Modi’s Audacious Gamble on Black Money

A scheme to capture large rupee notes raises questions about New Delhi’s economic literacy.

Even for a risk-taker, Narendra Modi’s abrupt announcement last week that his government was voiding India’s two highest value currency bills is an audacious gamble. Between them, the demonetized 1,000 rupee ($14.80) and 500 rupee ($7.40) bills account for about 85% by value of the $241 billion worth of cash in circulation in the Indian economy. As replacements, the government is phasing in a redesigned 500-rupee bill and a new 2,000 rupee bill.

The move has divided the country between those cheering Mr. Modi for stirring boldness and those decrying him for staggering rashness. But while the economic consequences of the decision are not entirely clear, there’s no question that the government’s obsession with so-called “black money” will have far-reaching political consequences for the prime minister and the ruling Bharatiya Janata Party.

Demonetization is part of a larger effort to curb India’s parallel economy, estimated by the World Bank as about one-fourth the size of the formal economy. But while Mr. Modi’s goals are laudable, his methods are unsound. By unleashing India’s notoriously capricious tax authorities on the business community, the prime minister appears to be betting that the upsides of being viewed as an anti-corruption crusader outweigh the risks of smothering a fragile economic recovery.

Elections early next year in Uttar Pradesh, India’s largest state, will be the first test of whether the gamble pays off. If the BJP wins, demonetization will be hailed as a stroke of political genius. A loss will raise questions about the wisdom of a focus on curbing illicit cash, rather than on creating jobs and boosting growth.

For the past week, demonetization has dominated the headlines in India, managing to edge out even Donald Trump’s surprise election victory. The defining image of the week: snaking lines in front of banks as depositors queued for hours, often without success, to swap the demonetized currency or withdraw cash in small bills for day-to-day expenses.

Indians appear sharply divided over Mr. Modi’s move. For the prime minister’s fans, the decision underscores his ability to take tough decisions in the national interest, and his commitment to clean up a parallel economy awash with so-called black money.

Once the initial inconvenience of lining up to exchange the old bills or withdraw cash from overburdened ATMs subsides, the argument goes, India would have taken a giant step toward using credit cards, electronic payments and checks rather than cash. This ought to draw more people into the tax net and reduce the amount of untaxed income sloshing around the economy. The only people who stand to lose are corrupt politicians and businessmen sitting atop mountains of untaxed cash, and terrorist groups that traffic in counterfeit Indian currency.

For Mr. Modi’s critics, however, the move is no stroke of genius. It raises fears that a small group of ham-handed bureaucrats and economically illiterate politicians are running Asia’s third-largest economy. Only the most gullible Indians believe that crooks store their money in bundles of cash. In fact they prefer gold, real estate and foreign bank accounts.

Moreover, the critics argue, the government has underestimated the economic costs of drying up cash—even if only temporarily—in a largely cash-based economy. They paint a chilling portrait of disrupted food supplies and large labor-intensive sectors of the economy effectively paralyzed for months.

For the most part, the media have focused on tales of grief, dislocation and uncertainty: the housewife forced to reveal her rainy day stash to an abusive husband, the parents who allegedly lost their baby after a hospital refused to accept old bills, the roadside vendor loath to enter a bank manned by unhelpful staff who look down on her.

It remains to be seen if the more apocalyptic predictions of severe economic distress sparked by demonetization will come to pass. But one thing appears certain: Mr. Modi owns this decision as arguably the most far-reaching—at least in terms of the number of people affected—of his two and a half years in high office.

As for skeptics, the BJP’s quixotic pursuit of black money suggests confused economic priorities and a distressing belief that a heavy-handed bureaucracy holds the solution to all problems. During his 2014 election campaign, Mr. Modi promised to unearth billions of dollars of what he claimed were illicit funds held in overseas bank accounts.

Part of the problem with the approach adopted by Mr. Modi and Finance Minister Arun Jaitley is their apparent belief that India’s tax officials are paragons of probity and efficiency. Instead of focusing on simplifying rules and lowering taxes—which would automatically boost compliance—Messrs. Modi and Jaitley appear to prefer ginning up a kind of hysteria about illicit wealth. Earlier this week, Mr. Modi promised to go after fraudulently held property next.

With exports flat and industrial growth sluggish, you might expect the prime minister to empower businesses rather than bureaucrats and tax officials. But Mr. Modi appears to have chosen his path. Now all that remains to be seen is whether the gamble pays off or backfires badly.

The writer is a resident fellow at the American Enterprise Institute, and a columnist for the Wall Street Journal where this article was first published

By Sadanand Dhume


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