Modi’s big currency gamble

Monetary mayhem with rupee recall

India’s Narendra Modi and the right-wing Bharatiya Janata Party (BJP) won power in 2014 in part on promises of economic reform, and in large part they have made good on those.

Modi has moved to lower restrictions on foreign investment, pushed for deregulation and tried to set up a national goods and services tax (as opposed to the current hodgepodge of state sales taxes).

The reforms have apparently had some effect. Last year, India’s 7.5 per cent GDP beat even China. Investors have been happy: the Nifty 50 large-cap index was up more than eight per cent on the year to the end of October, and had risen by nearly 24 per cent since its late February low.

Yet there remains an unpredictability factor in India’s ascendance, especially in the area of monetary policy.

In September, there was the departure of Raghuram Rajan, the respected economist and governor of the Reserve Bank of India, who had been a firm hand on the tiller since 2013. But last June he abruptly announced he would not be serving a second term, amid reports of infighting with Modi and his more nationalist BJP allies.

But this month, the granddaddy of monetary mayhem — a more tangible “wth?” from India — hit. On the same day that Donald Trump shocked the world with his U.S. election victory, Modi announced that all 500 and 1,000 rupee notes (about $10 and $20, respectively) would be taken out of circulation, effective immediately.

Indians would have to deposit the bills into a bank account or redeem them at a financial institution, subject to strict maximums, for new notes that are in extremely limited supply.

The scale of the demonetization is huge: The invalidated cash amounts to more than 80 per cent of all banknotes in circulation and is worth more than $370 billion. Not surprisingly, it has sparked panic in the streets and huge lineups at banks, in a country where nearly half the population doesn’t have an account. For those who do, depositing a large sum of delegitimized cash poses an additional problem: It might piqué the interest of tax authorities, who will ask where the money came from.

That points to the rationale behind Modi’s mega-cash withdrawal: corruption. With demonetization, he’s fighting it in spades.

Corruption and tax evasion are chronic yet intrinsic elements of the real Indian economy. The euphemistically called “informal economy” may be as much as 50 per cent of national output. It’s been estimated that every year tax evasion amounts to more than US$300 billion in lost government tax revenue, which as a percentage of GDP is the lowest of the BRIC nations. Then there’s the cost and inefficiency of everyday corruption in India, where just getting a driver’s licence or registering a property often requires a bribe; according to one 2013 estimate, the bribes urban Indians pay every year totals more than six per cent of GDP.

For this black economy, cash is the currency of choice. By delegitimizing the currency, Modi is attacking the crooks. And he has justified the surprise by saying that any notice would only have given fraudsters a chance to clean their dirty money, and he’s right.

The trouble is, it also caught everybody else unawares — even the banks and some elements of government, which seems to have been unprepared for the fallout. Critics suggest that the move has been mishandled, and that it just won’t work: The crooks will find another way to channel dirty money. (They always have.)

Meanwhile, critics say, the economic damage could be substantial — as much as two percentage points off GDP growth, according to former PM and Modi’s political rival, Manmohan Singh.

Still, Modi has stayed the course, urging Indians to adopt mobile payments (there are more cellphones than bank accounts in the country) and to see their sacrifices as a patriotic duty. At the central bank, where Rajan vigorously opposed demonetization, his successor, Urjit Patel, has been silent, suggesting acquiescence.

For the Indian economy, and for investors, the stakes are high. The demonetization has compounded a run on the rupee touched off by Trump’s election and the upward surge in the U.S. dollar. The Nifty 50 index, meanwhile, has declined by about five per cent since Nov. 8.

But here’s the thing: it just might work, and it might have unintended benefits. While demonetization will never eradicate corruption, it at the very least signals a serious commitment to do something about it — a commitment that could ultimately benefit businesses, consumers and shareholders.

As well, more than a billion people now have mobile phones in India, while “only” 125 million have smartphones. Demonetization could give a boost to India’s fast-growing digital economy.

Finally, the decline in the rupee and flight of capital from India in response to a stronger U.S. dollar might end up being overdone. Among emerging markets, India has one of the lowest levels of external debt as a percentage of GDP. It is not immune to a surging greenback, but will be hurt less than other EMs, like Turkey and Mexico.

The question is whether the short-term pain of Modi’s monetary mayhem will lead to long-term gain. If it does, India might still be a land of opportunity.