Tax evaders are spoiling Prime Minister Narendra Modi's play for the history books with his fight against illicit wealth. Indians have returned money faster than expected in a cash recall worth $210 billion. Now New Delhi is scrambling to demonstrate the value of the initiative, which is taking its toll on the cash-dependent economy.
There has been no big popular backlash to last month's decision to render illegal 86 percent of banknotes by value. That is testament to the Modi's charisma; he has convinced many working class people that the cash crunch is a small price to pay for destroying "black money".
The support rests on the premise that the rich are suffering more. Yet as citizens return currency to banks at a surprising pace, New Delhi's narrative does not stand up to scrutiny. In the five weeks since the extraordinary move, citizens have tendered over 80 percent of the outlawed ₹500 and ₹1,000 notes.
It suggests that there was not so much illicit wealth in the system in first place or, more likely, that Indians have found a way to turn black money into white by routing the cash through places like local temples and bank accounts set up for the poor.
That reduces room for a fiscal windfall, where the Reserve Bank of India might have repaid New Delhi any reduction in its liabilities; economists had estimated this could be as high as $40 billion. It also piles pressure on Modi to find another clear way to demonstrate he is winning the war against corruption.
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The prime minister bet any economic pain would be short and sharp. The Reserve Bank of India is playing along, with a revised forecast of 7.1 percent growth in gross value added – a proxy for GDP – for the year to end March 2017.
Yet that is merely a 50 basis point cut – which looks optimistic to the point of undermining the central bank's credibility. One month into the cash experiment, people are still queuing up outside banks and many ATMs are empty. Ironically, Indians that can access cash are hoarding more than they did before.
The lack of hard currency has led to the breakdown of supply chains. Some construction workers have downed tools. Sales of everything from medicine to mobile handsets have plummeted, board members have told Breakingviews. Vineet Jain, a managing director for Bennett Coleman, the country's biggest media group, tweeted that an advertising slowdown and salary cuts would follow.
The speed of any recovery depends largely on what Modi does next. The safest option would be to fully “re-monetise” the economy as quickly as possible but it looks like the Indian leader is doubling down on his efforts to reduce the amount of cash in circulation.
The central bank has re-issued notes worth barely one-third of the amount withdrawn, and New Delhi is now offering a slew of discounts on everything from petrol to life insurance policies to incentivise cashless transactions.
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That suggests that Modi is determined to make good on his election pledge to stamp out corruption – with one eye on local elections early next year in Uttar Pradesh, India's most populous state.
One option would be to go aggressively after tax dodgers, extracting punitive fines on large bank deposits made in recent weeks. Some bankers privately estimate proceeds from penalties could amount to $20 billion. Modi may also roll out further restrictions on property and gold – the two other top places Indians like to hoard wealth.
Such reforms are desirable in an economy where barely 1 per cent of the population pay income tax, but Modi may be dealing the economy too many blows at once, raising the prospect of a prolonged slump.
Inflation is currently under control, at 4.2 per cent, but may rise as small businesses that previously thrived by dodging taxes are forced to hike prices to stay afloat or fold, handing extra pricing power to larger firms. There is also concern a rise in defaults may tip the country's weak state lenders over the edge.
The end game may be to fund a redistribution of wealth, in particular a payout to the poorest, a constituency that has the power to give Modi a bigger support base and, in turn, control of India's upper house of parliament. A pilot "universal basic income" could be unveiled in February's budget, local brokerage Ambit reckons.
Modi's vision is bold but it has already undermined the central bank and there’s also a danger India will now abandon the path of fiscal consolidation. The non-cash costs are mounting.