How Narendra Modi's Cash Recall Gambit in India Backfired

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A taxi driver pleads in front of a gas station attendant to accept a 500 rupees currency note in New Delhi, India, November 9. Indians awoke to confusion after the government withdrew the highest-denomination currency notes overnight to halt money laundering in a country where many still make day-to-day transactions in cash. Altaf Qadri/AP

On November 8, when Indian Prime Minister Narendra Modi announced a surprise recall of more than 80 percent of the country’s cash in circulation, his supporters hailed the measure as an ingenious “surgical strike” against corruption and tax evasion. Everyone else was too busy running to the ATM.

Before the move, Modi had made little progress in fulfilling his campaign promise to bring back billions in untaxed “black money” stashed abroad so he could deposit it in the bank accounts of India’s poor. Washington, D.C.–based corruption watchdog Global Financial Integrity recently estimated that an average of $50 billion a year in illicit funds flowed out of India from 2004 to 2013, while bureaucrats, politicians and business tycoons amassed huge fortunes from influence peddling, backroom deals and outright graft.

Some Indians were so disgusted by this corruption that, much like Donald Trump’s supporters in the U.S. or Britain’s Brexiteers, they applauded Modi’s radical gambit—believing any action would be better than continuing to do nothing. But as it becomes more and more clear that replacing old notes with new ones will, at best, result in a small loss for the biggest crooks and only a short hiccup in the bribery business, the scheme is rapidly looking less like a clever economic maneuver than a brilliant but potentially disastrous piece of political theater.

The idea behind the recall was simple. Overnight, India announced that anyone holding 500- and 1,000-rupee notes had to exchange them for new bills before December 31. After that date, the old money will become worthless. The catch: The government is allowing people to swap only 4,500 rupees (about $65) in the old notes for cash. Anything more than that has to be deposited, thus creating a paper trail. Theoretically, this would either force those hoarding cash to come forward and pay taxes or their money would be worthless. Plus, anyone caught with more than 250,000 rupees in canceled notes—about $3,500—is now subject to investigation.

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To prevent word of the plan from getting out, which might have allowed the biggest violators to exchange their big notes in advance, Modi reportedly opted to make the radical move in secret. He apparently relied on the advice of a few top advisers.

He would have done well to seek further counsel, because his plan has now thrown India’s economy into chaos. The secrecy meant the country’s mint couldn’t print or distribute new notes until the announcement—so banks are struggling to meet demand. Even worse: Indians are standing in long lines to exchange or deposit their old notes, or withdraw cash just to buy groceries.

Black money—cash hidden to avoid taxes—is pervasive in India. Yet it’s not only that police officers, tax collectors and politicians demand bribes to do their jobs or look the other way, says Surjit Bhalla, senior India analyst at the New York–based Observatory Group, an advisory company specializing in monetary and fiscal policy. Virtually anyone who buys real estate in India pays for it at least partly under the table, and even the poorest Indians routinely forgo receipts to avoid paying sales tax. “Everybody,” says Bhalla, “has been made to commit this crime.”  

Black money can also represent proceeds from legitimate business, while illegal income from bribes or conflicts of interest can be “white”—as long as someone has paid taxes on it. So the politicians in Parliament or various state assemblies, many of whom have somehow earned tens of millions, if not more, after taking office, can pay taxes on their bribes and still get away with it. Recalling and replacing big bills won’t do much to stop this malfeasance, Bhalla says. As long as bribery continues, the new clean notes will swiftly turn into dirty ones. Corruption, it seems, has little to do with the denominations of the bills—except that large notes take up less storage space.

Meanwhile, violators keep as little as 6 percent of their hidden income in cash, according to some estimates. They invest the rest in property or gold—of which Indians hold some 15,000 tons, according to a conservative 2011 estimate from Citigroup, or they wash it by sending it abroad and bringing it back again as foreign investment.

Then there’s the question of legality. Lawyers from India’s political opposition have questioned whether some elements of Modi’s plan—such as denying people access to their own money—are against the law. Others see the move as an exercise in propaganda. “This is politics as a vast morality play,” wrote Indian political analyst Pratap Bhanu Mehta in The Indian Express, a left-of-center daily. “Literally every citizen is being enlisted (or conscripted, if you prefer) in a policy cause.”

This isn’t the first time a charismatic nationalist has used a simple, good-vs.-evil narrative to push a radical economic measure. In 1958, China’s Mao Zedong called upon millions of citizens to wipe out the country’s rats, sparrows, mosquitoes and flies to fight disease and prevent crop losses. And like Mao’s campaign, which engendered a plague of locusts by wiping out the sparrows that ate them, Modi’s strike against corruption has led to some unexpected and painful consequences.

Around 400,000 trucks were stranded around the country as of November 14 because their drivers had no valid bills to pay for incidentals (including bribes) on the road, according to the All India Motor Transport Congress—suggesting there may be shortages of essential supplies in the near future. Sugar processors have reportedly made only partial payments to workers, reserving whatever valid bills they had to pay for fuel needed to run their cane-mashing machines, while other factory owners have given workers several months’ salary in canceled notes to get rid of the old denominations. Critics say Modi’s move could even lead to a significant economic slowdown. As K.C. Chakrabarty, a former deputy governor of the central bank, warned, “You have stopped market transactions for 70 percent of the economy.”

Yet Modi and his Hindu nationalist Bharatiya Janata Party (BJP) have deflected any criticism of the pain and suffering resulting from the move by saying only people sitting on stacks of black money have reason to complain—recasting the serpentine lines at bank branches nationwide as a vast people-laundering machine: Criminals go in, and patriots come out.

By making or at least seeming to make the rich suffer alongside the poor, recalling the big notes could give Modi room to execute other measures that would otherwise be rejected as favoring the rich—such as lowering property taxes to reduce the incentive to evade them, Bhalla adds, “This gives them a certain credibility [with the poor].”

At least in theory. Lines at the bank are getting shorter in cities, while wealthy and middle-class Indians have adjusted by using debit and credit cards for more purchases—as well as downloading payment apps in record numbers. But such workarounds are not available to hundreds of millions of citizens who have also seen their salaries withheld or their sales drop because of the sudden lack of cash. Small shopkeepers who cater to the poor say business has plunged by as much as 80 percent (even in the capital, vegetable vendors, casual laborers and countless others operate entirely in cash). In rural India, there are fewer than 10 bank branches for every 100,000 people, and many open for business only two days a week.

Though Finance Minister Arun Jaitley has promised everything will be sorted out within 21 days, a local newspaper recently estimated it could take as long as six months to replace all the canceled notes with new ones, based on the speed at which the mint is working. Such reports are no easier to verify than the opposition claims that BJP insiders and big donors were given advance warning so they could convert their big notes into gold, jewelry and real estate. Other reports suggest some of the worst hit among the rural poor still support the measure—which they believe will not only punish the corrupt but also lead to a more equal society.

If the chaos does continue, Modi’s BJP will pay dearly in a series of upcoming state elections early next year. However, like other populist leaders around the world, he may have a better grasp on public opinion than his opponents.

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