In Nepal’s border city of Biratnagar, located close to Bihar, you find the most vivid illustration of the ability of Indians to convert old high-denomination currency notes into new ones without depositing their stashes of black money into banks or disclosing these to the government.

On November 8, when Prime Minister Narendra Modi announced that old Rs 500 and Rs 1,000 currency notes would be demonetised overnight, the money-changer in Biratnagar was just about willing to pay on par – that is, a person’s Rs 1 lakh could fetch her the equivalent amount in the Nepali rupees. This signified a sharp loss: before November 8, Rs 1 lakh in Indian currency could have got 1.60 lakh Nepali rupees.

Soon, the exchange rate started to go north – Rs 1 lakh could be changed for 1.40 lakh in Nepali rupees. From November 29, the exchange rate dipped a bit.

This was because of the Indian government’s new legislative proposals that seek to levy 50% tax on those who declare their black wealth and make it mandatory for them to park 25% of their disclosed amount in interest-free deposits with a lock-in period of four years.

“The Indian government’s announcement of November 28 saw Rs 1 lakh fetch anywhere between Rs 1.30 lakh and Rs 1.25 lakh in Nepali rupees,” said a businessperson in Biratnagar. “Truck drivers are still taking half their dues in new notes and the remaining in old Rs 1,000 or Rs 500. It shows the gangs engaged in converting old currencies into new ones remain high.”

If money changers in Nepal feel confident, it is because their patrons in India are reasonably certain of hoodwinking the Union government to change old currency notes into new ones after taking a hair-cut, a term usually used in the equity market to refer to the difference between the market value of a security and the value assessed by the lending side of the transaction.

In these confounding days of demonetisation, the hair-cut is defined as the cost a person incurs to convert his or her stash of invalid currency notes into the new high-value denominations or even Rs 100 notes.

Here are a few methods that people are using to turn their invalid currency notes into legal tender.

Multiple shell accounts

India has always had agents whose business is to convert black money into white money. For this purpose, they open bank accounts in names of people who have identity proof – and who are known to them. There are agents who are said to operate as many as 500 such bank accounts.

Every year, agents file income-tax returns on behalf of these account-holders, even paying tax to the government ranging from Rs 15 to Rs 100 to Rs 500.

Agents operate these accounts to make electronic transfers, known as Real-time Gross Settlement Systems or RTGS.

It is through RTGS that old currency notes are turned, rather magically, into new ones.

Assume person X approaches agent Y to change a stash of Rs 10 lakhs in old currency notes into new ones. Agent Y has a clutch of bank accounts that he operates. He deposits Rs 2 lakhs in old currency notes in the account that is in the name of A. Since the amount is below Rs 2.5 lakhs, A will not be asked to explain the source of his money.

Agent Y uses RTGS to transfer Rs 2 lakhs to the account of B, and also deposits Rs 2 lakhs in old currency notes into that account. This Rs 4 lakhs amount is then transferred to C’s account, into which another Rs 2 lakhs in cash is deposited. The Rs 6 lakhs that has accumulated is now transferred to D’s account, which is then replenished with a cash deposit of Rs 2 lakhs. The accumulated Rs 8 lakhs is transferred to agent Y’s account (or for that matter, in E’s account) where another Rs 2 lakhs is added.

Agent Y now has Rs 10 lakhs, which is the amount person X had given the agent to exchange from old to new. Y transfers the amount to X. He shows in his books that Rs 10 lakhs has been given as a loan to X.

A few days later, X issues a cheque of Rs 10 lakhs to agent Y, or electronically transfers the amount to Y’s account. In his books, Y then shows that the loaned money has been returned. He will withdraw Rs 10 lakhs once the limit on withdrawal is lifted in January 2017. The amount he will receive will be in new currency notes.

It is considered safer if X and Y are relatives or have had business relationships in the past. After all, nobody lends Rs 10 lakhs to an unknown person.

It is very unlikely for income-tax authorities to become suspicious of such transactions, let alone track them, as the amount being shifted from one account to another is not high.

But it is also because the accounts agent Y operates will have no past record of having been served income-tax notices. It is well known that once an assessee comes on the radar of income-tax authorities, they are routinely served notices for at least five years – and their transactions are scrutinised.

Agent Y will then take a cut, say, 30% of the Rs 10 lakhs and hand over the remaining Rs 7 lakhs to person X. Thus, Rs 3 lakhs is the hair-cut person X took to convert his Rs 10 lakhs in old currency notes into new ones. But X’s Rs 7 lakhs is still black money.

For person X, the transaction makes economic sense. In case the government’s legislative proposal of November 28 is accepted, he would have to pay 50% of Rs 10 lakhs as tax, that is, Rs 5 lakhs, and deposit another 25% or Rs 2.5 lakhs in interest-free deposits for four years. Therefore, all that he gets in hand is Rs 2.5 lakhs, though it would be deemed as white money.

Since no interest accrues on deposits, inflation would erode the real value of Rs 2.5 lakhs that X is liable to receive after four years. Given that he is habituated to hoarding cash, he is likely to prefer keeping the Rs 7 lakhs he has received in cash, or divert it to buy property, than disclose his concealed wealth to the government.

Overdraft facility

Assume businessman A operates a current account that has an overdraft facility of Rs 60 lakhs. To avail of the overdraft facility, he has presented collateral to the bank, say, his house. The bank charges him interest for whatever amount he overdraws.

Assume also that A conducts much of his business in cash and that by November 8, the day on which Prime Minister Narendra Modi announced his demonetisation policy, he had availed the overdraft facility to the tune of Rs 50 lakhs. This would be reflected in his books as cash in hand.

He could have used Rs 50 lakhs for making purchases or, as it often happens with small and medium businessmen, diverted the fund for personal use, such as adding a floor to his house. His bank is not bothered about what he does with the Rs 50 lakhs that he overdrew. After all, his collateral – house ownership papers in this instance – is with the bank.

Businessman A knows businessman B who has Rs 50 lakhs in old currency notes. A is willing to bail out B for which he will charge him a commission of 30%. He deposits the Rs 50 lakhs in old currency notes into his account. A can claim he received Rs 50 lakhs from multiple customers who paid him in old currency notes they received from others.

Under new demonetisation rules, a person cannot transact in demonetised currencies, but can deposit the same in his account. A’s challenge, therefore, is to prove from where and when he received the cash deposit of Rs 50 lakhs.

This he can do by collecting fake bills, of which there has always been a thriving market in India. Companies engaged in cash business often sell goods for which buyers do not ask for bills. Businessman A buys such bills, dated as per his wishes, from the market and alters his account books accordingly. He can justify the cash transactions now.

In January or thereafter, A can avail of his overdraft facility. He withdraws Rs 50 lakhs, takes 30% or Rs 15 lakhs as commission, and gives Rs 35 lakhs in new currency notes to B. The Rs 15 lakhs is the hair-cut B took to monetise his stash of old currency notes.

Lucky you: Bank manager is a friend

In the first 14 days post-demonetisation, a person could submit a photocopy of identity proof at banks and exchange old currencies worth Rs 4,500 for new. This provided banks with a huge reservoir of identity documents.

The buzz is that some unconscionable bank employees recycled these identity proof documents to launder old currency notes. For instance, assume bank employee Q had access to 500 identity proofs. This means Q had the potential to convert Rs 22.5 lakhs of old notes into legal tender. Q is in a position to help people convert their stashes of old currency notes into new.

Now try to look at the scenario from Q, who, for the sake of portraying his dilemma, is posted in Gorakhpur in Uttar Pradesh, or Siwan in Bihar, or Bellary in Karnataka. The most influential person in these places is likely to wear several hats – he would be a wealthy businessman-politician-gangster. Call him R.

Both Q and R are known to each other, as it is from Q’s bank that R has availed of credit. Otherwise too, R, aware of his clout, calls Q and says that 75% of new currency notes reaching Q’s bank must come to him and be exchanged for the stash of invalid notes in his possession.

Q can defy R at his own peril. He is likely to provide the hair-cut at the rate determined by R. It makes greater sense for Q to make a cut of 10% on the amount he exchanges for R rather than incur his wrath.

The ability of politician-businessmen of all big national and regional parties to bully bank managers is perhaps one reason why new currencies are in such short supply outside the metros.

Kisan credit card

This is a rolling credit scheme that public sector banks offer to farmers. The quantum of credit extended to a farmer depends on the size of his landholding and the type of crop he grows.

A credit account is opened in the farmer’s name and he is given a card, valid for five years and subject to renewal every year. He can use the card at Automated Teller Machines and Points of Sale to withdraw money whenever he needs it. This account is also linked to his bank account, from which he makes withdrawals as well.

Keeping just these technical details of the Kisan credit card in mind, assume farmer Z is eligible to withdraw up to Rs 10 lakhs on this card. At the end of the 12-month cycle, he should have returned the loan amount of Rs 10 lakhs plus the interest incurred on it. In case he has, his credit amount witnesses a compounded increase of 10% for the next year. In the fifth year, according to the State Bank of India website, Z’s credit limit would be 150% of what was granted to him in the first year.

Suppose Farmer Z has returned only Rs 3 lakhs of the Rs 10 lakhs that he withdrew, he can access credit to the extent of the amount he has returned – that is, Rs 3 lakhs – in the next year. In case Farmer Z hasn’t repaid any amount after two cropping seasons – kharif and rabi – the bank declares his loan as a provisional NPA or non-performing asset.

The incidence of non-performing assets in the Kisan credit card scheme is said to be exceptionally high. In 2012, it stood at Rs 165,000 crores, up from Rs 94,000 crores in 2010, a jump of 76%.

Demonetisation has come as a boon to both banks and farmers.

Suppose Y has Rs 10 lakhs in Rs 500 and Rs 1,000 old currency notes. The bank’s loan manager hooks up Y to farmer Z and negotiates the deal between them. Y gives his hoard of Rs 10 lakhs to Z, who deposits it in his bank to repay the Kisan credit card loan he had taken.

Since agricultural income is not taxed, the government cannot ask him what the source of his money is. He can claim it as the money he has saved over the years.

The repayment of the loan not only opens up farmer Z’s line of credit, but also increases it by 10%. In January, Z can use the credit card to withdraw money, after keeping for himself the agreed upon cut of Rs 1.5 lakh. The remaining Rs 8.5 lakhs, now in new currency, would be handed over to Y.

The bank too gains because it has managed to re-activate its non-performing asset.

Do not assume the amounts loaned under the Kisan credit card are meagre. Axis Bank, for instance, offers a credit limit up to Rs 2.5 crores.

The catch

There is always the possibility of farmer Z reneging on the promise of returning money in new currency to Y.

“Such deals do not have a legal backing,” said Sudhir Panwar, president, Kisan Jagrati Manch. “The person who has been betrayed [Y] can’t even file a complaint with the police. After January, it is possible you could see a spurt in social conflict in rural India.”

Much will depend on the clout of those who brokered the deal between the farmer and the businessman in the city. Panwar says such middlemen are often influential, powerful people of their social groups. Their pressure and the caste linkages between the middleman and the farmer will perhaps prevent the conflict from teetering out of control.

In fact, the poorer a person is, the less likely he will be to refuse to return the money of another person that he deposited into his account. Those who have deposited old currency notes of others into their Jan Dhan accounts will most likely belong to the most vulnerable sections of society. In villages, they cannot possibly rescind the deal struck between them and the middleman who represents the hoarder of black money.

“In several cases, their identity proofs and passbooks would have been kept by the middleman,” said VM Singh, president, Mazdoor Kisan Sangharsh Sangathan.

However, Singh points to another troubling aspect.

“A good many Jan Dhan account holders, technically, stand to lose their BPL [Below Poverty Line] cards,” said Singh.

This is because a person possessing a Below Poverty Line card is deemed to have an annual income of around Rs 27,000. But if a Jan Dhan account holder has deposited Rs 50,000 into his account, it implies he or she furnished fake details to get the benefits of the Below Poverty Line scheme.

Singh added, “The person stands to lose both ways – he cannot but return the money from whom he took. But because his account showed he deposited Rs 50,000, the BPL [Below Poverty Line] card could be withdrawn from him.”

Purchase and sale of agricultural land

For decades, black money has been diverted to purchasing property, the price of which is partly paid in cheque and partly in cash. In these days of demonetisation, the hoarders of black money are said to be principally targeting agricultural land to convert their invalid notes into legal tender.

Assume O buys a piece of agricultural land from farmer Z for Rs 20 lakhs. The circle rate (the predetermined price at which the government charges stamp duty) for Z’s land is Rs 3 lakhs. This O pays to Z in cheque, and the remaining Rs 17 lakhs in cash.

Z deposits both cash and cheque in his bank account. He cannot be called to explain the source of Rs 17 lakhs as agricultural income is not taxed. O gets the land registered in his name after paying the stamp duty on Rs 3 lakhs.

In January, O will sell the land back to Z for Rs 20 lakhs, of which he will receive Rs 3 lakhs, equivalent to the circle rate, in cheque and the remaining Rs 17 lakhs, in new currency notes. O also pays for the stamp duty Z has to remit plus a certain percentage of Rs 17 lakhs for helping turn his stash of old currency notes into new ones – both together constitute O’s hair-cut.

Purchasing a flat in Delhi

Switch over to Delhi, where, as elsewhere, property prices have gone south, because of which builder R offers to sell S a flat at Rs 1 crore. Its actual price is just Rs 75 lakhs. In return for S purchasing the flat, builder R is willing to take just the circle rate in cheque and the rest in old currency notes.

R can convert the old currency notes through the different methods spelt above. Or he could divide the money into small parcels to pay his dues and give advances to suppliers and contractors, all of whom will receive a higher amount as they too would incur a cost to convert old currency notes into new ones.

The builder is delighted that he has been able to sell a flat in the depressed realty market. As for S, his stash of invalid currency notes has not gone waste.

Gold, foreign currency, jobs, and buffaloes

There was a surge in gold prices as soon as the demonetisation policy was announced. Likewise, people took to purchasing foreign currency frantically, largely the dollar, the pound sterling and euro, of which India is supposed to have hoards that have not come through the official channel. This is one reason why a person who is lucky to lay his hands on one of these three foreign currencies will have to pay a market rate for them that would be higher than the official exchange rate

The market is also abuzz with companies offering jobs to those who wish to convert their stash of old currency notes into new ones. Assume U has a stash of Rs 1 crore in Rs 1,000 notes. Company V appoints U as an employee on an annual salary of Rs 70 lakhs. It then issues U a cheque of Rs 70 lakhs as a salary advance minus the tax that is required to be deducted at source.

U deposits the cheque into his account. Not only will his withdrawals be in new currency notes, but will also constitute his legitimate income. Company V will deposit the Rs 1 crore in old currency notes that belonged to U in the bank, not arousing suspicion as it used to draw cash for daily use even before November 8.

As an aside, a day after November 8, a village in West Uttar Pradesh saw its residents rush to Punjab to purchase buffaloes with their invalid notes. In Punjab, the price of buffaloes has dipped because of cow vigilantism. The sellers there were presumably willing to take old currency notes, certain they could turn them later into white.

The new owners of the buffaloes will wait for the supply of new currency notes to become normal before they sell the animals again. Till then, obviously, they can milk them.

The future

The ease with which people are converting old currency notes into new ones explains why Rs 8 lakh crores in the withdrawn notes has already been returned to banks. Market experts feel that the big sharks have not yet started moving their huge reservoirs of their old notes. They are waiting for the government to emerge out of confusion, evident from the manner in which it has been issuing new diktats, one after another.

Once Parliament goes into winter recess and new legislations are passed, the big sharks will begin to move their funds. From this perspective, the government is likely to receive more of old Rs 500 and Rs 1,000 currency notes than it had earlier envisaged.

This means the Reserve Bank of India will not be able to reduce its liability substantially and transfer huge profits to the government. The government might not be able to play Robin Hood with the panache it had hoped for.