It’s fair to say that the Indian government’s decision earlier this month to declare 86 per cent of the banknotes in circulation effectively worthless took most people by surprise.

Secrecy is the crux of a measure like this and that the government maintained secrecy until the time the measure came into effect is a tribute to its governance standards.

By demonetising – or more accurately delegalizing – the 500 and 1000 rupee notes, the government says it hopes to rein in so-called black money, the vast amounts of cash transactions that go untaxed. The move is also aimed at curbing counterfeit currency, which is used to finance terrorism and drugs and as a conduit for money laundering.

The decision means that what had been the two highest denomination notes will be replaced with an entirely new 500 rupee note and a 2000 rupee note.

Cash economy

In an economy where the bulk of transactions are done in cash, a measure like this was bound to cause fear and panic. Yet given the sweeping scale of this move it is worth noting that, while it has inconvenienced millions, it has not resulted in any significant unrest.

So why did the government take this action?

In the 2014 election campaign that brought him to power, Prime Minister Narendra Modi made much of tackling black money. The black economy is the trading of goods and services that escapes capture in the official GDP statistics. The tax lost on this activity is known as black money.

The most recent estimate of India’s black economy was by the World Bank in 2007 which put it at around 23.2 per cent of GDP.

Assuming, conservatively, that it has since grown to a quarter of GDP we can make a ball park estimate for the black economy of around US$500 billion, based on a current total GDP of US$2 trillion. If this were taxed at the current average of 16 per cent, the tax loss comes to around US$80 billion.

Yet despite a range of measures since coming to office, the public perception has been that Modi’s government has not succeeded in hitting the root of the problem. At the same time currency in circulation has been growing rapidly – going up by 15 per cent year on year since financial year 2015/16 and clearly outpacing the expansion of economic activity.

As delegalized currency is deposited in banks and as new currency comes into circulation, some very positive dynamics will kick in.

The government’s surprise move was evidently in response to this. However, how much of this black money will be exposed by delegalization remains a matter of conjecture. The impact will depend, among other things, on the proportion of black money that is actually held in cash as opposed to land, property, stocks, gold or foreign currency.

In the very short-term, delegalization may hurt growth – a shortage of cash puts the brakes on consumption. The faster and more effectively the government and financial authorities are able to handle the transition, the less will be the adverse impact.

What is important, however, is the medium- to long-term macroeconomic implications. As delegalized currency is deposited in banks and as new currency comes into circulation, some very positive dynamics will kick in.

Virtuous cycle

By far the most important outcome will be that as the shadow economy merges with the formal economy, it will spur economic activity into a virtuous cycle. This will be further buttressed by the ‘windfall’ deposits that banks will get which can be as high as 7.5 percent of GDP. Banks will see their cost of funds declining and this should encourage them to reduce lending rates and pump credit into the economy.

Delegalization should also be disinflationary. At an aggregate level, the supply side response will raise production capacity and prevent overheating of the economy. Moreover, real estate, which has been a safe haven for black money, will experience a squeeze. Although property values do not enter the CPI consumption basket, its benign impact will come through decline in rental values and transmission of that into the general price level.

Government finances will improve as tax is levied and collected on the disclosed wealth. How big this will be is a matter of debate, but there should be no doubt that the tax and enforcement agencies will scrutinize bank deposits closely.

The ‘cleansing of the system’ will also be positive for both savings and investment. It will improve the ease of doing business, inspire investor confidence and raise productive capacity of the economy.

Households, who have traditionally parked a bulk of their savings in physical assets like gold and dwellings, will now be positively biased towards financial savings which will have a significant multiplier impact on the economy.

Finally, the shift to electronic modes of transactions, engendered by the temporary squeeze in cash, may actually persist even after the cash position normalizes. That will be a big positive for growth and curbing corruption.

Lessons from experience

The key question is whether the positive impact of this sweeping move will last.

Delegalization is not a new or original idea. Several countries have tried it in the past and India has done it twice – in 1946 and again in 1978 when the 10,000, 5,000 and 1,000 rupee notes were withdrawn.

Global experience has been that the black economy started building up all over again once the government lets its guard down. This has been India’s experience too.

However, this time may be different for several reasons. In 1978, the value of currency demonetized was less than 2 percent of what was in circulation as compared to nearly 85 percent this time.

Second, the significant advances in technology over the last 40 years will facilitate more effective audit trail of cash, making it difficult for hoarders to countenance a determined government.

Third, the expected launch of the Goods and Services Tax (GST) in a few months, one of whose chief characteristics is self-policing, should reduce the scope for the black economy.

Ultimately, it will be up to the government to keep up the vigil, put fear into people transgressing the law through ruthless prosecution and bruising penalties and to curb corruption with a draconian hand.

The Modi government has both the challenge and opportunity of making this time different.

This is an amended version of a longer article that was first published on ISAS Insights from the Institute of South Asian Studies at NUS