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Analysis

Long-term gains, but for now chaos

by Meghnad Desai

Long-term gains, but for now chaos

 

On the same day as the election of Donald Trump, India’s Prime Minister Narendra Modi announced a radical demonetisation plan for India to combat ‘black money’, the practice of hiding money and transactions in cash to avoid detection by tax authorities.

Black money has been troubling India since before independence in 1947, when excess war-time profits were hoarded by a few in cash mountains. In a largely poor society, cash payments are the norm.

The thin veneer of modern tax laws and revenue services further encouraged hoarding of cash. Socialists of all parties, whose economics is theoretical rather than practical, compounded the problem by introducing punitive rates of taxation, making hoarding more profitable.

Radical action finds India unprepared
The Indian economy is enmeshed in the black economy. Sending money abroad illegally to a foreign bank is criminal, but does not affect the daily running of the Indian economy. Routine income tax evasion is also common.

The problem is with hoards of cash acquired in a variety of businesses. It is this money which not only circulates in clandestine activities such as drugs, prostitution and gambling, but also enters legitimate sectors such as real estate, jewellery and luxury consumption. This sort of black cash has become not just part of the economy, but a dynamic part. Electoral politics has also been shaped by these hoards of money.

The elimination of this black money at home and abroad has been one of Modi’s key policies, and his earlier amnesty scheme for cash hoarders gathered Rs660bn. Around Rs1.5tn has been brought back from abroad, but the bulk of black money and the core of the problem is in India.

In the latest phase of his project, Modi announced the replacement of Rs500 and Rs1000 notes with new Rs500 and Rs2000 notes. By demonetising the old currency, the value of those vast hoards of cash has been wiped out. It is the biggest redistributive policy move of the past 70 years.

Desai

The announcement took citizens and banks alike by surprise. Neither were prepared for such a radical action. There have been chaotic scenes as long queues of Indians wait outside banks to deposit old cash before the 30 December deadline. Restrictions are imposed on how much new money can be withdrawn, but due to the lack of preparation among the banks there are difficulties in supplying the new cash and delays while old ATMs are upgraded for new note sizes. The turmoil has been most acute in rural areas, where bank branches are scarce.

Setting precedent for reform
The scale of the shock has raised questions about an economic slowdown and reduced rate of growth, but this will wear off after a month, following which there should be an upward correction in purchases. The final numbers will show a negligible impact on national income.

In the long term, Modi’s policy should lead to a more widespread adoption of cashless culture, already popular among India’s youth. Small shopkeepers are already adapting to plastic. If India can be weaned off cash, there will be a considerable reduction in transaction costs as well as corruption.

For the meantime, banks inundated with cash deposits will have to cut lending rates, meaning that cash that remains hoarded will lose value. This will reduce the liabilities of the central bank, a dividend it can share with the government.

Demonetisation is the boldest step Modi has taken and, despite some shortterm problems, the scheme has plenty of support in India. Modi, who has previously been thought of as risk averse, has shown his willingness to hazard unpopularity for the sake of radical reform. This is promising for future possible projects such as labour market reform.

Meghnad Desai is Emeritus Professor of Economics at The London School of Economics and Political Science.

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