Fighting Corruption through Monetary Policy

While much of the world was focused on the day’s US presidential election, India’s Prime Minister and TIME’s Person of Year Narendra Modi announced on November 8, 2016 that the current 500 and 1000 rupee (around $7.5 and $15 respectively) notes will no longer be considered legal tender in India. While citizens have until December 30 to exchange the old notes for their new versions, many airports, railway stations, hospitals, and fuel stations only accepted the soon-obsolete notes until November 11. The ₹500 and ₹1000 notes are by far the most widely used denominations in India, together representing 86% of the bills in circulation in an economy where 98% of all consumer transactions use cash. Prior to Mr. Modi’s surprise live announcement, there was little to no public indication of this move, inciting a flurry of panic and quick analysis.


Why is this happening?

Deemed a ‘surgical strike’ on black money by Revenue Secretary Hasmukh Adhia, Mr. Modi implemented this program as a part of a larger effort to fight black money and corruption, which he has said “are the biggest obstacles in eradicating poverty”. India’s economy is heavily reliant on cash, therefore it is relatively easy for traders in black and grey markets to launder money made in those markets. For example, it is difficult to tell the difference between a ₹500 note that was obtained by selling illegal goods and a ₹500 note obtained by selling fruit on the street corner. A cash-driven economy allows an individual to be more flexible with which markets that they participate in, making participation in black markets more profitable than it otherwise would be.

But this flexibility comes with a crippling weakness. By suddenly declaring the most popular denominations worthless, anyone who holds any of the worthless notes must go to a bank and exchange them for their replacement currency. For legitimate business, this shouldn’t be too difficult, as they have income statements on hand that justifies their large cash deposits. Similarly, households who are not engaged in black markets are unlikely to have exorbitant amounts of cash lying around, and will thus face little questioning from banks when they attempt to trade their old notes in for new ones. However, individuals holding black money have a tougher time explaining where their money originated, meaning that much of this illegally obtained money will be lost.

However, there are ways for black money holders to get around the new policy and recoup some of what they stand to lose. Before airports and railways stopped accepting the soon-obsolete notes, many airlines and railway companies saw a surge in first-class ticket purchases paid for in the newly obsolescent notes, followed by cancellations the same afternoon and demands for payment in new notes. Additionally, some black money hoarders have reportedly paid others to deposit medium amounts of hoarded cash (under ₹2,500 so as not to alert authorities) in bank accounts accessible to the hoarder, or with the stipulation that the depositor would soon withdraw the money and pay it back to the hoarder when the new legal tender is available. Both of these methods, if inconvenient and laden with transaction costs, allow hoarders of black money to soften the blow of Mr. Modi’s ‘surgical strike’.


What is the extent of the problem of black money?

While placing an exact number on the size of the Indian black money economy has proven difficult, estimates are consistently reported to be in the hundreds of billions of US dollars. In 2012, India’s Central Bureau of Investigation reported that “Indians are the largest depositors in banks abroad with an estimated 500 billion US dollars[…]of illegal money stashed by them in tax havens”. Ambit Capital Research, a research firm focused on Indian economic activity, estimated in June of 2016 that, while the black economy had been steadily contracting since the 1980s, it’s current size is around 20 percent of India’s GDP, and larger than the GDP of countries like Thailand and Argentina.

Despite encouraging participation in illegal commerce, the size of the black economy also hides billions of taxable dollars from the Indian government, stunting the impact of development projects and anti-poverty programs put forth by the government. While the Indian government cannot easily recoup all or near all of its lost tax revenue, it has announced that deposits of more than 2.5 thousand rupee be taxed, and that individuals depositing large amounts inconsistent with personal income statements would be subject to be taxed at “the tax amount plus a penalty of 200 per cent of the tax payable…per the Section 270(A) of the Income Tax Act”. Assuredly, the government should see a large boost to its coffers by the new year, as well as a higher flow of incoming tax money in the future if participation in black markets is considered less safe economically as before, which one would expect it might.


Has this been done before?

This is not the first time that the Indian government has demonetized certain bank notes. In January 1946, the ₹1,000, and ₹10,000 notes were declared illegal, only to be reintroduced eight years later along with a new ₹5,000 note. In an effort to curb the growing presence of black money in 1978, India again demonetized the ₹1,000, ₹5,000, and ₹10,000 notes, thinking that the demonetization of the highest value notes would address corruption issues with minimal collateral damage. However, there had been unofficial consideration of this move since late 1972 when the Wanchoo committee, a direct tax inquiry set up by the government, released a report suggesting the then-hypothetical move would help curb the short-term influence of black money. This long run-up of unofficial talk undermined the surprise of the move when it was finally implemented, allowing hoarders of black money to prepare by depositing their earnings in banks or in assets like real estate and jewelry.

Elsewhere, demonetization – or stripping banknotes of their value – is relatively common worldwide. For example, the demonetization of various European currencies to make way for the euro is a salient example. However, demonetization for the specific purpose of fighting corruption is more rare, though the demonetization of higher value notes to fight illegal trade has gained some traction in the West as of late. Early in 2016, economist Peter Sands supported the elimination of the $100 and £500 bills, stating that the use of electronic payment systems has made these bills far less useful for individuals involved in legal trade, whereas these high end bills are essential to carrying out large scale black market commerce. Still, some doubt the feasibility or use of retracting these higher end bills, and the idea has yet to be really seriously considered.


What are the short-term and long-term economic impacts?

Undoubtedly, hoarders of large amounts of the illegal cash will be hurt by India’s demonetization of specific notes, as their stashes of wealth are now hardly worth more than the paper that they are printed on. Though there are ways around the issue as aforementioned, the circuitous route taken to convert the illegal cash carries transaction costs that are inconvenient at best. However the precision of Mr. Modi’s self-described ‘surgical strike’ leaves much to be desired. In addition to punishing purposeful tax evaders and black market tycoons, India’s small and medium sized businesses are expected to see activity slow dramatically over the next few weeks. Unlike large businesses who can run on credit, these businesses rely on cash transactions from customers for their products and cash payments to secure inventory and goods. Undoubtedly the lack of access to the most popular denominations of cash will only hurt these cash-based businesses, though the exact severity of the impact depends on how quickly these businesses and their customers can obtain access to the new ₹500 and ₹1000 notes. At this point, it is not clear how quickly this is expected to happen.

As time as gone on, it is becoming increasingly difficult to believe that Modi’s government has sufficiently considered many of the details of managing the transition. Banks are still not receiving enough of the new notes to meet their needs, and 33 people had died from exhaustion standing in queues to exchange old bills for new. Also, a week after the announcement, over 60 percent of the nation’s 9.3 million truck drivers have walked off the job after not having access to legal tender to pay road tolls. Considering that 65 percent of the country’s freight is road-based, the government’s lack of prioritizing the distribution of new currency threatens to slow the country’s domestic economy considerably for the next couple of months.

Additionally, Indian housewives up and down the country stand to lose personal fortunes. “For many generations”, it is said that Indian housewives have been stashing small shares of their husband’s incomes in shoeboxes and dark closet corners, which over time can build up into small fortunes. For many Indian women, these small fortunes represent a rare form of financial and personal freedom, as the fortune’s unbeknownst-to-many form of existence allows the holders to spend them however they please. Now however, women across the country are facing the difficult decision to come clean about their conduct to their families and face ridicule and humiliation, or lose the fortune’s altogether.

In the long term, this policy’s effect on the Indian economy is unclear. On the one hand, shocks like this demonstrate the ironically fickle nature of fortunes based upon large holdings of cash, which might encourage Indians to open bank accounts and trust electronic payment systems more than they have in past. Doing so would allow the government to tax more efficiently, and make it more difficult to hoard large fortunes in cash from illegal activity. Additionally, the move will make obsolete the rash of counterfeit ₹500 bills flowing in from Pakistan, often to fund terrorist activity.

While this move may well come to represent a potent one-time strike against black money fortunes, it is not clear whether it addresses the structural conditions that allow black money to flow freely in India. A one-time obsolescence of the most popular bills does not deter future black money holders from buying value-holding assets like real estate with illegally-obtained tender, and selling it later for legally-obtained tender. Indeed, much of India’s black money is laundered this way through the real estate, jewelry, and gold markets. While in the short term one would expect these markets to depress in the absence of black money, it is highly unrealistic that these markets do not rebound in the near future and re-emerge as a haven for black money as black markets get back on their feet.