The final word

The Reserve Bank of India (RBI)’s Annual Report, released on Wednesday, provides, in some sense, the final word on the government’s demonetisation exercise, which began on November 8, 2016. Multiple reasons were given for the decision to withdraw 86 per cent of India’s currency stock overnight — including the destruction of stocks of black money hoarded in cash, the possibility of windfall gains, the digitalisation of India’s payments architecture, and the moving of savings to financial assets. The RBI now says that 99.3 per cent of demonetised currency notes were exchanged at banks in the months following the announcement by Prime Minister Narendra Modi. The RBI is to be complimented for being extra careful in its release of the final numbers, however embarrassing they may turn out to be politically for the current administration. Finance Minister Arun Jaitley made a valid point on Thursday that demonetisation led to formalisation of economy and more tax collections. But from a broad policy perspective, it is now abundantly clear that the aims of demonetisation do not seem to have been met. 

The most optimistic view depended on two assumptions: First, that there were substantial stocks of money hidden from the tax authorities that were held in cash; and second, that this would not be returned, or returned at a higher tax rate. If returned at a higher tax rate, the government would receive the taxes; if not, it would count as a windfall gain on the RBI’s balance sheet, which it could then transfer to the government. The return of 99.3 per cent of the demonetised notes has blown a hole in this assessment. Other possible gains also seem to have dissipated. For example, there is no sign that counterfeiters have been unable to adapt to the new notes issued. Also, since the Rs 500 and Rs 1,000 notes were replaced by Rs 2,000 notes, it is not clear why the ability to conduct high-value transactions in cash — or store large sums in cash — has been significantly impaired by the act of demonetisation alone.

What is unfortunate, however, is that the act of demonetisation appears to have had a problematic effect on the pattern of household savings. The RBI’s data on household savings over the past years makes this quite clear. While household savings, which includes the savings of small unregistered enterprises that were hit hard by demonetisation, is at a multi-year high of over 11 per cent of gross national disposable income, its composition will give analysts pause. In fact, households are holding far more of their savings in cash than they did in the year just prior to demonetisation, 2015-16. While the proportion in stocks may be higher — a reflection perhaps of the buoyant stock markets — the proportion in bank deposits has seen a sharp decline. In other words, the attempt to financialise savings has, in fact, been set back. In any case, the ratio of cash to gross domestic product has reached levels comparable to the period before demonetisation. It appears that whatever behavioural changes demonetisation brought were not in line with the government’s expectation. It is to be hoped that the appropriate lessons will be learned for the drafting of future policy, and errors such as demonetisation, which clearly dented India’s growth story, will henceforth be avoided.

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