Indian Prime Minister Modi is never short of surprises. He recently gave one to the Indian public by recalling existing high denomination currency notes of 500 and 1000. The recall itself would not be surprising, had it not been carried out through the sudden cancellation of currency notes in circulation, which have ceased as legal tender and will only be exchanged at designated banks and post offices with new and different currency notes. The exercise will also include tax audits and scrutinising bug amounts, though that will take an enormous amount of energy and hassle. There have also been indications that new currency notes of 500 and 2000 will be introduced in the near future.
The move has caused frenzy, urgency and excitement, not all of that positive. Social media has termed it as Modi’s surgical strike on his own nation. A former Chief Minister of UP Mayawati has termed it an economic emergency with reference to political emergency imposed by Indra Gandhi in 1977. Long queues are seen outside banks and as expected, middlemen and touts have sprung up to fleece the pubic. At the same time, a sizable number of media and experts have hailed it as an innovative step to curb black money with future benefits for revenue generation and deterrence. The ripples have reached outside India though the reaction internationally has been more cautious and measured.
In Pakistan, a resolution has been moved in the Senate for withdrawing Rs 5000 currency note, the highest denomination note in circulation, following the Indian tactic. This proposed demonetisation will be different from the Indian move as the latter is essentially an exercise at a currency revamp and is a onetime measure. High circulation of currency is an indicator of inflationary pressures and at the same time means that the funds and loanable deposits at the disposal of banks will now be less. The currency revamp by India has more to do with an effort to integrate the black and informal economy though that will indirectly lead to more funds in the banking sector if the move is successful. The success of the move will be gauged by how much cash-deposit ratios and cash-GDP ratio fall as a result. The effect will also be reflected in changes in gold imports as well as real estate investments and from the figure of total value of high denomination currency in circulation. Though, it is close to impossible to determine the proportion of black money kept in the form of cash and mostly systematic black income is channelled in the form of gold and foreign currency as well as diverted to construction and real estate sector.
A large informal or black economy is a chronic issue with the economies of developing countries. A high proportion of informal economy means that government fiscal and monetary policy will remain ineffective and will neither give nor get signals for policy interventions. Revenue generation capacity will remain limited as most businesses will remain outside the tax net. A large informal sector also indicates the presence of dirty money; money from the proceeds of a crime. Currency plays crucial role in at least two of the three stages of money laundering i.e layering and placement. On the other hand, most of the policies aiming at documenting the economy end up being politically unpopular and administratively cumbersome. In Pakistan, the few documentation drives have always been non-starters from the very beginning.
Pakistan’s informal economy has been calculated at 73 to 91 percent of GDP by the Economists Kemal and Qasim at Pakistan Institute of Development Economics (PIDE), an estimate higher than earlier figures of 50-60 percent. The cash-deposit ratio also happens to be very high and further increased to recent imposition of tax on banking transactions which led to rise of cash-deposit ratio to above 30 %. How far a move like the one taken in India is effective in monetising the economy and mainstreaming the black money depends on seriousness of effort.
The answer mainly lies in how people form expectations as a result of such step. A lot depends on how sustainable and comprehensive the reforms are and how committed the government is. Demonetisation is just one step in the holistic reforms for documentation of the economy. In most developed countries, this happened gradually and over a long period of time. Certainty of policies and stability of macroeconomic indicators have been a hallmark of reforms which have been bolstered by strong independent institutions having the capacity to monitor transactions at every step of production and consumption.
The one-time measure like the one adopted in India can have short term advantages like sending a jolt to illegal businesses like hawala, expansion of tax base and expansion of bank sector. Whether that can have long term affects like rise in tax revenues, more and cheap bank credit and sizable shrinking of laundered funds is still unclear given that in short run there will also be inflationary pressure as well as hardship for illiterate and low income groups. The level of resistance to the move will also be an indicator of its effect. A low or nominal resistance will mean that the informal economy has adjusted it without much consequence and the move is expected to be yet another example of political gimmickry.
The writer is a member of Police Service of Pakistan and was Senior Superintendent of Police in Peshawar.