The prime minister’s controversial bid to crack down on corruption has tons
of costs.

Updated by Zeeshan  Nov 29, 2016, 8:40am EST

Tens of thousands of people have taken to the streets of cities throughout
India to protest an economic policy you probably haven't heard of before:

Three weeks ago, Indian Prime Minister Narendra Modi surprised his country
with an announcement banning 500- and 1,000-rupee notes -- worth about $7
and $15 respectively  -- in a bid to tackle corruption and terrorism.

He estimated that forcing people to exchange the country’s largest currency
bills for new banknotes would allow the government to crack down on “black
money” — unaccounted-for cash holdings that haven’t been taxed but, under
the law, should be. He also argued that it would strike at domestic
terrorist financing operations by capturing counterfeit money and rendering
the legitimate cash they kept in the shadows worthless.

Banning widely used banknotes would have a huge impact on any economy, but
in India the policy is transformative. Modi’s sudden ban instantly meant
that 86 percent of all the cash in circulation in India was no longer
considered legal tender, which means that businesses could refuse to accept
those bills as a form of payment. And the Indian economy simply runs on
cash: It’s estimated that between 90 and 98 percent of all transactions in
India, measured in terms of volume, involve it.

Unsurprisingly, Modi’s demonetization initiative has caused chaos across
the country. People want new banknotes, but the current supply of them
isn’t close to meeting demand. That’s created headaches for people as they
wait in long lines outside ATMs and banks, which routinely run out of cash.
For people who rely on daily cash earnings to survive, it can mean not
being able to obtain food.

The temporary shortage of banknotes is having other far-reaching effects.
Farmers looking to sow their next set of crops can’t buy the full quantity
of seeds they need. Property sales, which typically require huge cash
investments, are slowing. It’s even reshaping cultural life: Weddings,
which can cost millions of rupees, are taking a serious hit.

“A lot of marriages are being postponed, and those that are managing are
doing so by borrowing from relatives and friends,” says Niranjan Sahoo, a
senior fellow with the Observer Research Foundation, a think tank in New

Modi’s agenda to crack down on black money makes sense in theory but it
isn't working smoothly in practice. It's hitting individual Indians hard,
and the country itself may pay a heavy price: Many economists expect the
growth of India’s booming economy to slow substantially in the final
quarter of 2016.

How does the ban work?

As of November 8, old 500- and 1,000-rupee notes are no longer legal
tender. That means if you try to buy lunch with them, a restaurant owner
can refuse to accept them.

People in India have until the end of the year to go to banks and replace
those notes with other bills, including the new 500- and 2,000-rupee notes.

If someone wants to convert more than 250,000 rupees — roughly $3,650 —
they’re required by law to provide an explanation for why they have so much
cash and prove that they’ve paid tax on it. If they don’t, they’re expected
to pay a fine of 200 percent of the tax they owe.

Why is this happening?

The primary reason Modi initiated the ban is to force people with illegal
cash holdings to deposit the money into bank accounts and pay taxes on them.

India’s government collects a tiny fraction of the taxes that advanced
democracies do. The government recently released data that showed that in
2013, merely 1 percent of Indians paid taxes. As Kaushik Basu, former chief
economic adviser to the Indian government, recently noted at the New York
Times, the most reliable estimate of India’s “shadow economy,” or the
untaxed part of it, puts it at one-fifth of the country’s GDP.

The demonetization scheme is also a way to crack down on criminal activity.
It will be hard for people with large cash holdings from purely criminal
enterprises to explain how they paid their taxes, and so they won’t be able
deposit their money. And the government expects to be able to use the ban
as an opportunity to round up counterfeit currency minted by terrorist

In addition to all this, the ban also serves as a natural prompt for India
to transition to a cashless society, dovetailing nicely with Modi’s bid to
digitize services in the economy.

What are the effects so far?

The currency ban has been a huge headache for millions of Indians. Since
the old 500- and 1,000-rupee notes are the bread and butter of most
financial transactions in India, everybody has been rushing to exchange
them. But because the supply of new banknotes is far smaller than the
supply of old ones, there are currently strict regulations on the quantity
of new banknotes that people can withdraw at any given moment. And even
with these regulations, reports of banks running out of cash abound.

“Every day  -- and today is the 20th day  -- you can see there are long
queues for ATM machines and banks,” Sahoo says.

The cash shortage has been particularly hard on destitute Indians, many of
whom don’t have bank accounts. Some of them have to choose between waiting
in line for a day to exchange their defunct currency or working for a day’s
wages. And Basu estimates that many poor people may simply end up losing
their savings because of their mistrust of financial institutions and
concern about being harassed about where their cash came from.

“The policy is poorly implemented and has a high cost for those who are
least able to bear it,” Rohini Pande, an economist at Harvard’s Kennedy
School, said. “Even if [the government is] able to reduce corruption
somewhat, you have to balance that against costs or other ways of reducing
black money.”

Many experts don’t even have faith that this is an effective way to
counteract tax evasion. Basu says that most black money doesn’t take the
form of cash held in india but is instead held in gold, silver, real
estate, and overseas bank accounts.

Modi is using a very crude tool to crack down on black money. For many, the
costs are likely to end up more tangible than the benefits.

To The Point : Montek Singh Ahluwalia Interview On Impact Of Demonetization

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