Prime Minister Narendra Modi's banknote recall is becoming a make-or-break moment. He is under fire after a move to cancel large-denomination rupee notes amounting to 86 per cent of the total outstanding by value. The bold step to fight corruption has left Indians queuing outside bank branches since Wednesday (November 9) to swap old notes for legal tender, bringing parts of the nation's economy to a standstill.
The pain is most palpable for the informal sector, which accounts for almost half of GDP and the vast majority of employment. Tendering old notes above a minimal value for new ones requires a bank account, but 40 per cent of the population is outside of the formal banking system. No wonder tensions are running high.
Read Demonetisation and its aftermath
If Modi can ride out the immediate backlash, though, demonetisation could potentially provide a big fiscal boost. Suppose that holders of one-fifth of the notes in circulation will not try to exchange them out of fear of attracting scrutiny from tax authorities. That means currency worth almost $50 billion, or 2 per cent of GDP, could suddenly become worthless.
In theory that would sharply reduce the monetary liabilities of the Reserve Bank of India, and brokerage Edelweiss reckons that in turn could allow the central bank to pay a higher dividend to the government. Other economists suggest this may not be legally possible, but the RBI does face pressure each year to boost its payouts to New Delhi.
A windfall could help India boost spending while meeting its ambitious plan to narrow the fiscal deficit to 3 per cent of GDP by March 2018. It would give Modi the funds for big-ticket items such as a recapitalisation of the nation's ailing state-backed lenders, which could require more than $30 billion.
The twin effects of a slowdown in economic activity and the reduction in money supply should also bring down inflation, making room for more interest rate cuts, which could boost growth in the medium term.
The recall is certainly working: Banks have already collected a staggering $44 billion of deposits in barely five days. Modi clearly hopes that it will do the economy more good than harm once the initial shock of last week's move wears off. Either way, it could prove central to his legacy.