Can India’s currency ban really curb the black economy?


On November 8, 2016, in a late-night TV broadcast to the nation, Indian prime minister Narendra Modi, demonetised Rs 500 and Rs 1,000 notes. As of the midnight of November 8, 2016, these notes have been rendered useless.

This decision of the Modi government came as a huge surprise to the media as well as the citizens, given that there were no news leaks before the announcement. Newsreports suggest that the Reserve Bank of India, the Indian central bank, was given close six months to prepare for this eventuality. The government had asked the central bank to print more Rs 50 and Rs 100 notes. Despite the long period taken to prepare for this decision, there were no news leaks.

Further, the Rs 500 and Rs 1,000 notes which have been demonetised, can be deposited in banks as well as post offices up until December 30, 2016. The money will be credited in the account of the individual depositing the money. The notes can also be exchanged up to Rs 4,000.

While Indian cities are full of bank branches, those living in rural areas will find exchanging the demonetised notes a little difficult. Only 27 per cent of Indian villages have a bank within 5 kilometres.

The idea behind this move as per the government is to curb “financing of terrorism through the proceeds of Fake Indian Currency Notes (FICN) and use of such funds for subversive activities such as espionage, smuggling of arms, drugs and other contrabands into India.”

It is also to hit those who have a massive amount of black money in the form of cash. Black money is essentially money that has been earned through corruption and legal activities, without any tax being paid on it. There are several estimates of the total amount of black money going around in the Indian economy. A World Bank estimate puts the size of the black economy at a little 23.2 per cent of the economy in 2007.

By making high denomination notes worthless overnight, the government hoped that those who have black money in this form, will not be able to convert this money into physical assets like gold. Newsreports suggest that jewellers across the country worked overtime through the night of November 8 and November 9, 2016, to help convert black money held in the form of Rs 500 and Rs 1,000 notes into gold.

Starting November 10, 2016, the government will introduce new Rs 500 and Rs 2,000 notes. Those who have black money in the form of the old Rs 500 and Rs 1,000 notes will try exchanging them with new notes. They can’t go to a bank and deposit all their black money given that it is likely to lead to questions from the income tax department.

Any other way of exchanging notes will take some doing, given that the old denomination notes form more than 86 per cent of notes in circulation by value. Hence, it will not be easy to exchange these notes without leaving audit trails for the income tax department. To incapacitate those who are holding a lot of black money in the form of cash seems to be the major idea behind the move.

Crisil Research expects income tax collections of the government to improve as money earlier unaccounted for, enters the banking system and eventually gets taxed. Inflation is also expected to come down in the short-term as cash transactions come down.

Another area which is likely to be impacted is real estate. A portion of the payment while buying a house in India is almost always made in the form of cash. With the high denomination notes, having been demonetised it will become very difficult to organise for this payment. Hence, prices are expected to fall. If prices do fall it will be make real estate affordable. At affordable prices, the demand for real estate is likely to go up. This is expected to create low-skilled and unskilled jobs, which the country badly needs, given that one million individuals enter the workforce every month.

Further, the retail as well as the luxury goods businesses where a bulk of transactions are carried out in cash is expected to be impacted negatively, as cash transactions will come down dramatically in the short-term.

In fact, during the period the old notes are withdrawn and new notes make it to the market, the cash transactions are likely to remain down. India is a country where a bulk of transactions are still carried out in cash. A 2012 estimate carried out by the The Fletcher School at the Tufts University estimated that 86.6 per cent of the transactions were carried out in cash. While this figure would have come down since then, it would still be at a very high level.

Another research paper titled The Cost of Cash in India points out that “the ratio of currency to GDP in India (12.2%) is higher than countries such as Russia (11.9%), Brazil (4.1%), and Mexico (5.7%)”. Hence, India is still largely a cash driven economy and given this, Modi government’s move is likely to cause a few problems in the short-term.

Also, if the Modi government is serious about tackling the black money menace, it shouldn’t just leave it at this. As the former RBI governor Raghuram Rajan said in this context: “I think there are ways around demonetization. It is not that easy to flush out the black money. Of course, a fair amount may be in the form of gold, therefore even harder to catch.”

It is important that the government uses information technology to track down those who are earning money but not paying their share of taxes. As Rajan put it: “I would focus more on tracking data and better tax administration to get at where money is not being declared.”

Further, the government needs to quickly introduce electoral financing reform in the country.


The column originally appeared on on November 10, 2016.