War on Black Money

By Erik Rubinyi

On November 8, 2016, Indian Prime Minister Narendra Modi addressed the nation to reveal a startling fact. Starting at the end of his address the 500 and 1000 rupee notes, equivalent to around eight and sixteen dollars, would be invalid. In seconds, billions of rupees were rendered essentially worthless. The only way to recoup the money would be to turn the notes into the bank. Although this announcement may at first seem surprising, the reasoning behind this act is threefold: to increase the money supply, decrease black money, and combat terrorism.

The reasoning behind Modi’s plan is that the average citizen who only has small amounts of money in large bills can easily turn them into the bank, while criminal organizations with large stacks of illicit cash cannot do so without raising suspicions. In the past India has struggled to stymie the flow of black money, funds obtained through illegal activity or not reported for taxation,  through its economy. The portion of the economy involving black money is collectively called the shadow economy. According to a World Bank Estimate, the shadow economy makes up around 20% of India’s GDP, compared to around 9% in the United States and around 12% in the United Kingdom.

This has been a large problem as it has been blamed for financing terrorist activity in Pakistan and decreasing the capacity of the government to provide essential services. Citizens had until the end of 2016 to exchange their old notes for brand new notes. However, if anyone turns in more than INR 250,000 (around $3,650) and does not have a valid excuse, they are subject to a penalty between 50-90% of the deposited amount.

Although the intentions behind the withdrawal of the 500 and 1000 rupee notes may have been in good faith, the roll out has not gone smoothly. In a nation of around 1.3 billion people, withdrawing 86% of the money supply from circulation was bound to have consequences. Many local banks have run out of new bills to exchange leaving workers unable to collect their salaries. This is especially a problem in rural villages, where there is less access to centralized banks. It is also harming the overall economy. Around 98% of transactions by volume in India are conducted in cash. This means less cash flow in the economy is slowing down business in many parts of India; economists are cutting their growth projections for India this quarter.

Further, the act itself is ineffective as many wealthy Indians hold their wealth overseas or in tangible assets such as gold, silver, and real estate. Others simply rely on electronic transfers thus eliminating the need for cash altogether.   For those who have significant amounts of black money, they are increasingly disguising their money by funneling or laundering it through businesses dependent on cash and impacted by the cash shortage. There have also been reports of people flying the money north to farming areas exempt from taxation as well as various schemes involving special exemptions for temples.

The results of this grand experiment have yet to be determined. However, it will undoubtedly have a large impact on the future prospect of withdrawing high denominations to combat criminal activity. Although India is simply replacing its old 500 and 1000 rupee notes with new 500 and 2000 rupee notes, the idea of permanently withdrawing high denominations to combat criminal activity has also been at play in the Western world. Around the end of 2018, the European Union will cease printing of its 500 euro note after claims it was mostly being used to facilitate illegal activity.

While many have toyed around with the idea, a working paper by the Harvard Kennedy School even went so far as recommending stopping circulation of the fifty and one hundred dollar notes. The paper makes the argument that these notes are not used by everyday consumers, but rather mostly by criminal enterprises.  This is not an outlandish concept as the United States once had 500, 1000, 5000 and 10,000 dollar notes, which were retired in 1969 for similar reasons. India’s recent actions have been some of the most dramatic and quantifiable efforts by a large country to reduce criminal activity by manipulating high denomination bills. Although there are many differences between India and much of the West, more Western countries may take notice if India’s experiment makes a measurable difference.

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