Why black money and terror funding will continue in India

He reached inside, pulled out a wad of a thousand Swiss francs in notes and threw them into the air. Stunned, we watched the notes flutter silently around us from our sofa.

My two-year-old son began to laugh, impressed at what he had done.

Now normally I don’t typically have that much cash on me. But I needed to send some money abroad and the money transfer agency only accepted cash.

It didn’t look good. I work for a bank and there I was having my own money thrown in my face.

My wife looked at me disapprovingly and said, “What have you been teaching our son?”

It reminded me of a ludicrous episode that occurred a year ago. On 8 November 2016, the Indian Prime Minister Narendra Modi announced that all Rs 1,000 ($16) and Rs 500 ($8) banknotes would be invalid from midnight. For Indians was a bit like having your money thrown in your face.

These notes had to be deposited into a bank account by the end of the year and you were allowed to exchange a small amount into the new Rs 2,000 ($32) and Rs 500 ($8) banknotes just issued. Any single deposit of more than Rs 250,000 ($4,000) and the income tax authorities would be alerted.

Modi believed that corrupt officials, businessmen and criminals, would be stuck with “worthless pieces of paper” as these notes constituted 86.9% of currency in circulation.

Higher levels of bank deposits would allow for lower interest rates and more lending. This would also expand the tax net and capture more businesses that once operated in the informal economy. Overall, public finances would improve and it would rid India of its black money.

Unfortunately it didn’t really work.

What occurred was a brutal “cash crunch” and a painful short-term blow to India’s economic growth. In the shadows of India vast black-market economy, the counterfeiters ramped up production. There was now a huge shortage of cash and massive demand for their services. Within a very short period of time, beautiful high-quality fake Rs 2,000 banknotes were in circulation.

Months later, the National Investigation Agency (NIA) started carrying out its first seizures. The Border Security Force (BSF) also made some large hauls too: after all, many counterfeiters are unsurprisingly located beyond India’s borders, in Pakistan and Bangladesh.

By year-end, an astonishing 98.96% of the scrapped banknotes were successfully deposited back into India’s banking system.

The cash-rich had paid working-class “mules” to queue outside banks to exchange up to Rs 4,500 at a time. Meanwhile a network of friends and family – some genuine and some not – collectively made huge deposits for these individuals just below the Rs 250,000 limit.

Furthermore, it turned out that when the corrupt wish to park their ill-gotten gains, they don’t tend to keep it in Rs 500 and Rs 1,000 banknotes. It’s often tied up in other assets, such as real estate and gold. 

Overall, demonetisation wasn’t hugely successful in what it set out to achieve.

In the chaos caused, economic activity slowed and there is now probably more untraceable currency in circulation than there was before.

There was however, a huge surge in cashless payments. The Reserve Bank of India (RBI) reported that between November 2016 and December 2016, the value of debit card transactions rose from Rs 32,000 crore ($5 billion) to Rs 58,000 crore ($9 billion). This fell moderately in the months that followed, but it still remains far higher than pre-demonetisation levels.

It also supported the innovation and creativity that is currently taking place with mobile wallet payments in India – a technology where transactions are facilitated using mobile phones. One of India’s main providers of this service is Paytm, which has over 170 million users. During the demonetisation episode it saw an increase in traffic of 435%.

According the Harvard Business Review, significant advances are set to be made across digital payment technology in India. There are plans to mandate digital payments at gas stations, hospitals, and universities, with cash transactions over $4,500 banned altogether. Indian Railways will also no longer levy a service charge on tickets booked online, and the government is removing duties on point-of-sale devices and fingerprint readers.

However, India is starting from a very low base when it comes to cashless and digital transactions. These volumes are miniscule when you considered that India is an economy with 1.3 billion people.

The Indian government would nevertheless love the country to go cashless because then everything becomes traceable and taxable. Such a move would cast a wide tax net over India’s informal economy.

There are also some really powerful economic benefits for India too. For instance, it becomes quicker and easier to sell goods, which makes the economy much more dynamic.

Payment volumes also increase in a cashless economy, along with lines of short-term credit (i.e. credit cards) to speed up transactions. This is important because the increase in the sloshing around of money in the economy increases the overall growth in money supply, which creates even more economic growth.

However, in order to facilitate a cashless society, you need good infrastructure, which India severely lacks. To put in place what is needed for this “cashless” vision would involve marshalling huge amounts of capital resources and good organisation.

Meanwhile, there is something much more powerful and disruptive that could emerge. It’s more efficient, less resource intensive and much quicker to set up.

It’s called “blockchain”

Blockchain‘s digital ledger removes the need for intermediaries, which in India are widespread across all walks of life. They are both legitimate and corrupt, and both present a significant friction to economic activity. It also provides security, by offering an effective way to track contracts between parties. It could for instance help India rid itself of landownership fraud. 

The focus now, however, is whether this technology will lead to a well-circulated globally acceptable crypto-currency. Bitcoin may not be the answer as it may not survive, but there is a strong chance that such a currency will exist in the near future.

The Reserve Bank of India (RBI) is deeply concerned because it could undo the Indian government’s vision of a cashless society.

A crypto-currency is a digital form of cash. It affords many of the same benefits that cash offers: it’s difficult to trace, it can be stored anywhere and transactions don’t have to go through the banking system. Unlike cash, however, the RBI will have no control over the growth and supply of a global crypto-currency with conventional monetary policy.

Demonetisation was a bold move, but it failed in its objectives. It’s also questionable whether it helps speed up India’s journey towards a cashless society. What’s more interesting is if widespread usage of a crypto-currency emerges. But it could mean that black money and terror funding will still continue in India.