Demonetization and the Road Ahead for Businesses…
by Akshay Hegde
The Surgical Strike
The night of November 8th saw yet another surgical strike by our honorable Prime Minister Narendra Modi. At 8 pm IST, Modi addressed the nation on a highly contentious issue that was probably in the pipeline post the culmination of the Income Declaration Scheme(IDS) window, giving only until midnight for most of the currency in circulation to be accepted as legal tenders. This move is touted to be in the long term interest of the nation, aimed at putting an end to the black-money-run parallel economy and fake currency-sponsored terrorism affecting India. In its aftermath, the Govt. has faced a lot of flak with respect to its level of preparedness for such a critical overhaul of the monetary landscape.
To put things in perspective, India is the largest cash based economy amongst the developing countries with a high cash to GDP ratio upwards of 10%. India’s debit card penetration is low with 661 million cards issued, while its credit card penetration is even lower with only 24.5 million cards being issued thus far; adding to this is the abysmally low average number of card transactions per inhabitant, which at 6.7 is among the lowest in the world. India being home to about 22% of the world’s unbanked adults, leaves little doubt as to how mammoth a task it would be to bring all of India into the digital and cashless side of the economy.
The basic crux is that the Govt. rendered valueless about 86% of the currency in circulation as the PM addressed a nation that was unquestionably taken aback by this sudden decision. The demonetization actually followed a well-structured Income Declaration Scheme (IDS 2016) which was aimed at bringing those citizens of India with undisclosed income into the legitimate bracket of tax paying citizens by levying 45% tax on the disclosed amounts. Though this scheme was advertised as a success by those in the Govt., they were well aware of the amount of disclosure that was withheld and it was just a matter of time before the PM made an astute decision to make those guilty pay appropriately. To highlight the underwhelming extent to which income was declared, let us look at the amounts declared by Indians in the Voluntary Disclosure of Income Scheme (VDIS 1997) against the amount disclosed during IDS 2016 –
If one were to account for the undisclosed income during VDIS 1997 and calculate the market rate of return till this day, the amount of black money declared is nowhere close to the exacted amount that should have been declared.
Coping Up: Conversion of Black to White
Having been stranded with hordes of unaccounted cash, a large number of Indians were left in a state of shock and disarray as to how to deal with a situation like this — that too with a daunting timeline to it. In the wake of such a crisis, for those with a large stash of cash, there were bound to be some opportunists who would step up to make a cut when they carried forth a leverage. In doing so, a number of shady methods have been uncovered, which are being slyly deployed to circumvent restrictions imposed by the Govt. in exchanging and depositing old currency. Some of the methods adopted by Indians are as follows –
Advances — This method was deployed by those sitting with large wads of cash that was unaccounted for, mainly due to the nature in which such entities conducted business. Here these entities, who may have previously stretched payments for up to 90 days, came front offering their vendors advances in cash that were to be backdated in order to be able to make such money accountable for as an advance for future Purchase orders. Such entities also resorted to paying their employees’ salaries months in advance.
Cash Sales — This method has a limitation to it. The cash sales can only be justified to an extent with respect to the historical data related to such a company’s cash sales on records. However, this would have incurred a minimum tax rate of 5% for the transactions they book.
Laundering –This method featured in the MOs of large importers who have since time immemorial resorted to under invoicing and running a large part of their business without bills. Such entities tried to convert their black money into US Dollar via ‘Hawala’ agents with certain reports suggesting the conversion rates going at a huge premium (approx. Rs 130 ~ $1)
Gold — This method was also largely deployed by many Indian families, and this time the Jewelers were the agent of change. Black money was used to buy gold at a premium 100% to the prevalent Gold rates. This method saw a crackdown on a number of Jewelers across India’s metros.
Entry — This method is probably deployed largely when there is a large amount of cash involved. Chartered Accountants and their networks prove very useful in accomplishing such results. The procedure starts with finding a company with large amounts of cash on hand while they actually are in shortage to fill such cash on hand in their books. Such companies are scouted and the black money from entities is introduced into such companies. Once these companies convert the black money to white via their cash on hand, they loan such an amount in white to the entity that introduces such large amounts of cash into the ‘cash on hand’ company. After a few months or years, the entity manages to return the loan in white to clear its book ‘debt’, and at the same time receiving equivalent cash from the ‘cash on hand’ company in newly denominated currency.
JD A/C — This method is probably being utilized by politicians with a lot of power and reach. They are leveraging thousands of Jan Dhan Yojana Accounts created by the Govt. to deposit their black money to the extent required to stay under the radar. We have seen reports suggesting that previously never used JD Accounts have seen an influx of up to Rs. 21,000 Crores in days post Nov 8th, 2016.
But what happens to the money that doesn’t find its way into the system? Now, the Govt. expects about Rs. 3 Lac Crore to not come into the system which will in turn result in RBI booking it as a profit and passing on the dividends to the Central Govt. This money would be expected to be used by the Govt. as an addition to their budget.
Effects of Demonetization and impending GST implementation
For starters, the banks are going to be flooded with deposits. This will definitely lead to interest rates coming down as lending rates have been cut by 15 basis points while FD rates are cut by 25 basis points. This will help a lot more credit to be facilitated, which in turn leads to a lower cost of finance and better economics for businesses and individuals.
With such a forceful measure of bringing the country into the digital banking system, we have also seen Fintech players like Paytm launching their simple E-POS systems to maximize the acceptance of digital payments by merchants who were previously not accepting debit or credit cards. Paytm has already seen a 50% rise in the gross value of transactions it has processed since the wake of such a move.
However, the point I’d like to bring to attention is the effect this demonetization is having on MSMEs that employ a majority of the workforce in India. About 30–40% of working capital for these small and medium scale businesses comes in the form of unaccounted cash and with such a move there is bound to be an immediate repercussion to these businesses. Just recently, through our personal interactions with businesses we’ve come to know of how the wholesale markets in Delhi were shut for almost a week after this radical yet necessary step was taken by the Govt. Markets in other metros such as Mumbai, Bangalore and Kolkata also faced a slow down with many of them shutting way before their usual hours. This scenario will likely ease up within the coming months when normalcy sets in with pressure being taken out of such a cash crunch. This move will also likely revise the GDP outlook for India by up to 50 to 150 basis points before coming on track within a few quarters.
Demonetization at this point in time is in our opinion a heads-up to streamline the operations of those businesses that have been contributing to the large parallel economy prevalent in this country. Businesses that were previously involved in ‘kacha’ bills, under invoicing, half billing will now have to get onboard by accounting for all transactions with ‘pakka’ bills. The limits imposed on cash transactions for Un-Registered Dealers (URDs) and the need to record KYCs in case of larger cash transactions will have most businesses cutting proper invoices, which will be even more adhered to when the GST is implemented. The credit fungibilty associated with GST will make it harder for businesses to transact without invoices as the tax credit breakage would reveal those businesses who continue to run a parallel black money economy. This will become clearer with the schematic shown below –
Fortuitously in the long run, this will be a boon for B2B E-Commerce sites since there will be a correction in market prices as a result of strict requirements for invoice purchases, making such companies more competitive when they’ve tied up with manufacturers and distributors directly. All in all, though COD components of E-Commerce transactions will be drastically affected, this move will be welcomed with open hands by such E-Commerce companies.
