Why India wiped out most of its cash overnight

By Elliot Bullman

86% of the cash in India now cannot be used

India is in the middle of an extraordinary economic experiment. On November 8, Prime Minister Narendra Modi gave only four hours' notice thatvirtually all the cash in the world's seventh-largest economy would be effectively worthless.

One Rupee Indian coinsOriginal Image: "One Rupee Indian coins" by Kshitij Gupta, used under CC BY-SA 3.0 license, via Wikimedia Commons.

The Indian government likes to use the technical term "demonetisation" to describe the move, which makes it sound rather dull. It isn't. This is the economic equivalent of "shock and awe".

Do not believe reports that this is primarily about bribery or terror financing, the real target is tax evasion and the policy is very daring.

You can see the effects outside every bank in the country where queues of people clutched wads of currency stretched for as far as the eye could see.

rupees 435450

Mr Modi's "shock and awe" declaration that caught everyone unaware meant that 1,000 and 500 rupee notes have become obsolete overnight while the introduction of the 2,000 rupee note is designed to force people into the banking system. Think of that, at a stroke 86% of the cash in India now cannot be used.

India is overwhelmingly a cash economy, with 90% of all transactions taking place that way. And that is the reason behind Mr Modi's dramatic move. Since so much business is done in cash, very few people pay tax on the money they earn. According to figures published by the government earlier this year,in 2013 only 1% of the population paid any income tax at all.

Narendra_Modi_in_white_shirtOriginal Image: "Narendra Modi in white shirt" byBalatokyo, used under CC BY-SA 3.0 license, via Wikimedia Commons.

As a result, huge numbers of Indians have stashes of tax-free cash hidden away - known as "black money.” Even the very poorest Indians have some cash savings - maybe just a few thousand rupees stored away for a daughter's wedding, the kids' school fees.

But lots of Indians have much more than that. It is notunusualfor half the value of a property transaction to be paid in cash,with buyers turning up with suitcases full of 1,000 rupee notes.

The size of this shadow economy is reckoned to be as much as 20% of India's entire GDP. Mr Modi's demonetisation is designed to drive black money out of the shadows and get money into the banks. There is no limit to the amount that can be deposited in bank accounts until the end of December, but the government has warned that the tax authorities will be investigating any deposits above 250,000 rupees.

rupees 587271

The government managed to plan this audacious policy, printing billions of new notes without letting slip what was happening. Reportedly, even senior members of the cabinet were not told what was being planned, for fear that if word got out the entire policy would be undermined. The hoarders would have had time to empty their mattresses and launder their stashes into gold or other assets.

Keeping a secret of this magnitude in India, a country that thrives on rumour and gossip, is nothing short of a triumph and surely a reasonable justification for a few hiccups along the way.

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