Carrot vs. Stick: How India and Pakistan have tackled illegal remittances

India and Pakistan both make the top five countries for value of remittances received every year. According to the World Bank, Pakistan receives $19.3bn, while India tops the list at $72bn.

With the largest number of residents living abroad, India looks set to remain at the top of the list for some time to come as family members continue to send money home. However, these figures don’t cover all of the money being sent back to Pakistan and India.

Some estimates suggest that around 45% of remittances are made illegally through unsafe, unregistered agents, in an attempt to save money on fees. Both countries are keen to cut down on the amount of money being moved illegally, and both have made efforts to shift people from illegal to legal channels.

Their respective approaches have been opposite. While Pakistan has taken a positive approach designed to encourage the use of legal remittance agents, India has instead used rather blunt tactics, with the aim of accelerating the shift to formal channels.

India’s demonetisation

India’s approach to cut the number of illegal remittances was part of a more general effort to move people away from cash altogether and drive the growth of digital payments. This is a trend that has been underway for many years across the globe, driven both by consumer choice and availability. The Indian government decided to speed this process up, not only to accelerate the shift to digital, but to deal with issues that cash made possible, such as widespread counterfeit notes, bribery and corruption, and a reliance on money lenders charging excessive interest.

In 2014, a plan to provide a bank account for every household was announced, in an attempt to increase financial inclusion—opening a bank account was described by Prime Minister Narendra Modi as “a step towards joining the economic mainstream”. Anyone opening an account would receive a debit card, free insurance, and would not have to pay fees for a zero balance. The policy led to many new bank accounts, but cash use didn’t decline as hoped. Just this year, the World Bank found that the biggest effect of this policy was to create the highest share of inactive bank accounts in the world.

A new tactic was needed. On the 8th of November 2016, at 8pm, the government announced that all ₹500 and ₹1000 notes would no longer be valid at midnight. Those who had these banknotes would need to exchange them for new notes or deposit them in a bank account.

When the announcement was made, cash was used for 90% of transactions. And 86% of the cash in circulation were the two banknotes being withdrawn. While the aim was to disrupt the “shadow economy”, the effect was instead to disrupt the legal economy. According to Forbes:

“demonetisation...caused a sudden breakdown in India’s commercial ecosystem. Trade across all facets of the economy was disrupted, and cash-centric sectors like agriculture, fishing, and the voluminous informal market were virtually shutdown, with many businesses and livelihoods going under completely — not to mention the economic impact of millions of people standing in line for hours”

The surprise withdrawal of cash was deliberate - to prevent the black market from attempting to rid itself of the notes before the announcement. Unfortunately, the effect on a largely cash-based economy was catastrophic.

The Pakistan Remittance Initiative

The creation of the Pakistan Remittance Initiative (PRI) is a very different approach to dealing with illegal remittance channels and has had very different results.

Launched in 2009 by the government and the State Bank of Pakistan, following research into official and unofficial remittance channels, PRI was designed to monitor and handle all banking-related aspects of remittances. A system of incentives was also introduced for banks and other agents to encourage them to increase the volume of remittances, including paying banks marketing expenses as percentage of remittances processed.

Crucially, a real-time settlement system was set up between banks that allowed for a near-instant transfer of funds within the country. This reduced the speed of international money transfer from days to minutes.

Suddenly, the main advantages of unofficial remittance channels, also known as “hawala”, disappeared. It was no longer cheaper and faster to send money home through this riskier channel. Since the introduction of the PRI, worker remittances back to Pakistan have increased by 150%. A majority of this increase is undoubtedly the result of legal, official channels being more appealing than illegal remittance channels.

The carrot or the stick?

PRI is not without issues. Recently, there have been calls for it to end as certain institutions were profiting through its rebates and commissions at the expense of others. But it has undoubtedly been far more successful than India’s destructive and ill-conceived demonetisation policy.

When governments are considering how to deal with the “shadow economy”, it’s important that they consider that this term covers many different groups of people. While it includes those who are trying to launder the proceeds of crime and attempting to fund terrorism, it also includes those who are trying to avoid high fees when sending money back to their families. Both may be using illegal methods to transfer money, but their aims are very different!

India’s demonetisation has affected not just those using illegal channels to transfer money, but anyone using cash, i.e., almost everyone in the country. While it may have made life difficult for criminals, it was like using a sledgehammer to crack a nut, while also smashing apart the table the nut was placed on, and denting the floor underneath.

PRI, on the other hand, was not designed to deal with serious criminals, but instead nudge those who want to save money away from illegal channels. The result is that the illegal channels still exist, but these can now be targeted without also targeting those with innocent aims.

Governments that are looking to crack down on illegal remittances in order to tackle money laundering need to look at Pakistan and India as case studies—how to do it right, and how to do it wrong.