Over the
long weekend, I had planned to escape the toxic air of Delhi and flee to the
tranquil hills of Uttarakhand to breathe some fresh air, but had to drop the
plan abruptly for want of cash. For the same reason, we have not been able to
buy any fish, fruits, vegetables or medicines ever since Rs 500 and Rs 1000
notes were withdrawn, and have been forced to survive only on roti and dal of
which we had a stock. Given the unending queues at the bank, the plight is
likely to continue for some time.

Reforms
are always painful, and the pain is necessary to cleanse the body politic of
virus. But considering its significance and potential benefits, this step was
indeed a masterstroke. In a swift move, the Government has eliminated most of
the black money currently circulating in the economy, even though the growth in
some sectors may suffer in the short term, bringing down the GDP during the
current fiscal.

The
measures were not unexpected though, they are the logical culmination of a
series of relentless steps the Government had taken over the last two years
against black money — Jan-Dhan Yojna and opening of bank accounts for everyone,
renegotiating the tax treaties and automatic information exchange agreements
with other countries and tax havens, the Black Money Act, 2015 and Benami
Property Act, 2016, nudging people to declare their undisclosed income through
the Income Declaration Scheme, and some other measures. The demonetisation was
only to be expected as the next logical step.

Black
money is not necessarily generated through corruption, neither is all the black
income necessarily cash income. Many normal business transactions legitimately
generate large volumes of cash — for example, textiles, jewellery, luxury
goods, household appliances etc. Professionals like doctors and lawyers also
trade mainly in cash. Demonetisation may disrupt such businesses by curtailing
consumer spending on these goods and this can result in their negative growth
for some time. While businesses and people dealing with legitimate cash have
nothing to fear, the ban on higher denomination notes is sure to hit those who
are holding large amounts of black money in cash. Much of the black cash may
never surface at all. We, the common man, will only suffer temporary
inconvenience, but no financial loss or harassment by the tax authorities.

The
total amount of black money currently circulating in the economy is anybody’s
guess. The size of India’s black economy had expanded rapidly over the 1970s
and 1980s, but since then has been contracting slowly. A recent study estimated
the rate at 20 per cent of GDP or about Rs 30 lakh crore. The bulk of this
black money is believed to be locked up in physical assets such as real estate
and gold. The withdrawal of higher denomination notes will severely impact the
real estate sector, especially the secondary market transactions where 60:40
ratio is believed to be the norm between legal and black money.

India’s
economy remains overwhelmingly a cash-driven economy. In 2015, 78 per cent of
all consumer payments in India were made in cash, against the 20 per cent to 25
per cent norm in developed economies. The total value of currency in
circulation today amounts to Rs 17 lakh crore, and 86 per cent of that cash,
amounting to Rs14.6 lakh crore, are only in Rs 500 and Rs 1000 denomination
notes. While the total number of bank notes in circulation rose by 40 per cent
between 2011 and 2016, the circulation of Rs 500 notes rose by 76 per cent, and
that of Rs1,000 notes by a whopping 109 per cent, during this period.

The most
corrupt who are have the largest stocks of illegal cash will obviously suffer,
because they cannot easily deposit the money that would be under surveillance
and the risk of going to jail. So this money does not surface at all, and as
pointed out by experts, since the notes are a liability on the account of RBI
even though the liability may be notional, the liability of the RBI and the
Government on this account is automatically reduced. The rest of the
illegitimate cash will get sucked out of the black money market to enter the
normal financial system, where they will contribute to tax along with a 200 per
cent penalty.

Given
the estimated size of India’s shadow economy of Rs 30 lakh crore, Rs 7 lakh
crore, or 50 per cent of the total value of Rs 500 and Rs1000 denomination
notes, might be a conservative estimate of the black money lying in cash. Even
if 10 per cent of this is destroyed, the rest will enter the banking system,
where, along with penalty, they are likely to contribute between Rs 4 and Rs 5
lakh crore as tax to the Government coffer, which almost wipes out our entire
fiscal deficit. In one deft stroke, the Government has ensured an almost
deficit-free year, and hence obviating the need for fresh borrowing. It can use
the excess liquidity to significantly increase the investment in income-
generating capital assets, and also in human capital, both adding to future
growth.

Let us
consider the cascading effect. As the black money gets sucked out of the
market, several sectors like real estate will be forced to correct their
current prices, leading to a fall in inflation. All the money that will now
enter the formal financial system will continue their contribution to future
taxes, as their tracking by tax departments will become easier. As inflation
falls and taxes increase, the government finances will improve. If the
Government uses this increased liquidity judiciously and does not squander it
in useless populist schemes, the fundamentals of the economy will get stronger,
and accelerated GDP growth will more than make up for the temporary loss we are
likely to witness in the short term. As inflation drops and liquidity improves
phenomenally, interest rates will certainly drop giving a significant boost to
the economy, more than what the RBI can ever hope to do through manipulation of
its policy rates. There will of course be a transfer of investment from
physical assets like real estate and gold to financial assets as people will
shift their investment preference — to dollars or equity where they can still
save taxes. Coupled with lower interest rates, this will in turn boost the
corporate sector, hopefully creating the badly-needed jobs. The excess
liquidity with the bank will also help them manage their NPAs to some extent.

The
black money market will of course spring up again, it definitely will, and high
denomination cash will continue to be used as conduits for corruption and
hoarding of black money. But there are two aspects to it. The first is
psychological — people who have lost money now will think twice before
hoarding cash. This psychological aspect can be a very important determinant of
behaviour. The second is based on pure economic logic. The accumulation of
black money can reach dangerous levels only over a period of time, and is triggered
by retrograde economic relationships established through political machinations
— retrograde because they hinder the normal operations of market forces. Left
to itself, the invisible hand of the market has a way of wiping out anything
that affects its normal operation.

The
current build-up of black money can perhaps be traced to those days when the
marginal tax rates were as high as 97% and there were various other distortions
arising from the faulty command and control economic model that we followed.
The Janata Party’s 1978 demonetisation of Rs 1000, Rs 5000 and Rs 10000 notes
did not help because in those days, these notes constituted only a tiny
fraction, about 1.6 per cent of the total value of currency; even in 2001,
their value was only 25 per cent, against 86 per cent at present. Besides, the
tax system today is much simpler, rational and taxpayer-friendly; it is poised
to become simpler still in future, thus creating an in-built disincentive
against black money. Governments today can also be expected to display more
maturity and not to interfere in the market unnecessarily. When the cost of tax
compliance becomes lower than the cost of tax evasion, generation of black
money becomes uneconomical. Thus in future it may take much longer to build up
the stock black money to a level where it will start distorting the normal
economic processes.

The Rs
2000 notes may also be demonetised in the not-too-distant future, scooping up
whatever will be left of the black money currently in the system, and Rs 1000
notes reintroduced. But as of now, this step is truly a ‘surgical strike’
against black money that may change our growth trajectory for the next decade.

The
writer is a commentator. The opinions expressed are personal.