Demonetization: Impact on Informal Sector

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On November 8, 2016, the government announced a historic measure by demonetizing Rs 500 and Rs 1000 notes by which 86% of the cash in circulation became invalid. The situation was further aggravated by putting caps on the deposits as well as restrictions imposed on cash withdrawals. The objective was to break the functioning of a parallel economy; stop the circulation of counterfeit notes and usage of high denomination notes for terror financing activities; and especially to unearth the “black money” that has not been declared to the tax authorities.

The ongoing public debate on demonetization has raised several questions related to the need of the initiative; its economic impact in the short and medium run on the informal economy and has the so called “big bang policy reform” the potential to live up to its expectation; was this initiative actually a good policy decision which is marred by poor implementation? There are also questions being raised about operational challenges and financial expenditure in printing new currency, recalibrating ATMs, replenishing cash in remote areas, etc, that have accentuated the costs of the decision.

Starting with the rationale behind the measure is the presumption that there is large accumulation of wealth kept in the form of cash in the economy and people, who have accumulated this ill-wealth, use this cash to amass even more wealth through the black or parallel economy in an ever-growing spiral. However, this assumption is only partially true as most of the accumulated black money is kept in the form of land, buildings, gold or invested abroad. What is in cash constitutes only 4% of the total amount of black money on which taxes are not being paid.

While there are certain illegal activities like smuggling, circulation of fake currency and drug peddling etc. that use black money on recurring basis to run their activities, but they collectively account for a very small fraction of “black money”. The actual amount of black money comes primarily from corruption and tax evasion. However, this money is further reinvested by the holders for future consumption and the so called black money circulates in the economy through most of the legal transactions. The illegality is basically limited to the income from these investments on which tax is evaded.

If we analyze the cost of the said drive on to the informal sector of the economy where all this cash is used in India and which accounts for about 45% of gross domestic product (GDP) and nearly 80% of employment[1], disruption of this liquidity for virtually all transactions within the informal sector can be very costly both in terms of growth and employment generation. Informal firms are an important supplier of inputs to formal firms. Employment and output in the organized sector are greater in those states in India that have a greater presence of unorganized suppliers of inputs. Therefore with the inability of the informal sector to provide inputs to the organized sector, the industrial growth is expected to slow down to 4% in Q3FY17, down from 8.6% for Q3FY16[2].

Moreover, some of this cash is held by millions of the poor as savings and for meeting contingencies for which they are essentially dependent on cash. Since about 14.5 crore people in India are mostly working on a daily wage for non-contractual employment, their livelihood is being hurt. There are many reports about manufacturing establishments and construction sites temporarily shutting down due to shortage of cash for daily disbursal. Further, rural economy is badly hurt due to non availability of cash for sowing and other purchases. More so, the so called notion of cash less and digital economy has also disrupted legitimate economic activity with the fact that there are about 1.5 crore shops, but only 15.1 lakh point of sale devices that can handle credit or debit cards[3].

Questions are being raised about the need and soundness of the policy irrespective of its actual implementation. If we dive deep into the statistics, it is estimated that India’s shadow economy stood at around 20.7% of the official GDP with 15th rank as per a study by World Bank in the year 2010. It should also be noted that countries like Korea rank lower than India. This is much better than one would expect at India’s level of development. The World Bank Development Research Group on Poverty and Inequality and Europe and Central Asia Region Human Development Economics Unit in July 2010 estimated ‘Shadow Economies’ of 162 countries from 1999 to 2007. It reported that the weighted average size of the shadow economy (as a percentage of ‘official’ GDP) of these 162 countries in 2007 was 31 per cent as compared to 34 per cent in 1999. For India, these figures were 20.7 per cent and 23.2 per cent respectively, comparing favorably with the world average. So, while the black money problem is important, it is not as important as is often made out to be.

It is also estimated by a study conducted by the National Investigation Agency and the Indian Statistical Institute that the total percentage of fake currency in circulation is only about 2.3% if compared with the total value of currency in circulation. Also if we see India’s currency to GDP ratio, it appears to have responded to the growth of the economy. It began its upward trend in the late 1970s when growth increased, and then accelerated further during the growth boom of the 2000s. This ratio declined during the period of high inflation in the late 2000s and early 2010s but it rebounded after 2014-15 to 12 percent when inflation declined again[4]. Now as the currency to GDP ratio will take time to rebound, the growth will also take a hit by atleast one percentage point.

In totality, the grand decision of demonetization was not based on tackling the real nature of the problem that is corruption and tax evasion. To further substantiate the point, a Ministry of Finance White Paper published in 2012 showed that, for the years between 2006 and 2012, cash seized during searches and seizures ranged from 3.75% to 7.3% of total undisclosed income for those cases. This means that banning notes would make those with black money lose small portions of their unaccounted wealth, and not lead to any significant punishment.

The government chose a very expensive course before exhausting much less disruptive options. There are key operational constraints that government should have paid attention to include – the capacity and cost to print currency at about Rs 12,000 crore to Rs. 17,000 crore in printing new notes and additional logistics cost of exchanging the currency, the pace of ATM recalibration, the logistical limitations of high frequency replenishment of cash in remote areas, and the capacity of bank and postal offices. However, the critical constraint is turning out to be the capacity to print enough cash to demonetize the value of discontinued notes. Due to the printing constraint, even if the branches and ATMs function perfectly, the currency shortage constraint has crippled the banking sector. The other constraints despite financial inclusion drive is that crores of households are not banked, and many who have bank accounts do not have convenient and continuous access to banking establishments.

Finally, this drive has damaged and punished the entire informal sector for a long period and has done absolutely nothing to curb either corruption or tax evasion. As far as fake currency is concerned, this could have been done through gradual replacement of old currency with new currency. However, all these constraints were known well in advance, but were probably not given proper importance.

[1] Sen, Pronab (2016), “Demonetisation is a hollow move”, Op-ed: Mint

[2].http://www.business-standard.com/article/economy-policy/gdp-growth-to-slow-down-to-6-5-in-q3-icra-117022001077_1.html dated February 21, 2017

[3] Reserve Bank of India, Data on Bank-wise ATM/POS/Card Statistics for October 2016, accessed on February 21, 2017

[4] Economic Survey 2016-17, Demonetisation: To Deify or Demonize?, Ministry of Finance, Govt. of India.

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Rashmi Singh is an Associate Economist with PHD Chambers.