Government policies and interventions for development in various sectors and issues arising out of their design and implementation.
General Studies 3
Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.
Demonetisation: Success, Failures and Lessons learnt
The Reserve Bank of India (RBI) has released numbers that show how most of the currency notes that were cancelled were deposited in banks. Now that we know that 99% of demonetised money has come back, the government’s estimates of how much black money would be extinguished have been proven wrong. As the RBI’s latest annual report has confirmed, Rs 15.28 lakh crore or 99 per cent of the Rs 15.44 lakh crore worth of the notes withdrawn overnight on November 8 was turned in. Thus, almost all demonetised notes have been returned to the central bank, including the stock of black money held as cash.
How money laundering took place?
The total reduction in black money was much smaller than what might have been envisaged. To the extent that it was possible to exchange money legally, individuals did so. After that it was done illegally.
Those who could not exchange money legally found money changers. When the government announced that old notes could no longer be exchanged, but only deposited, new ways of changing the stock of unaccounted cash emerged. Individuals with bank accounts, including Jan Dhan accounts, and companies showing cash accrual from sales came into business. Large amounts could be laundered through this route as it did not involve immediate cash payouts by banks, since cash shortages still persisted with the RBI and banks scrambling to remonetise the economy.
Even when people have to pay tax on their hoarded cash, and a change fee they preferred to do that rather than lose the whole amount.
Data from Prowess, a database of companies in India, shows that in the quarter of demonetisation, when purchasing power had fallen sharply, net sales by companies rose significantly.
At the same time, the number of tax payers and tax collections rose. The tax department is said to have found thousands of shell companies which were possibly engaging in the activity of depositing money in their accounts during the demonetisation period, claiming that it was cash from sales. This provided a means for laundering money.
There is no doubt that those with holdings of unaccounted cash lost some of their wealth in the process of laundering it. To some extent, taxes were paid on it in the process of legitimising it. But in addition to that, illicit wealth was redistributed from black money holders to money launderers. Whether the money launderer was a company owner, a bank employee or a Jan Dhan account holder, there was now a need breed of criminals with wealth obtained from illegal means.
Objective seems unachieved:
The objective of reducing counterfeit currency seems unachieved.
In 2015, the National Investigation Agency established that at any point only Rs. 400 crore of counterfeit currency is in circulation. That’s 0.028% of total currency. Now, CNBC has calculated only 0.0007% of the returned Rs. 1,000 notes as being fake and only 0.002% of the Rs. 500 notes. In value terms the total is just Rs. 41 crore. So either a lot of fake currency hasn’t been detected or didn’t exist.
In terms of tackling terror funding, the Finance Ministry has said: “As a result of demonetisation of specified bank notes, terrorist and Naxalite financing stopped almost entirely.” But no proof has been provided.
Reduced dependence on cash: Both in number and value, digital transactions increased sharply after November but also dipped sizeably thereafter. There were 671.49 million transactions in November, rising to 957.50 million in December before shrinking to 862.38 million in July. So, the use of cash initially diminished but has been steadily increasing thereafter.
Negative economic consequence of demonetisation:
The disruption of unorganized supply chains that are dependent on cash transactions; it is still not clear how smoothly they were being rebuilt as the economy was remonetized.
No less has been the damage to institutional credibility. The RBI is yet to convincingly demonstrate that the demonetisation decision was not forced on it. At any rate, it was ill-prepared to deal with the aftermath, in terms of making available adequate quantity of replacement notes in the right denominations. That remonetised notes are mostly of the illiquid Rs 2,000 denomination — constituting over 50 per cent of the total value of currency in circulation even as late as March 31 — didn’t help matters.
The economic costs— whether manifested in a crash in farm produce prices or a wide swathe of cash-dependent informal enterprises going bust, not to mention the sheer time wasted waiting in lines — are incalculable.
In the period immediately after demonetisation, there was expectation that it would bring a windfall for the Centre. To the extent that the scrapped Rs 500 and Rs 1,000 denomination notes were not deposited or exchanged at banks — especially by those who had hoarded their ill-gotten wealth significantly in cash — the resultant reduction in the Reserve Bank of India’s (RBI) currency liabilities would generate a “profit”, which it could then distribute as dividend to the government. But this did not happen.
Potential advantages of demonetisation:
Attack on the scourge of black money, tackling corruption, counterfeit currency, terror funding and reducing dependence on cash
Salient lessons learnt:
The government did not seek the advice of experts before going ahead. The strategic decision to surprise holders of illegal wealth would anyway have restricted the circle of those who could be informed, but it seems that the idea didn’t come from experienced policy advisers.
Good policy design should take into account how people will respond to any change in the rules of the game. In other words, incentives matter. Most rational human beings will adjust their behaviour to further their self-interest. Those who had illegal wealth held in cash obviously gamed the cash exchange process. Good incentive-compatible policy design is thus as important as good policy intent.
Political dynamics can be quite different from economic dynamics. That voters have continued to back the Bharatiya Janata Party (BJP) despite the pain imposed by demonetisation shows that the ruling party has gradually redefined its typical voter from the traditional trading base that supported the Bharatiya Jana Sangh to the aspirational middle class that has a lower tolerance for corruption.
International evidence suggests that few countries address the problem of black money by demonetising their currencies. If the problem is large-scale crime, corruption, bribery, bureaucrat-politician nexus, rent seeking, tax evasion etc. the answer lies in reforming the criminal justice system, law and order, administrative reforms, bringing transparency in the functioning of the state and rationalisation and simplification of the tax system. In this context, the GST will be a far more effective mechanism to bring down tax evasion in indirect taxes considering the greater incentive for compliance that its design holds.
This episode in India’s policy-making highlights an essential tenet of policy-making — the need for a cost benefit analysis. For any objective that is to be achieved, we need to examine various policy options and analyse their costs and efficacy. For an economy on the path of reform, with many more reforms still to come, long-term sustainable impact can be achieved only when we strengthen the policy-making process as well.
It is still quite possible that demonetisation will have positive consequences over a longer period— the growth in the direct tax base, the switch in the financial holdings of households from cash to bank deposits, and the increased use of digital payments. The question to be asked is whether the potential long-term benefits will be greater than the short-term costs that the Indian economy had to bear.
Connecting the dots:
What were the objectives of demonetisation? How far was it successful? Critically analyze.
The demonetisation drive in many ways proved to be a fialed one. Discuss. What are the lessons learnt when it comes to policy-making in future.
TOPIC: General Studies 3
Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.
First phase of reforms in armed forces
The Centre has approved major reforms for the Indian Army aimed at enhancing combat capabilities and rebalancing defence expenditure. This will be the first such exercise since Independence and will involve restructuring British era systems. Posts of 57,000 officers, soldiers and civilians will be restructured and the Army would have state of art regimen and better logistic support units after the overhaul. This phase of reforms, which concern only the army, will be completed by end-2019.
There will be major changes to optimise signal establishments that handle the Army’s communication networks, restructuring repair echelons, redeploying ordnance echelons, better utilisation of transport echelons and closure of military farms and Army postal establishments in peace locations.
It will help improve operational efficiency.
The idea is to improve the army’s “teeth to tail” ratio, that is, increase the number of soldiers actually doing the fighting against those needed to support them to fight. For example, additional vacancies for commissioning officers in combat units like infantry, artillery, armour and mechanised infantry will be allotted to overcome these deficiencies. This way the ‘teeth to tail’ ratio (combat units to administrative +logistics ratio) would improve.
Restructuring by the Indian Army is aimed at enhancing combat capability in a manner that the officers/JCOs/ORs will be used for improving operational preparedness and civilians will be redeployed in different wings of the Armed Forces for improving efficiency,” a defence ministry statement said. The savings can be utilised for overcoming deficiencies in combat arms, especially for officer cadre.
These reforms emanate from the recommendations of an expert committee headed by Lt General D.B. Shekatkar (retd), which was tasked to recommend measures for enhancing combat capability and rebalancing defence expenditure.
The committee submitted its report in December last year, and its 188 recommendations have been studied and debated by the ministry and the defence services.
The defence ministry has chosen 99 recommendations which pertain to the army, navy and air force — 65 of them, which are internal to the army, have been approved for implementation in this phase.
It is believed that the other 34, which are internal to the air force and the navy, will also be implemented soon.
The rest of the recommendations of the Shekatkar committee, which deal with higher defence management, defence ministry and other organisations, such as the DRDO, ordnance factories and DGQA must also be implemented.
The ministry has been silent about these steps which would have far-reaching effects towards reforming and modernising the decision-making structure for national security.
Also, following proposals from various committees needs to be implemented-
Chief of Defence Staff should be created.
Ensuring 2.5-3 per cent of GDP as defence expenditure,
Political and bureaucratic consensus beyond the scope of the defence ministry but have not been debated so far.
The recommendations of both the Arun Singh Committee, following the Kargil Review Commission, and of the Naresh Chandra Committee needs to see the light of the day.
The approval of the Union cabinet for the first phase of reforms in the armed forces is a welcome step. With a live threat from both China and Pakistan, defence reforms are an urgent need of the hour. The first steps with restructuring the army are important but they must be quickly followed by implementation of other recommendations, particularly those of higher defence management. Anything less will be another opportunity lost.
Connecting the dots:
The central government has already initiated army reforms based on recommendations of Shetkar committee. What are these reforms? Also explain how it must be quickly followed by implementation of other recommendations, particularly those of higher defence management.
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