Friday, January 6, 2017

Where's the Dirt?

From an email conversation on demonetization with a reporter from the Calcutta Telegraph (Devadeep Purohit) December 28. His story ran January 1 here.

There are divergent views on when the impact of demonetization would be over. Are you looking at any timeline? 

Well, there are some obvious timelines:

Short-run: December 30. I predict that there will be no last-minute extensions for deposits, simply because an embarrassingly large fraction of the estimated Rs 16 tr outstanding appears to have come back, well over Rs 14 tr (and I am sure the number will be far higher as we get the updated figures). 

[Backdrop: The rupee is about 68 to the dollar, and Indian GDP is around Rs 130 tr.] 

It's embarrassing because I am sure the government did not want so much of the outstanding money to obediently come back! Either the share of black wealth held in cash is small, or people have been very efficient in using money mules of various kinds to launder their black money (presumably at a price, but not one that the government will pocket). The truth is probably in between.

Medium-run: the fiscal year ending 2017, where there are some more opportunities to bring in money; for instance, anyone can deposit via Pradhan Mantri Garib Kalyan Yojana and pay a 50% penalty tax (plus another 25% blocked off as a forced loan to GOI); supposedly no questions asked. Though I doubt that after this, people will ever believe that this government can honor commitments about no questions being asked. I'd be interested in seeing the numbers they can generate here, as the high conversions mentioned above suggest that most of the money has already come back.

So will there be no access at all to the black dividend? Apparently, there is a sizable amount of around Rs 7 tr which has been deposited by "large agents" (depositing Rs 200K or more per person). Maybe there is something there, but it is too soon to tell. Each case will have to be followed up. All I can say is that the Income Tax Office will have to do some serious work for a change, investigating these cases.

Longer-run: Up to now what we have seen is effectively a huge GOI-instigated withdrawal of currency, which the Indian public appears to have participated in with great efficiency, though also with great hardship and cost. It is unclear that anything substantial has been achieved in terms of accessing the black dividend, at least in the here and now, while there have been huge costs imposed on the poor, about which much has been written. But what about the longer-run? This takes me to your next question:

The Prime Minister has emphatically spoken about today’s pain for tomorrow’s gains while justifying demonetization. Do you think that demonetization can have positive spin-offs for the economy?

Possibly. If there are any gains to be had, it will come through the fear of using cash for large transactions, or rather the unwillingness to accept cash for large transactions, in the anticipation that the Government might pull off such a stunt again. For this we have to take something important into account. Everyone criticizing the demonetization is correct in stating that the percentage of black wealth held in cash is low (almost surely way less than 10%). But that is not true of individuals who are gearing up for a large transaction, such as buying real estate. There are important points at which the cash ratio shoots up. If there is a real distrust of cash then these spikes (which facilitate large transactions) will be discouraged, and that could be a positive for bringing more transactions under the legal umbrella.

But I also hasten to add that this potential gain comes at a corresponding cost. Everyone has already spoken about the short-run cost on the poor. But there is a long-run "trust cost": if he can dismantle the currency, what is he going to dismantle next? What new de-mons do I have to look out for when making a long-term investment in India? The fears that have been planted in the hearts of those seeking to make illegal transactions have also their reflection in legitimate fears among people and organizations who are seeking to carry out legal transactions.  It isn't just a question of today's pain versus tomorrow's gain.

And of course, on top of that, this naive comparison of pains and gains is problematic. Prime Minister Modi is not supposed to be passing judgment over a utilitarian calculation of costs and benefits, especially when the costs have been borne overwhelmingly by the poor.

A lot of estimates about the possible fall out of demonetisation on the GDP are doing the rounds. But some experts think that given the quality of data availability in our country, it is difficult to come up with such estimates and they even apprehend that the data might fail to capture the true impact. Your thoughts on this debate.

It's really not so much a question of data as of imperfect economic theory. We know the amounts circulating under R500 and R1000 notes pre-demonetization. We will have accurate figures of how much will come back by the end of the year, and we know that the replacement procedure has stumbled badly and can quantify that. With these three figures in hands we can calculate the net monetary shrinkage in 2016, and we can apply a simple quantity theory of money to make predictions for short-run GDP shrinkage. (Here's a serious, careful example.But we don't know how the informal sector will adapt, or has adapted, to the whole thing; how much that sector has gone "informally cashless" and has managed to facilitate transactions anyway. 

Believing as I do in the inexhaustible creativity of the Indian financial mind, I would not be surprised if there were some pretty clever adjustments to enable business as usual under a commonly perceived crisis. That would cushion the drop. So I am partly doubtful of back-of-the-envelope predictions, not because the macro data is bad but because we simply don't know how people can adapt. (That said, it's better to have these around as simple benchmarks than have nothing at all.)