India’s Big Money Gamble

In a surprise move to strangle its shadow economy, India has canceled its two largest bills, prompting major shifts in the world’s third-largest economy.

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An activist from India's Congress Party holds banned 500 and 1000 rupee notes during a protest against the government's decision to withdraw high denomination notes from circulation, in front of the Reserve Bank of India in Hyderabad on Monday, Nov. 28, 2016. Indian Prime Minister Narendra Modi, in his Nov. 8 televised address, announced the demonetization of India's 500 and 1,000-rupee notes, which made up 86 percent of the country's circulating currency.

AP Photo | Mahesh Kumar A.

While many Americans were absorbed in the US presidential elections, India embarked on a radical economic experiment.

The Prime Minister, Narendra Modi, made a surprise television appearance at 8:15 PM to announce that, as of midnight that night, the 500 and 1,000 rupee notes would no longer be deemed valid currency.

The notes, worth about $7.50 and $15.00, are the two largest denomination bills in the country and account for approximately 86 percent of all bills in circulation in a country where an estimated 90 percent of transactions take place in cash.

"India has demonetized before," Suresh Sundaresan, the Chase Manhattan Bank Foundation Professor of Financial Institutions at Columbia Business School, explains. The Indian rupee has been printed in an array of denominations over the years, from 1 to 10,000. "But to pull over 80 percent of the nation's cash from circulation — and to do so in a surprise — is nothing short of shock treatment for the economy."

The stated purpose of the policy is to curb corruption and disrupt drug and terrorist networks, but many understand the true target to be tax avoidance. It's estimated that less than 2 percent of the population in India pays any tax at all. The surprise announcement was intended to prevent individuals from changing their money for lower denominations.

The canceled notes will be replaced by new Rs 500 and 2,000 notes, and individuals have just 50 days to change their cash over. In the near term, however, individuals can only change Rs 20,000 (approximately $290) per week due in part to the challenges faced by the government in printing and distributing new bills. "By some estimates, to bring the new currency up to the normal circulation levels, it may take two to four months," Sundaresan explains. As a result, most will be forced to move their savings into bank accounts. By one estimate more that $75 billion had already been deposited by November 18.

Any individual attempting to deposit Rs 250,000 or more will need to explain their cash holdings and prove they’ve paid taxes on them. Revenue Secretary Hashmukh Adhia has said that any mismatch between income and deposits will be treated as a case of tax evasion, incurring a fine of the tax due plus a 200 percent penalty. That amounts to a massive transfer of wealth from the general public to the government, Sundaresan points out, all of which could fund improvements in education, healthcare, and infrastructure to spur further development.

With the banks suddenly flush with cash, interest rates have been falling. It's also been a boon for fintech on the subcontinent, prompting a surge in adoption of new payment systems including mobile payments. The country’s largest mobile payment provider Paytm registered five million new users in the two weeks following the announcement, according to India’s Financial Express. Rival Mobikwik, backed by Silicon Valley venture capital titans Sequoia Capital, has boasted of a 7,000 percent increase in bank transfers.

The move has not been without its critics. Protests have struck up across the country, led in particular by left-leaning and regional parties. Kaushik Basu, former chief economist at the World Bank, took to the opinion pages of the New York Times to criticize the move, arguing that it would have a crippling effect on the poor and middle classes while achieving little of its intended goals. There has been concern, in particular, about near-term liquidity constraints on farmers, who are heading into planting season and need to purchase seeds and fertilizers, though the government has now approved the use of defunct Rs 500 notes for this purpose. Amartya Sen, a Nobel prize winner, cautioned that the move could undermine confidence in the government and the economy.

Sundaresan agrees that the move is unlikely to fully curb corruption. Those with the largest untaxed holdings keep them not in cash, but in durables like property and gold or numbered offshore accounts, meaning that additional steps, including tracking capital parked in foreign accounts, overhauling the tax code, and clamping down on so-called “benami transactions,” in which property is purchased in another’s name would be necessary to capture the largest offenders and curb the problem.

Even so, Sundaresan argues that the move is still in the country’s best interest in the long term. “We’re seeing the short-term costs play out now,” he explains. “But in the long term, a wider tax base, greater take up of banking and digital payments, and increased transparency and lower corruption should all significantly improve economic performance and make India a more attractive destination for foreign direct investment.”

About the researcher

M. Suresh Sundaresan

Suresh Sundaresan is the Chase Manhattan Bank Foundation Professor of Financial Institutions at Columbia University. He has published in the areas of Treasury auctions...

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