Data trickles in ...

Four weeks in to the demonetized world, we are still scrambling for data. With every passing day, one thing is becoming clearer - the replacement currency will not be exactly equal to the 15 lakh crore withdrawn currency. The talks and press releases are emphasizing on B2B and B2C transactions going online, and unless there is a major upheaval at grass roots; India will learn to live with fewer currency notes.

The amounts deposited have been higher than expectations, and half way in to the available time, more than half of currency notes have been deposited. Therefore, the brown scenario is now unlikely and we'll see nearly 100% of currency notes deposited. What this means is that individuals holding the currency notes have deposited it themselves, or laundered away and got 100s or 2000s.

An easy supply of 2000s and other currency notes would have made it easier for people to launder away the old notes. So, the current shortages faced by citizens were in a way necessary to limit the laundering as far as possible.

How are people managing without the cash? There have been reports of drop in trade, and in some cases drop in production (including production of services). In no reports, this drop is more than 40%. This is a good news, considering the fact that drop in currency is almost 75%. Thus, the pain in the system is not as high as the shortage in cash. It tells us that a large chunk of money was not getting used (except maybe during elections). It also tells us that people have learnt to live without currency notes - through use of credit or through use of other payment systems.

Latest data from RBI about electronic payment systems shows that there is a 40% jump in electronic payments compared to November 2015. Complete data is awaited, but in my judgment, this estimate should hold good even when we get the entire data. This jump was 26% in May 2016 and 27% in September 2016. It would be safe to assume that an additional 10% business has moved online. This figure is approximately 10% of GDP and approximately 100% the currency that was withdrawn (net of new issue). Available data shows that RTGS / NEFT transactions explain most of the jump, and a low increase in transactions using credit / debit cards or using prepaid instruments. One of the reasons behind this could be that the data for credit / debit cards and prepaid instruments is yet to arrive from several financial institutions.

If one had to judge the situation on the basis of available data, one could say that significant number of previously cash transactions have moved to white payments. Assuming everything else stayed the same, one can see about 10% annualized GDP growth for the month of November, especially if some of the panic transactions that have taken place showing a back-dated invoice (illegally). The story for December could turn out to be a little different, as businesses find new substitutes to cash and when there won't be any back-dated transactions. 

I still don't know whether this is going to affect either the stock or flow of black money. The movement to clean society is also dependent on moral stand taken by people and businesses; and the responsiveness and compliance by the state machinery - for instance the income tax department. Till such time, we have no choice but to face the "inconveniences". 

Only time will tell whether the cash crunch will continue in to January and force more people to move to white transactions. Indications from RBI about new 20 and 50 Rs notes imply that they are in no mood to increase the currency in circulation back to 8th November 2016 levels. Thus, I stand by my forecast of 10% GDP growth (official figures) within 1-2 quarters, until 15th December when we see the advance tax figures.

Indian Time Machine

Indians are short of time. Always impatient! You can easily spot an Indian guy in any queue at a foreign location, without looking at passports. He's fidgety! I think its a necessary side effect of raw processing power. Civility in western cultures has killed this restlessness in its people.

The smart Indian guy won't change himself, so he desperately wants the world around him to run a bit faster. At least when he's waiting for something. The smart guy has also found something which helps him achieve it - a time machine ! It has got a circular console with one useful button and a few decorative buttons.

He's totally sold to the idea that the time machine works. So, he uses it all the times when he wants others to move faster. That's during milliseconds after traffic light turns green, seconds after discovering that a vehicle ahead is stuck, or within a minute of waiting for a co-passenger to arrive. The machine is so simple that even an illiterate or a 2 year old can operate it!

Hope the bubble of belief is burst soon !

Whither pain?

As I said on Facebook, I'm secretly in love with Modi.. My jaws can be found dropped for the duration of his well prepared speeches. It happened 3-4 times since 2010. So, like any confused lover, since 15th August 2014, I keep myself away from him, so that I can concentrate on work and life. Hope my rationality prevails <<blush>> <<blush>>.

Its been sufficient time since the announcement, and we seem to have reached a temporary equilibrium. Data is very hard to come by, and will continue to do so till permanent equilibrium comes in another month or two. I'm eagerly awaiting RBI figures on supply of M3 money after the disruption. The latest weekly statistics are still reporting data from October 28th. Apart from these, one should keep an eye on advance tax numbers on 15th December and currency situation in field around beginning of month, when a lot of people transact in cash. In the mean time, let us see where the pain lies.

I wanted to start with GDP numbers floating around, but I'll save it for the end. Let us first discuss qualitatively what losses the economy is bearing.

Productivity - Since much of my network is salaried, one thing people have been talking about is the man-hours lost in queues outside banks and ATMs. Many of them are using personal time, and some smartypants are using work time. In both cases, the client billing is still on and office work or shop floor work hasn't suffered much. Then comes the countless hours spent on discussing the move. Even that hasn't impacted real productivity. If this wasn't there, people would have discussed Deepika Padukone! In fact such topics bring a wave of energy in organizations, as everyone turns an economic advisor.

While absenteeism of regular employees has an upper limit that is planned in annual plans, the absenteeism of casual labour or contract employees affects the plans, when there is a shortage. In other words, the contract workers do not take the ownership of work for the period on which they are not on premises, whereas regular employees are held responsible for work even in absence. Now, wherever the shortage was so high that production was suspended, one can say that we lost out! For instance, there are daily wage workers in construction sector, who prefer to be money mules rather than "backbreaking work". Some persons I know are claiming demand side issues, where factories are unable to pay to laborers in cash and therefore not hiring them. In many units the regular economic activity has come to a grinding halt. Loss of production to the principal, yes. Loss of productivity of labour, probably not (because there is already a market for such labour. In fact I'm not seeing daily wage earners in their regular spot of hire lately.).

Supply Chain - Barring the temporary shortage of salt earlier, there have not been any reports of unavailability of any goods or services. If the situation prevails for more than 2 months, then maybe we'll see telltale signs of shortages and rationing spreading to areas other than currency. As I write, reports of reduced movement at toll plaza and logistics hubs are emerging. Is it to avoid getting caught in transit or due to operational difficulties is not known. One can imagine that a trucker from Punjab may not want to pick up goods from Andhra Pradesh without some advance and deposit in Maharashtra on credit. Advance is usually smaller amount, and many transporters are likely to be stuck at destinations for want of cash payments. The party receiving goods is at a loss due to demurrage charges, economy is losing for want of right goods at right place and transporters should be unaffected.

Yet, if some reports are to be believed, then new bookings have slowed significantly. In cargo business, less than 500 kms trips are managed by local players and beyond that by national players who usually do a multi-city long haul before returning to base. The local players shouldn't mind accepting credit as they're in the same city as one of the consignor or consignee. Long haul players deal with tariffs upwards of 10,000. For this ticket size, the payments can be made through cheques and other means. However, the crew may find it difficult to live with limited cash in hand. Usually, during such times, the truckers start their movement towards base. We could see a disproportionate number of empty hauls then. The situation is serious if it stays beyond 2 weeks. Toll data should be closely monitored by authorities. Supply of 2000 rupee notes could ease some pressure.

Agriculture - Contrary to media reports, I do not believe that sowing or harvesting would be affected much. On sowing front, private sector is known to offer credit (and many other perks); whereas public sector offers seeds at almost 75% subsidy. Besides, every seller knows that the shelf life of seeds is limited, so offering credit is the best way to tide over the currency shortage. Similar argument can hold for other inputs - except labor. Hopefully farm labor would see अच्छे दिन now, on the back of a good monsoon and demonetization !

On harvesting front, there are problems (opportunities), particularly for perishable goods. A producer may want to sell, but the buyer (trader) may not have currency. So, they either buy on credit, or in white (Jan Dhan transfer). Farmer may not mind this, as farm income is largely tax free; but the trader would not want to get exposed. If there are any honest traders (and societies), then they may come forward at such times and be happy. I've seen honest manufacturers sharing this sentiment, but haven't come across an honest trader till date :-|

Transactions - That brings us to the most crucial element in any economy and this exercise. Wholesale and retail trade has reduced in all places, and in some places there is no trade. A quantitative discussion comes up in the penultimate paragraph, but here, I want to check what are the real barriers to trade. Currency cannot be the only reason, because most business is on credit, except for very small value purchases and for walk-in customers. It could be either the fear of getting caught or lack of trust in counter-parties (we don't know who is going to get caught next, and our money may get stuck).

Other reason could be that traders (and other businessmen) always took such schemes with a pinch of salt. The community memory among traders is terrific! So, perhaps the community sees this as temporary phase that shall pass too. One core competence of a trader is to maintain deep pockets (not necessarily with own money), and then have resilience to tide over tough market conditions, such as new entrants, unfavourable pricing, regulations, etc. If traders adopt this approach, then volumes may fall drastically. Although that would show up in prices, and prices have not changed much - barring salt. It remains to be seen whether Modi can think ahead of the traders! Hopefully the government's focus areas like National Market for Agriculture are materializing soon, which could substitute the old generation traders along with organized players.

Overall economy:

So, there are estimates that GDP will shrink by 0.5% to 3.3%. Estimation of official GDP is done using three inputs - 1) MCA21 database for registered companies, 2) tax collection when (1) is not available, 3) effective labour input for unincorporated enterprise (such as a barber), where even (2) is not available. The third part, which probably contributes 25-30% to GDP doesn't measure GDP, but assumes that people working in certain sectors are producing certain GDP. Official estimates for the third part will not change in coming days at all. Among the remaining two, the first one - corporate GDP is calculated using income reported from MCA21, which is completely white in both parties - buyer and seller. A company doesn't report whenever any cash income is received, as it can be easily pocketed by individuals (promoters or others). Many companies prefer a distribution partner to take care of the black (cash) part of the business, and stay fully white themselves. Thus, neither corporate GDP nor GDP of unincorporated entities will not shrink due to inconvenience - unless there is a drop in demand for goods. Both these account for about half of GDP estimate.

Now, let us look at the other half, which is calculated using tax collection. It includes entities that are not Companies, such as restaurants, builders, professional services, shops, C&F agents, etc. It is widely expected by Indian and foreign media that demand would fall because of lower risk appetite, tendency to postpone purchases, and drying up of cash incomes (black) - which tends to be spent more than white. The second contributor is the inability to transact due to availability of currency notes. Both these are likely to stay for another month. Albeit, shortage of currency notes can be mitigated by transacting on credit; and postponed purchases will take place eventually.. these could be omitted to keep fewer variables in discussion. Being responsible for half of GDP, this component affects the overall GDP linearly or perhaps more - a 20% fall in this sector would reduce GDP by at least 10%. Further, a 20% fall for one month would reduce the annual GDP by 0.83%  Thus, for 1% shrinking to happen, the market demand should be lower by about 24% for next one month. If the demand generated by black money is indeed 24%, then I will be happy to take my words back and happy to see a lower growth rate in the short run. Reason for the happiness is that the 24% black transaction can be caught now! (Assuming we have a vigilant system that also has the capacity.) In my view from ivory towers of Banjara Hills, the demand has NOT fallen by 24%. It has indeed fallen in traditional cash only marketplaces - usually biggest market in a city. My good friends are emphatic about fall in their locality, and some are emphatic about no fall in demand or trade. My hunch is that for every 100 Rs loss in cash revenue, points of sale have seen a 50 Rs increase in non-cash (electronic) payments. Thus, the net white sales (tax collection) haven't fallen, barring sectors like real estate. Thus, the impact on true GDP from trade would be roughly 1/24th of the drop in trade numbers, and 1/48th if my hunch about electronic transition is right. If one looks at markets around us, then the B2C trade hasn't fallen by so much as to drop GDP by what analysts have forecast.

Even then, at a personal level, everyone is in pain, everyone is spending time in arranging money and energy on discussing money. Yet, a vast majority of my network is happy and ready to slog for the move. A very small fraction is the opposing intellectuals who do not have faith in our machinery. For me its anyway a sweet pain ;-), which can be understood only by those who have been in love !

Flow of old currency notes

Signs of a growing economy can be seen in the increasing M3 money supply. Accompanying graph shows the total deposits with the banking system in India. The number is about 6 times the currency in circulation, and growing rapidly quarter after quarter. The data is not perfect, as few banks and remote locations continue to operate on paper based ledgers and report selectively. One needs to provide for a possible deviation from the reported figures, but the trends are hard to miss. Latest release from RBI says that a net amount of about 4.1 trillion was deposited since the demonetization started, taking the total deposits from 100 trillion to 104 (brown thick line). This is very good news for the implementation. Going forward, there are two scenarios - 1) blue dotted line all the old bills are deposited, or 2) brown dotted line indicating the pace of deposits slows down in coming weeks and just about half of outstanding currency notes are deposited.

What is likely to happen to all the old currency notes? Let's look at the mechanics of demonetization from this perspective, and then see if it can do us any good. Broadly speaking, there are only four possibilities with the 22 billion or so currency notes that seized to be legal tender earlier this month. But before that, let us grasp who uses currency.

For convenience, I divide the Indian citizens in to five groups (the recommended number for market segmentation) - Jan Dhan Mazdoor, Salaried Middle Class, Businessman with reported income, Black Business (a.k.a. politics) including persons whose wealth originates from corruption, and lastly Farmers with one account in family. These groups are distinct when it comes to their financial reporting, otherwise they're just like you and me; someone in the family; a friend in college; a neighbour; etc. The financial differences are that Jan Dhan Mazdoor has nothing to report, Salaried Middle Class reports everything until he/she gets in to real estate, Businessman reports income when absolutely necessary, Black Business doesn't report and Farmer doesn't pay taxes even if he reports.

1) Deposit in Bank

Starting 10th November 2016, people and organizations, rich and poor, honest and evading, queued up to deposit old currency. Queues were even longer for exchanging the currency, for whatever reasons. Many still haven't done either of this yet! But most individuals will deposit the old currency by year-end. The press release for amount of deposit has just come from RBI, and the numbers are very encouraging!


If a person holding say 1 Crore in old currency decides to declare the wealth and deposit, then he will have to show a source of income. Most likely, it would be a previously unreported source of income through misrepresentation of facts. I'm not a tax expert, but if the source is not agriculture or gift, then there is a 200% penalty on tax. For average effective tax rate of about 23%, the depositor will end up paying 69 lakhs to government and keep 31 lakhs for future use. Not many will like their hard earned money to shrink so much!

There are reports of Jan Dhan Mazdoors and Salaried Middle Class getting offers to deposit cash on behalf of someone in business end of it. Nobody knows how many people fall for such offers. But barring that lot, its going to be honest people or neo-honests who will deposit. Real black cash is unlikely to be deposited. Nonetheless, one would see a lot of deposits - at least about 2 lakh crores (2 trillions) - that's 20 crore households depositing 10,000 each. A lot of it would be working capital used by businesses. Maybe 1% of this would be previously unreported income. So, government doesn't gain much in tax collection. The gains would be that a large fraction of this 2 lakh crores will now be used without withdrawing - through money transfers, debit cards, cheques and mobile platforms. Thus, with every deposited note, the likelihood of a white transaction happening goes up - not just during the period of currency shortages, but beyond. I like the prevailing currency shortage, as it is forcing people and businesses to use a more efficient way to transact!

2) Burn or Destroy

The real fun that the masses were waiting to see was rich people running from pillar to post with suitcases full of money. Germans have a term for this pleasure in someone else's plight - schadenfreude. Following video is doing rounds on WhatsApp proves that we are experiencing schadenfreude.

Its a natural and rational response for someone stuck with a lot of unreported money to find ways to come out of the situation. Reporting wealth and taking 69% hit may sound good on paper, but, for someone whose source of income exposes further black wealth (say real estate), it would be suicidal. Such a person may prefer to destroy currency notes rather than depositing or exchanging - officially or unofficially.

I expect anyone with benaami properties to take this route. My guesstimate is that nearly one-fourth of total currency in circulation will be destroyed. That's a whopping 3 lakh crores !

Isn't this a loss for the economy? If one treats entire economy of a country as a firm, we destroyed value of the economy by destroying an asset which could have generated future returns. Its like an industrial accident destroying a plant, and there is no insurance! One could have bought crude oil for next few months with this money. 

Well, yes and no! Continuing the analogy of firm, currency in circulation is like outstanding shares of a company. The more you issue, the less is its value - both domestically due to inflation, and internationally due to exchange rates. So, yes we may lose productive assets (currency) that could have given us future returns; but reduced money supply can also appreciate rupee. Alternately, RBI can increase the supply of M2 / M3 money - pushing down interest rates (already fallen by 0.36% ). Even in the absence of such benefits, I would still not mind people burning up cash (literally), looking at the moral side alone.

3) Convert to 100s or 2000s

A sane businessman with a lot of cash would neither like to burn it nor like to take 70% hit on it. The businessman would rather choose to convert it in to something else. 100s or 2000s; or something that's tradeable like gold. Surprisingly, I didn't find any rush around the jewelry shops situated along my daily commute - imagine the kind of expectations my wife could have!

In my view, its this hoarding of 100s is the real reason for any shortage. Evidence of this can be seen in an employee driven retail store, where cash counter is difficult to hide; versus a restaurant that is managed by family. Restaurants in my locality are offering 25% discount on the bill, if payment is made in 100s, whereas the retail store we frequent is flush with 100s till a supervisor comes to collect.

If whatever I said here is true, then it is disturbing, and completely under the radar of the government. The people with unaccounted 500s and 1000s will continue to hold currency notes, with 2000s and 100s. At the moment, informal sources tell me that 100s are available at 50% premium.

Even if the original owner of unaccounted currency doesn't deposit with a bank, someone else does. In the restaurant example, perhaps the owner will deposit old notes by showing it as part income and part working capital. The restaurant is likely to switch more and more upstream transactions to white, provided that's his main business.

4) Continue to transact

Private circulation of old notes may continue to take place beyond 30th December. Legality of all this is not clear yet. People do collect and preserve old currency notes for antique value. These get traded at a premium too.

Albeit, this will be a negligible fraction of total circulation.



So bottom line is that a majority of currency notes will get deposited, like they already have been. Some will get exchanged for goods illegally or other currency notes. Much of these would get deposited eventually, otherwise it has to be burnt. The third biggest portion would be the destroyed notes. The destroyed notes is the extent to which we manage to curb black money stock in currency. The blue pie describing the deposited currency is more likely to be spent on white economy, and as mentioned in earlier post could form another measure for success of the scheme. Going forward, it will be interesting to watch these indicators - some of them measured, some are not really measured by anyone!

The hope is that the Jan Dhan Mazdoor and Salaried Middle Class switch to whiter transactions. Regular businesses reduce their exposure to black transactions. As I write, many are forced to adopt electronic currency and reduce the exposure. The bubble of black business shrinks for want of willing partners.

After effects on economy

Earlier post contended that a logical conclusion of the demonetization move is expected to take the M1 money in circulation to about half - 8 trillion rupees. It is also likely to take some B2B and B2C transactions online, while the other transactions may become more efficient (more transactions with less working capital).

Considering the resilience of Indian economy, the GDP will be maintained overcoming the short term pain that is felt as I write - 1) productivity lost in queues, 2) lost transactions due to shortage of currency notes, 3) perverse transactions arising out of differential aversion to illegitimate currency. Following examples of perverse transactions came to my notice 3a) gold purchases at above market rates, 3b) payment of school fees in advance - up to 10 years in advance, 3c) exchanging a 1000 rupees note for 7-8 notes of 100 rupees, 3d) depositing cash in a dormant account for a fee.

None of this is likely to impact the true GDP, unless the currency situation goes totally out of control. I have confidence in Modi administration and RBI to step in at the right moment and make mid-course corrections. What is beyond their control is how much of economy will move to electronic payments (green circle) and how much of the demonetization will be absorbed by transaction efficiency (purple circle). One of the factors determining the size of these circles is the size of brown circle - amount of currency to be brought in (M1). This brown circle is the trade-off for Modi's fight against black money and smoothly running the economy. Success of the demonetization initiative could be measured as the relative sizes of green and purple.

Irrespective of whether the purple circle grows more or the green circle grows more, I'm assuming that the true GDP will be maintained, just to keep matters simple. By true GDP, I mean the perfectly calculated GDP by measuring actual product at every economic unit. This is different from the official estimates of GDP. One major difference arises from the presence of informal sector (a lot of it is black money). When a restaurant serves a customer, but does not pay taxes then it contributes to true GDP; but it does not get measured in official GDP. Similarly, a roadside (under the tree) barber serves a customer, it is in true GDP, but not in official GDP. The restaurant example is black money, but barber is not; because barber probably earns less than subsistence level.

With the demonetization move, there is going to be some trigger in consumption expenditure as spending is better than hoarding/depositing cash, and risking getting caught. Secondly, previous sources of black income will now be spent in formal economy - say buying an iPhone rather than a benaami property. Thirdly, a positive change in green circle will result in an increase in reported transactions - both black money and informal sector. Lastly, more people with white income will now switch to electronic payments, as acceptance for cards would improve and as experience of last week would have forced merchant establishments to accept cards rather than lose business. Thus, I see a significantly higher official GDP in coming days. In Q1 next fiscal (I sincerely think its going start in April and not Jan as speculated by WhatsApp forwards), we'll definitely see a double digit growth rate in official figures - riding on the back of a) GST, b) demonetization, c) 2016 monsoon and hopefully d) tax collection efficiency. This could even be seen as early as next quarter !

Thus, there are four possible events after the demonetization, depicted in figure below -

Why are the markets not rallying ? 1) The domestic investors are shit scared to think rationally. 2) FIIs are clueless about what is black money, and where does it link to. 3) Nearly every investor is exposed to real estate, which is likely to take a hit. In such times, risk aversion spills over to other sectors. 4) Spill over effect from small caps / real estate that have exposure to black economy.

After effects on black money flows

In this post, I attempt to understand the possible outcomes of the move. Its based on available public information, news and rumors as on date.

We know that there is substantially less currency in the system as compared to 8th November. Roughly, we have one fourth of total currency by value. Some transactions have moved to electronic platforms, which show a two-fold increase in transaction value. This increase does not compensate for the loss in currency transactions. Accompanying graphic shows that the cash in the economy has shrunk significantly, to a level comparable to the most cashless economies. At this level, if entire stock of 100 rupee bills is in circulation, then most of the low value transactions should continue to happen. Yet, there are reports of vegetable vendors and other small establishments; and common people facing difficulties in transacting. Reasons for shortage are many - panic hoarding of currency by people to take care of emergencies, mismanagement on part of administration, and conversion of black 500 / 1000 in to white 100s. Bottom line is that the volume of transactions are hit. This is the temporary hardship for 50 days that PM has talked about. In addition, many man-hours are lost in bank / ATM queues. This could also impact the productivity and spending. On the ground, a look at old market shops would tell you that volume of transactions are hit. But, we'll tide over this soon!

One short term solution is that credit is given by buyer or seller; and settlements made once currency flow eases. In some places old notes are getting used, in others chits and stamped papers. All are examples of trust based credit, backed by a paper.

What happens in the long run? At this time, it appears that the RBI will reduce the supply of currency notes and coins (M1 money), otherwise the entire exercise is meaningless. It would be like removing the cobwebs during diwali and leaving behind spiders. The spiders will form cobwebs again! My hunch is that we'll cross the grey circle by a big margin, and be somewhere at 50% of orange circle. If that happens, and say we have half of what our economy had on 8th November, we will be running the economy with 8 lakh crores cash give or take. For this amount of cash to reach the remotest parts of the country; 50 days are just enough. So I don't take reports such as this and this seriously.

The bigger question is would 8 lakh crores be sufficient? Will there be shortages of currency notes, the way we face shortages of coins? Will people use gold coins just like retailers used chocolates?? Other countries are running with far fewer currency notes (per unit GDP). Will we be able to do it without much inconvenience?

The answer lies in an elementary concept of economics known as velocity of money. In simple words, more transactions should take place for every currency note. A note bearing a certain serial number should change more hands on a given day, than it used to. There are markets in our country, in which dozens of transactions take place on a particular currency note in a given day. Rest of the economy should adopt that efficiency. Yet, nothing increases the velocity of money as good as switching to electronic payments.

Images of micro entrepreneurs using electronic payment
are doing rounds on WhatsApp

A report by World Economic Forum shows that only 20% of transactions are electronic (by value) in South Asia, whereas OECD countries have achieved over 60% electronic money. In my experience, most registered companies in organized sector use cheques or electronic payments for their reported transactions. Its the micro enterprises and informal sector that are slow to adopt financial institutions, or electronic payments. With options such as paytm, MobiKwik, PayUmoney, M-pesa, and Unified Payments Interface of NPCI; there going to be an explosion in electronic payments at small and micro establishments. The shortage of currency notes may provide a much needed tipping point. Even before the announcement of currency replacement, industry experts have pegged the growth rate in plastic money and mobile payments at high double digits (30-70%). If these are to be believed, then before next general elections in 2019, we may be seen using as few currency notes as OECD countries ! Thus, a higher penetration of electronic payments is expected to take place in both urban and rural marketplaces.

However, ease of transactions is not the real reason why Indian economy built up so much M1 money (currency). The biggest reason lies beyond the operational aspects. Any amount of cash is insufficient in India for a deeper reason. We the citizens are habituated for freebies, for evading taxes and for avoiding other forms of user charges.

For instance, the biggest concerns for anyone I talk to is about the civic amenities provided, and yet the tax collection rates in best of our civic bodies barely crosses 40%. This implies that 60% of properties are existing without fulfilling their share of promise (tax payments). I'm taking the civic body example because for property tax, it is possible to calculate the collection rate in the first place. The tax is usually on a stock quantity - number of households in a city; which is a verifiable tangible asset that can be observed at any point in time. Now let us extend the argument to areas where a collection rate is not possible to be calculated, because we don't have enough data. In my previous post, I mentioned that we don't have reliable estimate for size of black economy. The economy cannot be verified at any point like an immovable property. To assess a reliable tax base on transactions (sales tax, VAT, excise, etc.) or direct taxes; one needs to know the value of total flow. This requires 24/7 vigilance at all places by the government. This is impossible to achieve. So, we as citizens try to hide the transactions and income. We undertake anonymous transactions with cash. This is where we have the roots of black money - buyer wanting to hide identity, seller wanting to hide identity or both wanting to hide identity. A shrewd businessman can sell goods and receipts separately. There is a market for such things. Isn't it possible to buy medicines without receipt; and to buy a receipt without the medicines?

A possible side effect of reduced M1 money is that some buyers and some sellers will not be able to lay their hands on currency notes. Such people are in minority at the moment, even after demonetization. Only when there are a large number of such people would one see a palpable impact of the demonetization move. Whether such a shift to white transactions happens will depend on push and pull factors identified here.

Black Money 101

Just 72 hours ago, our flamboyant prime minister Narendra Modi announced the discontinuation of currency notes with denomination of 500 and 1000. The move is aimed at curbing the menace of counterfeit currency that funds terrorism. New notes with 500 and 2000 denomination, and a possible 1000 denomination will be substantially fewer in circulation. The emotions displayed in WhatsApp groups ranged from panic and fear to victory and jubilation. Many declared the war on black money to be finally over, with GPS enabled nano-chips working as the metaphorical last nail on the coffin !

It took me over 24 hours to overcome the effects of Modi's emotional appeal and think logically about where will this really take us. I am summarising my thoughts, starting with what is black money and then inspecting whether it will be curbed in the absence of a technology to track the currency notes through satellites.

Black money, corruption, bribe, parallel economy, shadow economy, unaccounted income, unorganized sector, hidden economy, etc. are some of the words often used interchangeably. Black money is the name we Indians have given to money not reported to tax authorities. It stays out of calculation of national income (GDP). Graphic shows the black money is generated from a black transaction - purchase of goods or services in black. It could happen because the buyer doesn't want receipt in his / her name, say in case of benaami properties. It could also happen when seller doesn't want to give a receipt - usually to avoid taxes. Bribe paid to an official is a subset of black money, as it involves a transaction in which the seller is providing a service illegally or without authorization. Bribe is a form of corruption in which cash is exchanged, whereas corruption is not limited to cash benefits for self. Corruption expands the benefits beyond cash to friends and family of the corrupt. Thus, both corruption and bribes are black transactions; but not the only source of black money.

Every economy in the world carries with it some unreported income, quite often used for criminal activities. Luckily, most of Indian black money is not used for drugs, prostitution and gang wars.. but that's hardly a solace. Estimates for most developed economies put the amount of black money at about 10-20% of the respective GDP. Some of the developing countries from south Asia, Africa and South America have estimated size of 25-75% of GDP. In India, the latest official estimate is 30 years old. About half a dozen studies prior to that put the extent of black money at less than 10% of GDP of respective years. More recent estimates by journalists and opinion leaders have put the size at almost 100% of the economy. If one believes the unofficial estimates, the production, sales, per capital income and consumption in the country are roughly two times the official figures. Truth perhaps lies somewhere in between.  

Economics tells us that marginal propensity to consume is always less than 1.0 In other words, generated income tends to get saved for future use. So no matter how lavishly one would like to live, someone earning black money would end up saving a part of it. There is a large market for it in India in the form of gold and real estate. Under current state of our record keeping and law enforcement, both gold and real estate provide ample opportunities for investing surplus black income with relative ease.

The problem statement for good governance, therefore, has three components - black money accumulated so far; black economy running at present; and stock of black money to be generated in future.

Let us begin by looking at the total accumulated black money since time immemorial. Reliable estimates are not available for this. Anecdotal evidence suggests that most of the wealth in India is black, barring perhaps the investment in to securities and bank savings. My belief is that the amount of black money is in multiples of GDP, but let us take the more conservative and published estimate of 1.0 times the GDP.

Accompanying graphic shows a comparison of amount of currency in circulation with the amount of GDP (which is also my conservative estimate of the amount of black wealth). Bulk of the black money is either in gold or in immovable properties. A large part of it is abroad, in fact according to one estimate nearly 1.0 times our GDP is stashed away in Swiss banks. A small fraction of black money is also kept as cash, we do not know exactly how much is stashed away in mattresses and other places, but it cannot be more than the total currency printed by RBI. This amount of currency in circulation is about 13% of our GDP, and some of the printed cash is getting used everyday - or was getting used till 8th November. So let's say about half of the printed cash was in circulation (which is how much other countries use) and the other half was being stored. By replacing the currency with new and improved bills, a fraction of the black wealth has been destroyed - unless the owners are smart enough to beat the system like they've done in the past. Being a large country, this fraction turns out to be huge - of the order of 8 lakh crores (8 trillion) INR. To put it into perspective, this is roughly half of all the taxes collected by the central government last year (including personal and corporate income taxes).

Would this be a deterrent to people accumulating black wealth? If we believe that the cash portion of black wealth was uniformly divided across all owners, then Tuesday's announcement was like a very bad week in the stock market. It wiped off 6% of total black wealth. Owners of black wealth are prepared to take much bigger shocks ! If we believe that the cash was unevenly distributed, depending on the nature of business, then picture changes just a little. Some businesses are efficient at conversion of black cash to other assets, and some are not. But eventually, most of the black money gets converted in to gold, real estate in India, or assets abroad. Only the inefficient owners would have ended up with liquid cash. They would have probably learnt a lesson and may change for good. The move could not have been a deterrent to efficient owners, who don't keep too much cash any way.

Thus, by and large, the fear of Tuesday night alone would not curb black money, corruption or bribes. I'm happy to see some fear, but the thick skinned have weathered this one quite well. In Hyderabad, the real estate lobby managed to get this out on front page today - https://goo.gl/S9Vbrz .. perhaps in a knee jerk reaction due to panic. I think businessmen in Gujarat, Mumbai, Kolkata and Delhi are doing far better keeping their heads cool.

Then, what are the other mechanisms that can curb the black economy running today and thereby reducing the generation of black money in future. Hopefully we should have an answer soon ! The motive with which government and RBI acted on 8th November was perhaps the fact that globally, poor and rich countries carry far less cash than us. We carry about 13% of GDP, whereas everybody else carries just 5%. But common citizens sometimes construe it as a raambaan ilaaj on corruption.

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Target audience for this piece is laymen (and women). Questions and comments are welcome to evolve our answer against black money !