On Nov. 8, 2016, India’s Prime Minister Narendra Modi proved one more time that he’s not an ordinary politician when the government withdrew the legal-tender status of the 500- and 1,000-rupee currency notes.
These notes, which represented 85 percent of publicly held currency by value, must be deposited in banks by the end of the year. Removing the notes caused havoc. Cash amounts to about 14 percent of India’s gross domestic product (GDP), compared with an average of about 5 percent for emerging economies.
The demonetization makes good on Modi’s promise to attack corruption and illegal economic activities while promoting digital banking and financial inclusion. Following through on these promises is quite a challenge. India’s formal economy represents only 15 percent of GDP, which explains why tax receipts as a percentage of GDP are low and why corruption levels are extremely high.
To a point, Modi appears indifferent to the political risk he’s taken. He’s only halfway into his term and important state elections are to be held next year. Perhaps the most vital of those elections is the one in Uttar Pradesh (UP). The state has a population of 205 million, more than 20 percent of which is Muslim. The outcome here could negatively affect the national standing of Modi’s political party (a Hindu nationalistic entity).
The sooner the issues stemming from demonetization are resolved, and they are being resolved relatively quickly, the better for Modi and his plan. Otherwise, the opposition and chattering class will gain momentum against his digital banking and financial inclusion initiatives.
Part of the opposition to the move to ban 500- and 1,000-rupee notes is that cash is used extensively in India during election periods to fill the buses with supporters for political rallies and buy votes. Given the busy election schedule next year, and the constraints demonetization will put on hoarding cash for use during elections, the opposition’s objections are easy to understand.
When it comes to the economy, demonetization will materially affect growth for the next six months. But the economy should experience a V-shaped recovery, with certain parts of the economy taking more time to recover.