Paradox of Grift: Why Old

Notes that the Poor Off-

loaded at a Discount
Finally Sold at a Premium
Smaller informal economy players have totally lost out in this bizarre game,
when they sold their currency at a discount only to help hawala dealers and
middlemen make huge profits.

Prime Minister Narendra Modis demonetisation program has hit the various stakeholders of the
rural and informal economy in different ways over the last 50 days.

However, one recent phenomenon really takes the cake.

Smaller players in the informal economy workers, traders, farmers and mom-and-pop shop owners
sold their Rs 500 and Rs 1000 notes in desperation at a discount of 20% to 30% during November.
In almost all cases, this was legitimately earned money, and not black money. Shakuntala, who
works as a part-time cook in three houses every day, had Rs 4,000 in old 1000 rupee notes when
Modi made his demonetisation announcement. After standing in line for three hours to exchange
them, she was forced to sell her notes for Rs 3,000 in valid notes, taking a hit of 25%, in order to
make it to work on time. These kinds of distress sales were widely reported by the media in the first
days of demonetisation.

Now, according to senior government officials, those very 1000 and 500 rupee notes were aggregated
by middlemen and sold to businesses at a premium of 20% in December. Thus, the demonetised
500 and 1000 rupee note became a commodity much like farm produce, which is picked up cheap by
middlemen and sold in urban markets later at a premium. This bizarre commodification of the
Indian currency notes happened, according to industry observers, due to the flawed implementation
of the demonetisation programme.

While smaller players in the informal sector of the economy were getting rid of their 1000 and 500
rupee notes, as they had limited access to banking services and needed cash to spend urgently,
various middlemen and hawala traders were quietly aggregating the notes (at a discount) for future
trade (at a premium) with businesses which needed those 1000 and 500 rupee notes desperately.

What kind of businesses would buy old notes, and that too at a premium? Economic intelligence
officials in the government confirmed that the demand for 1000 and 500 notes reached its peak in
mid December. This is when businesses were willing to pay a premium for the old notes because on
their balance sheets, on the asset side, they had cash in hand listed without necessarily having
actual cash to back it up.

How did this happen? After demonetisation was announced, many medium-size businesses, which
typically have up to 30% of their working capital from the parallel cash economy, needed to push
that black cash into some legitimate accounts in the balance sheet.

So these small businesses started approaching providers of shell companies in money laundering
hubs like Kolkata, Jaipur and Surat where ready-made company balance sheets are offered with a
cash-in-hand component without the physical cash being there. These balance sheets are
legitimate as they are filed with the relevant company law and income tax authorities. Normally the
tax authorities do not question or verify higher cash-in-hand shown in the balance sheet as they are
only suspicious against businesses who show less profits and less cash. Something like Satyam
Computers, which showed much higher quantum of bank deposits in the balance sheet for many
years without being detected.

So many small businesses hurriedly got access to fresh quotas of cash in hand through shell
companies and started pushing their black cash into those balance sheets which were already filed
with income tax department. Thus the black money got legitimately pushed into the system, through
the cash-in-hand quotas provided by numerous shell companies. All of this happened over the past
50 days.

The demand for 1000 and 500 rupee notes peaked in mid-to-late December because of the rush to
physically disclose the cash-in-hand quotas of thousands of shell companies serving as money
laundering vehicles. This, government officials say, happens for two reasons. The first is that
businesses that use shell companies often fall short of the cash-in-hand component. If business X
uses shell company Y, which has Rs 100 crore as cash-in-hand on its balance sheet, and X only has
Rs 90 crore in black cash, then it needs to acquire another Rs. 10 crore in cash to fulfil that cash-in-
hand quota.

Secondly, a number of shell companies are often unused, which means that providers of shell
companies need to scramble to acquire some cash in case they are caught in a government raid.

The tax department along with the cooperation of various banks will have the near-impossible task of
identifying these violations in the next few months.

What this whole process has ended up doing is that it has forced struggling, small traders to sell their
notes at a discount in order to legitimise fake cash-in-hand accounts held by businesses.

Thus it is evident that the rich have devised ingenious ways to push their cash into the banking
system while the poor have been forced to sell their currency at a discount. A chartered accountant,
who did not want to be named, said it would be nearly impossible for the tax department to
investigate millions of balance sheets of small companies which may have pushed their cash as
legitimate assets in the balance sheets of shell companies. Indeed, the poor have totally lost out in
this bizarre game when they sold their currency at a discount only to help hawala dealers and
middlemen make huge profits.