Bad News for India?

Millions of Americans stayed up late to watch the election returns on November 8. Halfway around the world, Indians were also awake, as Prime Minister Narendra Modi announced sweeping changes in the country’s monetary policy. At around midnight, he declared that 500 and 1000 rupee notes, worth about $7.50 and $15, will no longer be accepted as legal tender.

The changes effectively cancel roughly 22 billion notes spread across India, stuffed in coin purses, stored under mattresses, and used in under-the-table deals. These notes are 86 percent of all circulating cash. Modi stated that this recall is meant to curb the use of “black money” and to reduce widespread government corruption. People have until the end of the year (less than 40 days) to exchange their current notes, at banks and ATMs, for new ones.

In addition to new 500 and 1000 rupee currency, the Reserve Bank of India is introducing new 2000 rupee notes, worth about 30 U.S. dollars.

The uncertainty of India’s cash-based economy has economists worried about the security of its future foreign investments and unforeseen repercussions on citizens.

This disruptive move is not unprecedented. It follows a similar decision of the European Central Bank, which recently phased out 500 euro “mega notes” due to concerns about illegal immigration, corruption, and the fallout from the terrorist attacks in Paris. Countries in crisis have also used such a monetary policy before: Germany after World War II, the Soviet Union on the brink of collapse, and Zimbabwe drowning in hyperinflation have all issued currency callbacks. But the policy does not signal India’s economic strength to foreign investors.

Kaushik Basu, a former chief economist at the World Bank, categorizes this currency move as “bad economics.” The ban on most of the existing currency immediately triggered a run on banks and ATMs, forcing individuals to wait in line for hours to exchange the equivalent of, at most, about $30. The banks simply did not have enough bills.

While people still have until the end of the year to exchange their currency, the current notes are essentially worthless. Merchants and shop owners are reluctant to accept the larger banned bills, as they no longer have smaller notes for change, thanks to the bank runs. The government’s move seems to do little to fight corruption, but it is already negatively affecting the nation’s law- abiding citizens.

The Reserve Bank of India’s contention that the policy will reduce the use of “black money” and fight corruption may be true in the near future. Looking further ahead, however, criminals will simply store their “black money” in the new currency as soon as it is available. Moreover, the addition of the larger 2000 rupee notes makes storing illegal currency even easier.

The mandate to exchange old bills for new ones also creates a new black market. Take, for example, this plausible scenario: an individual approaches a farmer or shopkeeper (or some equally hard-working, honest person) and offers to change the latter’s 500 and 1000 rupee notes for new ones. But there is a catch: the farmer will get only 800 rupees for the 1000 rupee note. As economist Prabhat Patnaik describes it: the government’s move shows “a lack of understanding of capitalism … Consequently, instead of curbing black business it will actually give rise to the proliferation of black business.”

There are no obvious significant repercussions on the global economy as a whole. It is not difficult to imagine spooked foreign investors holding their money if the Reserve Bank of India indicates there might be more surprise currency actions, but this seems improbable given the unlikelihood of positive results from the current one. Moreover, the new monetary regulations will directly affect only people’s cash reserves, not money stored in investments.

Unfortunately, however, the currency change is negatively affecting tourism. International visitors typically withdraw cash just before their arrival or upon arrival. Now, ATMs and banks across the country have little or no cash to give out. Additionally, some tourists who are currently travelling have either run out of cash or are relying on debit cards that are scarcely accepted by locals. For a country that relies heavily on tourism, stranded foreigners are not a great advertisement.

In addition to its likely minuses for the population and the economy, this currency reform does not seem productive or effective for the Indian government. Many economists agree that the costs will greatly outpace the limited benefits. Even if there do turn out to be few negative results, the exchange is a lot of hassle for no gain in the battle against corruption.