How India's Currency Crisis Could Shape its Economy

SMITH BRAIN TRUST — What is it like when 86 percent of the banknotes in circulation in a country are rendered worthless overnight? That's what India has been finding out over the past three weeks. On the evening of Nov. 9, Indian Prime Minister Narendra Modi announced that, by morning, all 500 and 1,000 rupee notes would no longer be legal tender. 

The highly controversial move has sparked protests and criticism of a change too sudden and too poorly planned by the government. However, some say that when the controversy dies down, Modi's popularity could be higher than ever.

The startling demonetization move was intended to crack down on so-called black money and tax evaders. But it also sent shockwaves through a country where people rely heavily on cash. Some 80 to 90 percent of India's economy is cash-based, and the 500 and 1,000 rupee banknotes — roughly $7 and $15, respectively — represented the most frequently used denominations.

Now Indians were being told they had to deposit or exchange that money, and possibly pay tax on it, before the end of the year. Anxious crowds immediately began forming at banks. Banks and teller machines quickly ran out of the new currency notes. Opposition parties criticized Modi for not providing people with advance notice about the massive currency changeover.

Doing it any other way would have negated the intended outcome, says Nagpurnanand Prabhala, a finance professor at the University of Maryland's Robert H. Smith School of Business, part of which was to bring back untaxed black money into the financial system where it could be taxed. At least 20 percent of the Indian economy takes place outside the tax system, according to World Bank estimates.

With its demonetization scheme, the Indian government was essentially betting that people who held black money legally would come forward to deposit or exchange the old banknotes. Those who held substantial amounts — in excess of 250,000 rupees — would be taxed on it at penal rates, currently about 50 percent.

Meanwhile, India was betting that many people holding black money for illegitimate reasons would keep to the shadows, rather than face police or tax authorities. Their ill-gotten gains would become worthless paper. "The big fish will be caught," Prabhala says.

The demonetization was also aimed at hobbling terror financing organizations within India by taking their counterfeit notes out of circulation and by slowing the rate at which they can make new phonies. Whenever banknotes are redesigned, it takes counterfeiters some time to figure out how to fake the new bills convincingly.

Though the move was a surprise, the timing, Prabhala says, seems anything but accidental. When Modi took office in 2014, an estimated 600 million Indians — or roughly 50 percent of the country — lacked any bank account at all. Modi set out to change that and to modernize the digital business infrastructure, opening 254 million bank accounts for the country's "unbanked" and giving them Rupay cards, similar Visa or MasterCards, but with lower fee structures. Supporting digital infrastructure, including a unique ID scheme covering a billion people, a unified payments interface, new payments banks, and a value-added tax system with electronic collections, has been rolled out steadily.

"Things would be much worse without these changes," Prabhala says. Now, with more than two years until Modi faces re-election, experts say, he has time to demonstrate to the country the benefits of this sudden, controversial move.

"He is quite a gifted politician with good political skills," says Smith School professor Kislaya Prasad.

Already, things may be calming down. ATM lines have become shorter, there are few lines at banks. In two or three months, observers say, things likely will be back to normal. People have until the end of the year to exchange the old banknotes for the new 500 and 2,000 rupee notes. Economists such as former Prime Minister Manmohan Singh expect a 1 to 2 percent hit to the growth rate of India's gross domestic product this year.

"But there will be other factors to offset that," says Prasad, director for the Smith School's Center for International Business Education and Research (CIBER). For example, interest rates have been dropping because the banks are suddenly flush with cash. Although low rates make borrowing cheap, and that has a stimulating effect on the economy, the bank surpluses may be temporary.

And "it's always a knife's edge," he says, "because people worry that inflation might increase and that's been relatively under control recently."

And that knife's edge is not a comfortable place for economies or markets. "Uncertainty is intrinsically bad," Prasad says. "There is a level to which it undermines the overall confidence in the payment system. And that's a bad thing." 

India's demonetization can be seen as complementing the  government's push to have more purchases made digitally, where they can be easily tracked and taxed, as it moves to adopt a goods and services tax (GST). The value-added tax is set to roll out in spring.

There are also rumors that Modi might soon require a registry of all real-estate property, similar to the title system in the U.S., as he looks to fully tax India's real-estate market, where off-the-books money has long played a role. The move would likely slow the market's pace and soften property prices, at least temporarily.

Typically, real-estate transactions in India were equal parts "white," or recorded and taxed, money and black, or off-the books, money. Prasad says. Capital gains and other taxes, such as stamp duties, are paid on the white portion, but not the black.

Before that happens, there's the issue of demonetization, and the question of what happens with all of that outstanding cash – the black-money rupees that become worthless paper when they aren't exchanged by the end of the year.

So far, about 65 percent of the demonetized currency has been tendered. Experts estimate that up to 25 percent will remain in the shadows, never exchanged nor deposited.

What does that mean for India?

By its very nature, cash, or legal tender, is a liability of the central bank. When a big chunk of cash goes out of circulation in India, the central bank's balance sheet — and thus the government's balance sheet — strengthens.

The bank could issue bonds for the outstanding currency, or "sterilize" the money by replacing the old banknotes with brand-new ones, keeping the country's cash base unchanged. The strenghened balance sheet could create fiscal room for the government's spending wish lists, Prasad says.

"While citizens experience considerable short-term pain of demonetization, a key question is whether there are longer-term gains, but as importantly, how these long-term benefits are communicated in a way that touches people," Prabhala says. 

Would the inconvenienced citizens get a "black money recapture" dividend from the government?