27 January 2017 | By Siddhartha Thyagarajan Insight

India: demonetisation

Insight: Siddhartha Thyagarajan, CBI India policy adviser

While the economic reasons for India’s demonetisation are compelling, digitising a cash-based, informal economy in a country where rural electrification is incomplete and data protection law is lagging behind could backfire. CBI India policy adviser Siddhartha Thyagarajan outlines the pros and cons

Advantages of demonetisation

It will boost banks and the wider economy

Banks have been weighed down by non-performing assets (NPAs – loans that are not being repaid). Gross NPAs for India’s public sector banks alone stand at INR 5.8 trillion (£69bn). Demonetisation has allowed banks to restructure their debt portfolios and lower interest rates, thereby increasing their capacity to grant more loans for new business ventures.

India’s tax to GDP ratio during 2016 fluctuated between 16.6 and 17.7 per cent. This is significantly lower than the average for other emerging market economies (21 per cent) and OECD (Organisation for Economic Co-operation and Development) countries (34 per cent). India's overall tax to GDP is 5.4 percentage points less than that of comparable countries. It is expected that demonetisation will boost the tax to GDP ratio, by creating greater transparency and by expanding the tax base significantly, boosting capacity for public spending.

Digital transactions are transparent

The digitisation of currency bodes well for the economy as money can then be more easily accounted for. The move has been supported by multilateral agencies which suggest that digitisation is the way forward for modern currency transactions. The digital economy has been one of the biggest beneficiaries of demonetisation. E-wallet companies such as Paytm (owned by China’s Alibaba Group) have registered huge increases in online traffic since the move was announced. In the last week of December the government launched its own mobile payment application Bharat Interface for Money (BHIM).

A curb on cash is a curb on crime

Reports claim that the ‘black’ economy is responsible for nearly 20 per cent of India’s total GDP, amounting to INR 125.25 trillion (£1.46 trillion). Government agencies say that fake notes worth around INR 700 million (£8m) find their way into the economy every year. A large part of this is attributed to counterfeit currency notes that reportedly enter the country through borders.


Disadvantages of demonetisation

India is a cash economy

Around 22 per cent of India’s INR 153 trillion (£1.80 trillion) economy is cash, compared to 8.6 per cent of the US economy and 12.7 per cent of China’s. Small businesses, a large chunk of India’s rural and agrarian economy, depend on cash for daily transactions, as do daily wage earners. It’s estimated that 48 per cent of India’s 1.3 billion-strong population are paid in cash. More than 80 per cent of these people work informally, generating more than 40 per cent of total output. This means that private consumption and small-scale industries have been severely hit by the cash crunch in the economy. In the first 34 days since demonetisation, small-scale industries cut 35 per cent of their workforce and saw a 50 per cent decrease in revenues, according to the All India Manufacturers’ Organisation.

There is no guarantee against ‘black’ cash returning

While banning old currency notes was meant to deal a body blow to the black economy, it does not act as a guarantee against money that is unaccounted for returning in new currency or in other forms. Post-demonetisation, India collected nearly INR 3.93 billion (£46m) in income tax raids, of which INR 860 million (£10m) was in new notes. Sophisticated launderers have already used offshore accounts, investments in property and investments in gold, making it important for the government to create a wider safety net.

Lack of data privacy laws make digital wallets risky

India has seen a phenomenal post-demonetisation rise in the popularity of digital wallets. But e-wallets make users vulnerable to hackers. India does not have  comprehensive data protection legislation. Rural electrification and internet penetration is also not complete. Unless these issues are addressed, digitisation of the Indian economy may remain an aspiration.

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