changed and those who earlier collected Rs 500/1000 notes will now switch to hoarding money in Rs 2000 notes. So, this will have no impact on the future generation of black money. Yes, it will destroy the stock of black money today but the generation of black money will continue. Janta Party government carried out similar demonetization in 1978 and it had no impact on black money generation post 1978, so it is foolhardy to assume that it will make any dent this time- the nature of laws and babus has hardly changed since the 70s.

So, what should you make out of this policy? Brace yourself for a rude shock if you really believed that black money formed a significant part of Indian economy. And if you don’t get this rude shock, then it was just an empty noise without any substance and black money was not even an issue to begin with. Also the thinking that black money is the underlying problem and needs to be solved needs a change. Black money is a symptom of the inefficiencies and bad laws in the economy, which forces a large number of businesses to cut corners to remain viable.

Read Part II of this series.

P.S. 1- The article only dealt with the economic issues of black money and some people will point out its impact on terrorist infrastructure or future state elections. There might be some side benefits like hitting the illegal currency racket operated by Pakistan but it is still important to look at the pros and cons of a policy which is sold as an economic miracle. Also, it is essential to think if it was the best way to hit terrorists even if it might end up hurting the Indian economy in the future?

P.S. 2- There is 3rd scenario not mentioned above, if you believe in super powers of black money hoarders- they have large amounts of money but they find a way to fool Modi government. In this case, black money would be large but since they can save their money by fooling govt., economy would not be hit!!

Read the below thread for more insights: