demonetization, digitalization, and the windfall

The demonetization
The government announced on 8 Nov that by midnight of the day high value notes of Rs.500 and Rs.1000 would no longer be legal tender. It also noted that all cash holdings should be deposited into the bank account of the owner of cash by 30 Dec 2016. 

Well, the responses thereafter have been mixed; some in favor, and some opposing. That is obvious in a democracy. And that the news media is busy tackling the matter in a way that suits their ratings and increases advertisement revenues is another matter. That is obvious too because they are running a business, not public service; never mind the moral grounds, have they ever? As mentioned, that's another matter.

India is a country where most of the transactions take place in cash; it could be as much as 70-90% as pointed out by some sources. Therefore, cash is an essential commodity for the most. The digital currency has been picking up only recently. The idea is to move towards a cashless economy, where most (and all high value) transactions are carried out in an electronic form: net banking; debit cards; credit cards; and other e-platforms. This is good for the long term. 

How about the short term? There are consequences of course, especially for the poor, and emergency situations. And discussions about this galore. The purpose of this post is to check what is in place for the cash that is hoarded in India. 

Cash is held by the businesses, in the normal course, which is scheduled for depositing the next day; cash is held by the working individuals, in good faith, to carry out their daily affairs; cash is also held by housewives as part of their routine savings. These are all, may be, after-tax rupees. Besides, cash is also hoarded by these businesses and individuals as evasion of taxes; black money. 

The action
All genuine cash holders might takeout cash, and deposit in their bank accounts as authorized by the government. If the tax officials find any mismatch between the cash deposited and income tax returns filed in prior years, there could be tax and penalty levy. Despite this, genuine cash holders would be better off by declaration and deposits. 

However, the guilty would have to think before any action. They have a few options:

Option 1: Declare the black money, and deposit in bank accounts. Be open to scrutiny, and pay taxes and penalty. This could open up their box of...; be prepared for that.

Option 2: Do not declare, which is to say that take the cash and burn it. Let the smog be; let this be their festival of firecrackers without noise pollution. The loss is equal to the value of cash burnt. Move forward with life. 

There is another option for them: Donate the cash (without expecting anything in return) to as many poor as possible, with each poor person getting a very small value in cash, which can be deposited in that person's bank account for use. This will yield the cash hoarders good wishes from the poor. This option is not as ethical as option 1; yet.

The consequence
Nevertheless, it would be interesting to find out how the whole thing is actually going to play out. Here's the RBI's balance sheet as of June 2016; it had Rs.17,077 b of currency notes issued. 

We also note from its annual report that the RBI had Rs.16,415 b of currency notes in circulation as of March 2016.

How much is the black money held in cash? Let's take Rs.17,000 b as the value of notes. Of this say, Rs.15,000 b is from high value notes of Rs.500 and Rs.1000, which have ceased to be legal tender. Now, it is anyone's guess that how much of this Rs.15 t is held in the form of black money. For the sake of arithmetic, 25% comes to Rs.3,750 b. Too high? assume 10%; too low? assume 40%. The fact is that we do not know yet.

The windfall: Any cash that is not deposited in the bank account will become worthless. When it becomes worthless, the RBI will have that much lesser obligation to honor. People have been speculating about this proportion of lower liability, and about the likely use of that windfall: It could stay with the RBI as part of its reserves, which means lesser currency in circulation; is that lower inflation? It could be used to issue additional currency notes of equivalent value without impacting inflation. It could be paid out to the government as dividends. It could be used as a special equity boost to the public sector banks. It could be used to extinguish the government debt. It could be...blah blah blah...

The fact is that we do not know: 1) The size of cash that will be trashed; 2) The likely action by the RBI - to print new currency of the equivalent value, or to not to print at all; and 3) The likely use of the windfall.

As a consequence, though, at least some part of that parallel (black) economy will be gone. In the short term, these informal small businesses and real estate operators will be hurt, and will be forced to either close their operations or become part of the formal (after-tax) economy. In the long run, the share of the formal economy is likely to increase resulting in higher GDP. 

However, the value of black money is much larger in the form of gold and real estate as compared to cash holdings. Hoarded gold and unaccounted real estate are much difficult to crack. That said, going forward, even these transactions will be difficult to deal with before-tax cash. 

The idea of a digital economy is tempting. Let's wait and see how it will play out.