Investigating the Effects of Demonetisation on the Size of the Underground Economy in India

“November 8, 2016, would be remembered as a watershed in the history of the Indian economy. The Government of India, under the leadership of Prime Minister Shri. Narendra Modi, announced the demonetisation of the Indian Rupee, immediately nullifying the INR 500 and INR 1000 cash notes—a single decision meant to destroy the underground economy—affecting each and every citizen of the nation, regardless of their occupation, status or wealth. Being an Indian, and witnessing the government’s sudden announcement of INR demonetisation and the uproar it caused in industries, businesses and households all across the country has highly motivated me to investigate why Prime Minister Modi thought demonetisation was the only answer to shrink the underground economy in the country.

The Indian Government used the demonetisation tool in 1946 and 1978 but both the times, it failed due to the dynamics of the economy. Since the day this policy was “surprise” implemented for the third time, it has garnered criticism from international media and policymakers who have labelled this major political action rather counterintuitive.

The Government of India released a statement saying this action will reap long-term benefits for the economy with the fourfold objectives of curbing corruption, counterfeiting the fake currency, stopping the use of high denomination notes for terrorist activities, and preventing the accumulation of black money generated through income not disclosed to the tax authorities.” However, there is not enough literature surrounding the effects—both successes and failures—of demonetisation.“This paper intends to examine the past case of demonetisation of the Euro in the European Union to determine the effectiveness of demonetisation as a tool to reduce the size of an underground economy.

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Major results and findings of this paper are drawn by conducting a panel regression analysis which revealed a statistically significant, positive correlation between demonetisation and growth in underground economy and the same type of correlation between demonetisation and exchange rate appreciation. Finally, these findings were applied in the context of India to observe the demonetisation of the Indian Rupee (INR).”

Understanding Demonetisation and the Underground Economy

“Demonetisation is the retraction of specific currency denominations in circulation and the subsequent replacement with new notes and coins.”“Initially, demonetisation was done by replacing the already existing currency with a new one, to decrease the large amount of cash circulating in the economy, and to regulate hyperinflation. However, over time, governments began to expand their objectives regarding demonetisation of their local currency in order to target the jeopardies of the underground economy, i.e. the corruption, black money, illegal activities and production of counterfeit notes.”

“The underground economy thrives on cash transactions, with around 95% of these transactions made in this “hidden”, non-traceable medium. Monitoring these cash transactions and in turn, promoting alternatives methods of payments results in a shrunken demand for cash and ultimately, shrinks the shadow economies. Hence, using demonetisation as a tool—replacing existing currency and making it inconvenient to obtain cash to lessen its prevalence and reliance—directly coaxes more individuals to transition into the formal banking sector that demands documentations and official proofs of transactions made at all times. Moreover, making certain denominations of currency illegal or obsolete in the market and nullifying their value will oust the black marketeers and place them under strict regulatory scrutiny. Illegal cash holders will need to formally reveal all the black money they possess in the process of exchanging their existing money for the new notes, thereby leading to formal documentation and destruction of this black money—decreasing its supply in the economy.”

“While demonetisation and increased regulations hinders the abilities of black marketeers to engage in underground activity, there can be ways like currency substitution that circumvent such type of enforced regulation. The theory behind this suggests that if the effects of demonetisation fall on the country’s exchange rate, motivated individuals go several steps further to substitute their local demonetised currency for other foreign forms of currency in overseas markets—a situation where illegal transactions increase but the circulating amount of cash in the economy remains unchanged. Furthermore, not all countries in the world formally monitor and document the transfer to new currency from the old during the execution of such policies; this renders the mission of destroying black markets difficult and impractical. This provokes us to think and question the overall effectiveness of demonetisation as a formal action to reduce underground activity.”“Although several economists and policymakers over time have investigated and explored factors that lead to the formations and expansion of underground economies, only a few studies delve into the successes of using demonetisation to reduce the size of informal economy, or the failures like currency substitution that were counterproductive.”

Case Study Introduction

“In 2002, the European Union (EU) announced the adoption of the Euro, replacing 19 other local currencies. During the smooth transition period of the new currency, strict documentation of the Euro outflow against the inflow of local currencies by the EU central banks was commanded which pressurised people to document the origins of the large amounts of demonetised local money they held. Member states had the time frame between January 1 to February 28 to comply and the maximum limit on the amount of cash that could be exchanged in a single transaction was left to vary across member states. While banks in Spain, Greece, Germany and Luxembourg allowed exchange of unlimited amounts at a fixed rate, other nations like Austria, Italy and Ireland had per person cash exchange “ceilings” of €635, €516 and €3633. As a result of these deposit and withdrawal monitoring mechanisms, black money notes sourced from illegal activity or tax evasion was retracted from circulation by the government, which in turn shrunk the size of underground economies in the region.”

“Despite the aforementioned successes of demonetisation as a contractionary tool, it can sometimes have opposite effects on the size of the informal economy due to the lack of formal monitoring systems during the transitionary phase, especially when the rate of issuing new currency does not match up to the rate of documentation of the existing, old demonetised currency in the market. In 1978, the Government of India implemented the High Denomination Bank Notes Act where notes for INR 1000, INR 5000 and INR 10000 were declared no longer legal tender. The government ambitiously expected to completely destroy the shadow economy which constituted of around 15% of the GDP at the time, however, instead of that desired effect, the shadow economy only grew in size by over 18% . In 2010, the estimated size of the underground economy in India was at 19% (Schneider et. al 2010) which by 2016 before the demonetisation, was pronounced at 46% of the GDP . Resulting from the creation of informal, undocumented and further propelled by the expansion of large-scale industries like textiles, construction and retail, this informal economy is mainly driven by cash transactions using high-value bank notes that promote tax evasion and illegal transactions. After the scraping of INR 500 and INR 1000 bank notes from circulation and the introduction of the newly created INR 500 and INR 2000 notes, the Modi government has illustrated the positive outcome of demonestisation as projected India’s expedient growth rate of 7% in the fourth quarter of 2016—attributing this increase in GDP to the dissolution of these bank notes that the underground economy thrives on.”Look at Charts 1 and 2.

“However, the reality of the state of this economy is not as simple as the rate of GDP growth—it is essential to calculate the costs and the overall impact of demonetisation as a tool on the economy. The amount of circulation cash that was nullified by the Modi government accounted for over 86%, affecting a large portion of the population, especially the lower- and the middle-class households that used the INR 500 and INR 1000 notes in their day-to-day transactions. The retail markets across the country have also been largely affected, for example, Hindustan Unilever Limited, a subsidiary of Unilever, saw its sales fall 2.1% within a month of demonetisation. The 50-day time frame to redeem and exchange notes at banks caused an outbreak of chaos and a cash crunch where millions of people were lined up at the banks, foreign exchange counters and empty ATMs for days together to have their chance to exchange their cash. Furthermore, with the scarcity of ATMs across the nation coupled with an estimated 600 unbanked people in India, the long-term benefits of demonetisation look slim. For any amount exceeding the limit of INR 250,000, the holders were questioned as to why they were holding cash in such large amounts—this type of scrutiny discourages black marketeers from cash hoarding, however, such stringent actions have hindered the smooth transition from a cash-based to a cashless economy, especially due to the shortage of new bank notes to supplement the old, nullified notes. In addition to that, economic growth can take a serious hit due to the speculation of currency depreciation and the resulting incentivised substitution of foreign currencies. With majority of the cash in circulation declared obsolete, investors will turn to stronger currencies in foreign markets.”

“The quantity of currency in circulation can seriously affect the demand for currency and exchange rates. Hence, understanding the relationship between demonetisation, the money supply and the exchange rates is crucial for testing Modi’s theory of the effectiveness of demonetisation.”

Methodology

“The size of the underground economy is significantly impacted by numerous independent variables like inflation, unemployment, income tax, interest rates, corruption and GDP growth. Consequently, in case of decreasing money supply, INR demonetisation should have a decreasing effect on the size of the underground economy.”

“The panel regression used in this research contains analysis of all Euro-19 countries of the European Monetary Union (Austria, Belgium, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovenia, Spain, Slovakia, Sweden, and the United Kingdom) over a period of 17 years, from 1998 to 2015. The main objective of this regression analysis is to examine the relationships between currency demand, the size of underground economy and the demonetisation after the “Euroisation” in 2002. The size of the underground economy is the dependent variable in this study, represented at the percentage of GDP . The list of independent variables includes GDP per capita, GDP per capita growth, inflation rate, unemployment rate, tax rates, long-term interest rates, and corruption ranking .”

“The behaviour of numerous entities can be observed across a timeframe using a panel regression since it also allows the control and modification of differences or unobservable variables across entities.”

In line with our objective to investigate any possible correlations between the size of the underground economy ad GDP, tax rates, unemployment, exchange rates and corruption; the equation for my panel regression is:

“Where under_econ represents the size of the underground economy, inflation represents the inflation rate as a percent of the GDP deflator, tax represents the tax on capital gains and income as a percent of GDP, intrate represents the long-term interest rates as a percent of GDP, unemp represents the rate of unemployment as a percent of the labor force, corrupt represents the ranking on the Corruption Perception Index scale from 1-9, gdppc represents GDP per capita in US Dollar figures, gdpgrowth represents the per capita growth rate, and a variable with an interactive dummy to account for the year that a specific country adopted the Euro (joined and eurojoin (dummy)).”

Computed Results and Analysis

“Table 2 illustrates the results of this panel regression—combining all independent variables with country and year fixed effects. Figure 1 indicates the trend of the changes in the size of the underground economies in each of the Euro-19 countries over the window of 1998-2015. While most of the countries show a similar downward trend, it is important to note the downward trend post 2002 (indicated by the red dotted line), the exact year the Euro was implemented. This could be a reflection of the demonetisation on the size of the underground economy.”

“A 1% increase in inflation leads to a 1.026% decrease in the size of the underground economy. This result is in line with my earlier predictions of a negative relationship, however, it contradicts the usual theory that increasing inflation leads to decreasing purchasing power which in turn encourages black marketeers to enter informal economies to minimise their costs (Asiedu and Stengos 2014).”

“A 1% increase in the income tax leads to a small 0.254% increase in the size of the underground economy. Consistent with my forecast—increasing taxes promotes tax evasion as citizens are more likely to find ways to avoid tax burden.”

“A 1% increase in the unemployment rate results in a 1.11% decrease in the size of the underground economy. Consistent with my forecast—increasing unemployment in an economy will result in individuals who will seek informal employment and income in the underground economy.”

“A 1 unit increase in the Corruption Perceptions Index ranking leads to a decrease of 51.44 units in the size of the underground economy. This correlation goes against my initial prediction of a positive relationship. Rose-Ackerman (1997) suggests that “corruption perceptions could influence attitudes towards institutional credibility and can thus incentivise or deters illicit activity.”

“A $1 increase in GDP per capita results in a 0.000257 unit increase in the size of the underground economy, confirming my prediction of a positive correlation.”

“A 1% increase in the GDP per capita growth rate results in a 2.51% increase in the size of the underground economy, again, paralleling my forecast.”

“The second kind of panel regression, the stacked regression, is conducted by gradually introducing one variable at a time into the equation, the results of which are also shown in Table 2. The noteworthy results, i.e. the outcomes of interest, are the coefficient and standard errors regarding eurojoin the dummy variable. It can be observed that when eurojoin is the only variable added to the model, the coefficient produced is 17.52 with -38.02 as the standard error. This outcome suggests that for each single year before the adoption of Euro as the central currency, there was a 17.32% increase in the size of the underground economy. When the inflation variable is added to the model, the coefficient falls down to 16.74. Addition of tax raises the coefficient to 17.49, unemployment increases it gradually to 18.52, eleccons to 19.1, and then corrupt, gdppc and gdpgrowth further increase the coefficients to 28.62, 28.54 and 30.44 respectively. The results in the regression however, are not statistically significant for any of these aforementioned iterations, and thus, do not provide any evidence towards the correlation between Euro adoption and the size of the underground economy.”

Conclusion

“The Indian Prime Minister Narendra Modi had an ambition to eradicate corruption, the black economy and counterfeit using a powerful economic tool like demonetisation. In this paper, I ventured into testing his theory by first examining the 2002 Euroisation by the European Monetary Union, it effects on the shadow economies and the effects of the consequent demonetisation of the 19 local currencies on their respective economies. By aggregating explanatory variables gathered from my various sources—Btejer (1978), Feige (1979), Bordo and Choudhari (1982), Tanzi (1983), Frey and Weck-Hanneman (1984), and Schneider (2005)—I derived a panel regression for 17 years from 1998 to 2015 to further investigate the importance of Euroisation on the sizes of the underground economies in the EU. By including the study of this past case, the introduction of the INR 200 note into the system following the barring of INR 500 and INR 1000 notes can be likened to the dismissal of local currencies and the adoption of the Euro. My research births no evidence that supports the theory that demonetisation shrinks the sizes of underground economies. Although due to the limitations of this paper I was not able to delve to establishing a causal effect, my panel regression results show correlations between the adoption of a new currency and the size of the informal economies. Confirmation or not, the results contradicts the Prime Minister’s aforementioned theory about the effectiveness of demonetisation.”

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Investigating the Effects of Demonetisation on the Size of the Underground Economy in India. (2021, Apr 03). Retrieved from http://studymoose.com/investigating-the-effects-of-demonetisation-on-the-size-of-the-underground-economy-in-india-essay

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