IN a completely unexpected move on November 8, Indian Prime Minister Narendra Modi issued an order “demonetizing” 500-rupee and 1000-rupee currency notes, declaring that they would no longer be considered legal tender after December 30.
Modi’s unprecedented action, as he and other Indian government officials explained, was intended to remove money from India’s “black” economy, and return it to the formal financial system. According to various estimates, the informal economy is worth about a quarter of India’s $2 trillion annual GDP, and it is an aspect of life in the country of 1.3 billion that Modi has wrestled with since he took office in 2014.
The informal economy – which is a problem because it evades virtually all taxes – thrives in India because about 90 percent of all transactions are in cash. Despite an aggressive push by the government to develop cashless payment systems, they have been slow to spread in a country of India’s size and diversity, and most business is still done the old-fashioned way. Modi’s first move against the informal economy was to implement rules against cash hoarding, and when that didn’t work, the next step was to simply remove the money from the financial system.
The chaos it has caused is, according to a journalist friend from Mumbai, almost unimaginable. Business owners who have huge stockpiles of cash have resorted to extreme measures to rid themselves of the money before the deadline, paying employees for months in advance, or buying large amounts of gold (which has also attracted the attention of the authorities). The 500-rupee and 1000-rupee notes account for about 86 percent of all available cash; while the government plans to replace the old notes with a new 500-rupee note and a higher-denomination 2000-rupee note, there have reportedly been delays in producing the new currency, leading to a serious cash shortage.
The situation has been further complicated by the sloppy way the government has been handling the recall of the currency notes. Until the deadline, people can deposit the money in their bank accounts; up until November 24, they could simply exchange notes at a bank, but only up to a limit of 4,000 rupees. In any case, banks have become almost completely paralyzed, due to the volume of panicked customers. To help ease the situation, the government allowed people to spend the old notes at gas stations until December 15, but late last week changed the deadline to last Friday, giving everyone less than 24 hours to get rid of the old currency by buying fuel. Another problem was encountered when people tried to withdraw the first 2000-rupee notes from ATMs, only to discover that the larger money jammed the machines; the government said it would take up to three weeks to recalibrate the machines to work properly.
The latest estimates from most economists are that the cash crisis will knock at least 2 percent from India’s GDP growth, which was Asia’s best at 7.3 percent last year; already, according to reports from Mumbai and New Delhi, consumer spending has dropped significantly. In addition, there have been reports over the past couple of weeks that many businesses have either closed temporarily or are finding it difficult to operate due to shortages in both supplies and cash to pay for them, and tourist numbers have dropped significantly, as visitors worry that they will not have usable money to spend.
To make matters worse, now that the “demonetization,” as chaotic as it has been, is nearly done, Modi has had to consider the next step in his campaign against the “black economy,” since it is clear the demonetization has not had that significant an effect. What he has done is to encourage tax officials to step up their enforcement efforts and conduct raids to discover wealth that might be hidden in forms other than cash – gold, primarily, that being the traditional Indian choice for durable, portable wealth.
Critics have charged, however, that this is likely to be a huge source of corruption; tax officials have been given a large amount of discretion to decide what is and is not illicit wealth. Expressing a commonly held viewpoint in India, Bloomberg View columnist Mihir Sharma wrote, “India has experimented with a ‘Raid Raj’ before and it’s led only to corruption, harassment of ordinary citizens and the targeting of political enemies…. Rather than cleaning up tax administration, the government has handed tax officials more power than they’ve had for decades. The rich will pay what they need to escape harassment; the rest will suffer.”
No one is suggesting that Modi drop his aspiration to unwind the “black” economy, but his reckless approach is doing more harm than good. In the short term, other economies like the Philippines, which present an alternative to India, may see some slight benefits from India’s chaos, but the hole in the global economy Modi could cause if someone couldn’t convince him to spend a little more time considering the consequences of his decisions would not be something anyone should wish at all.