Modi's bold demonetisation drive is only half the battle won
The demonetisation of the Rs 500 and Rs 1,000 notes announced by Prime Minister Modi on November 8 constitutes his government's boldest and most transformative move.
In one stroke it has sucked out of circulation notes representing a value of about Rs 15 lakh crore out of the total national stock with a value of about Rs 17 lakh crore. The magnitude of this move has naturally affected every single Indian.
Accordingly, demonetisation is the most hotly debated issue today and is likely to remain so in the coming weeks. It has also sharply polarised opinion.
Most opposition parties, those with black money, which regrettably includes much of the elite, the so-called "liberals", and the inveterate Modi baiters, have been vituperatively critical of this move.
The bulk of the common citizenry, as well as those who wish to see a strong and corruption-free India, have, however, been strongly supportive despite the considerable inconvenience faced by them.
An objective assessment of whether or not this step should have been undertaken demands a dispassionate evaluation of its positive and negative effects.
So drastic a demonetisation was long overdue in order to effectively address the crippling impact of black money in the country, the annual generation of which has been variously assessed as ranging from 25 to 50 per cent of the GDP. No previous government has shown the gumption to take this issue head on so boldly even at the cost of some loss of popularity.
The demonetisations undertaken in India in 1946 and in 1978 pale in comparison in terms of scale with what has now been done. As against the current demonetisation, which extends to around 88 per cent of the value of the total currency in circulation, the devaluations of 1946 and 1978 extended to a only about 11.5 per cent and 1.6 per cent respectively of the value of the total currency then in circulation.
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| The demonetisations undertaken in India in 1946 and in 1978 pale in comparison in terms of scale with what has now been done. (Photo credit: PTI) |
The move is welcome as it sterilises almost the entire stock of black money in India that in the words of the Wanchoo Committee of 1971 "is like a cancerous growth in the country's economy which if not checked in time, is sure to lead to its ruination."
Demonetisation is likely to have the following positive cascading effects on the economy particularly in the medium to long term:
1. Black money has resulted in a huge loss of revenue to the state. Its elimination will result in substantial gains for the national exchequer;
2. Since black money is traditionally invested in real estate it has led to artificially high prices in the housing sector. These will come down sharply and housing will become available at more realistic prices;
3. Elimination of black money acting as a curb on inflation will make for lower interest rates which will give a fillip to the Indian economy and will make Indian exports more competitive;
4. The large cash deposits being made consequent upon demonetisation will improve the health of the banking sector and further incentivise it to provide cheaper credit which will, in turn, promote growth;
5. It will provide a windfall gain to government as out of the demonetised currency of 15 lakh crores only around 60-75 per cent will be deposited in banks and the balance which will be in the nature of unaccounted income will be permanently sterilised. This amount will be injected by the government into the economy for developmental activity with zero inflationary impact and a substantial boost to GDP growth which will within a year or two attain double digit levels.
6. It will not only penalise the corrupt by depriving them of a substantial portion of their ill-gotten gains but will also serve as a deterrent to others.
7. The sudden liquidity crunch accompanying demonetisation is inducing Indians on an across the board basis to increasingly take to cashless transactions either by cheque or through a range of digital means. The resulting enhanced transparency in financial transactions will make for much better tax compliance and efficiency.
8. With this attack on black money the service infrastructure which had evolved for its protection composed of brokers, touts, musclemen on the one side and a group of income tax practitioners, chartered accountants and liaison officers on the other side to establish a black money culture or an evil network within the economy will tend to dissipate.
Apart from the aforesaid massive gains from demonetisation that will accrue over time an immediate benefit has been the elimination of the entire stock of fake currency printed by Pakistan to promote terrorism in India.
As a result Pakistan-inspired terrorist actions in India have taken a severe hit. This is evident in the sharp fall in militancy in Jammu and Kashmir.
While demonetisation has already had some positive outcomes and while many more are in store there have also been some negative fall outs. The most important of which is the considerable inconvenience faced by everyone due to the cash crunch.
The severity of this has been accentuated by the fact that in much of India many transactions are still cash based. Hence the spectacle of hundreds of people stuck in long queues before banks and ATMs seeking to withdraw cash which is in short supply.
Such long queues could have been minimised had there been better planning by injecting more newly minted currency notes into the system. The excuse that this was not possible as secrecy had to be maintained does not quite wash.
Suitable pretexts could have been devised to preposition a larger amount of funds with banks without compromising on secrecy so as to have met substantially more of the demand than was actually met.
More serious than the inconvenience caused to people at large is the fact that the demonetisation has led to a sharp downfall in GDP growth. The severe cash crunch in a country where cash is still in much use and cashless transactions are relatively new cannot but have a serious negative impact on economic activity.
This will lead to a fairly dramatic downturn in GDP growth for one or two quarters which some estimate to be as high as two percentage points. Failure to rapidly infuse more cash into the economy will inevitably accentuate the pain.
Of course, over the next year or so the GDP slowdown will be more than made up by much faster and possibly double digit growth.
Clearly, the short-term adverse effects demonetisation will be more than offset by the medium and long term gains accruing there from. Better planning and implementation, while keeping in mind the overriding constraints of secrecy, could have somewhat reduced its negative impact.
For the future it is to be hoped that the Modi government will capitalise on the gains of demonetisation. For one, there must be no let up in the war against corruption, tax evasion, black money and black wealth.
For another government must engage in a rapid infusion of investments to boost the economy. Finally, it must imaginatively reduce taxation, both individual and corporate, in order not only to reward the people at large for having stoically put up with the hardship of demonetisation but also in order to incentivise them to refrain from engaging in black money transactions. This will give an enormous fillip to development and revenue collection and thereby place the country firmly on a high growth trajectory.
A root and branch reform of the direct tax structure is also imperative for India to preserve its buoyant domestic consumption as the principal driver of future economic growth.
For this, a major reduction in the burden of direct taxes, principally income, corporate, and property-related - taxes must be urgently undertaken.
In addressing this issue, it is not only the tax rate that is important, but also the slabs at which the taxes kick in. At present, these are too low, and must be raised significantly. This will most benefit the common man.
It is possible that there may be some initial loss of revenue, but the experience of those countries that have lowered the tax burden suggests that the loss is temporary.
As the positive growth effects manifest themselves, the revenues also rise. A less punitive tax structure tends to enlarge the tax net, increase revenue, and ensure better tax compliance.
Prime Minister Modi has shown boldness in respect of the currency reform; it is time to show similar boldness in terms of matching tax reform.