This article was first published in the February 2017 international edition of Accounting and Business magazine.

Around the world, experts in the future of money have been captivated by a bold experiment in India. On 8 November 2016, prime minister Narendra Modi announced that from midnight the country’s largest denomination bank notes would no longer be legal tender in shops. Savers, he declared, would have until 30 December to deposit their cash in banks or be left sitting on piles of worthless printed paper. 

The move has caused pandemonium, with people queuing outside banks and retailers reporting slumping sales. It will take months, even years, before it is clear whether the pain will be worth the long-term gain. Modi’s monetary shock therapy, which will remove notes accounting for 86% of cash in circulation, is intended to clamp down on corruption and tax evasion – moving the Indian economy from the shadows into the light. 

‘The heavy use of cash in India has a lot of negative knock-on effects on the economy,’ says Shilan Shah, India analyst at Capital Economics. ‘It starves the banking system of deposits that could be lent out to fund investment. It facilitates tax evasion, which deprives the government of funds to invest in infrastructure and education, dampening productivity growth.’ What’s more, the pervasive sense that nobody pays their full share of tax becomes self-perpetuating, encouraging more people to cheat.

For David Birch from electronic transaction consultancy Consult Hyperion, the Indian experiment will help to answer a range of questions with global significance. The first is whether Modi’s approach is the most effective strategy. ‘On the one hand, this sudden announcement gives black-market operators less time to adjust,’ he says. ‘On the other, it is likely to cause a far higher degree of economic disruption than a transition over six months or a year,’ he admits. 

It will be several months before the full extent of the damage is revealed by the economic data. So far there is a striking lack of consensus over the short-term costs. While many economists have shaved between 0.5 and 1 percentage points off forecasted GDP growth for the full fiscal year, others have been far more pessimistic, with Ambit Capital arguing that growth will slump to just 0.5% in the second half of fiscal year 2016, which runs to the end of March. 

The wide range of forecasts is not entirely surprising given the unprecedented nature of India’s move. ‘We have never seen anything like this before in a fully functioning, even flourishing, economy,’ says Birch. ‘Removing cash on this scale is something that has historically only been attempted in nations suffering from hyperinflation or economic collapse – such as Germany after the Second World War or Russia after the disintegration of the Soviet Union.’ 

By contrast, India has been the fastest-growing major economy in the world over the past year. The International Monetary Fund has India growing by 7.6% in 2016, compared with an average of 4.2% for emerging nations and 1.6% for advanced economies. 

Cash-based sectors will be hardest hit. Deutsche Bank has estimated that fast-moving consumer goods sales are down by 30%. And in a nation where many house purchases are made in cash, the property market may be set for a slowdown, too. Shares in listed Indian real estate firms lost close to a fifth of their value on the day after Modi’s bombshell announcement. 

The short-term harm could be magnified by the fact that India has an under-developed mobile payments system, Birch warns. ‘In Kenya, where so many people use M-Pesa, a mobile cash transfer system, this kind of move would be less traumatic,’ he says. ‘In India, mobile payments have been held back by regulation. In an ideal world, this should have been developed first, to limit the short-term dislocation.’

Instead, India is among the most cash-reliant economies in the world, with notes and coins in circulation equivalent to 14% of GDP. For comparison, the average in other large economies is 5%. Almost 80% of consumer transactions in India take place in cash.

This is a key source of vulnerability for the Indian economy. ‘This kind of cash-dependence makes it a lot easier for officials to take bribes or for all Indians to avoid paying tax,’ says Birch. Of course, nobody is arguing that withdrawing these notes will enable India to catch up with most wrongdoers. Since bank deposits in excess of 50,000 rupees (US$750) will be investigated by the tax authorities, it is believed that some wealthy black-market operators are hiring poorer Indians to line up to deposit money into their personal bank accounts to be transferred back later. Even if this is the case, however, Birch believes that Modi’s plan could end up tipping the balance by raising the cost of corruption and tax evasion. 

The potential gains could be considerable. Only 5.5% of India’s earners pay income tax, and tax revenue amounts to just 16.6% of GDP, according to the Organisation for Economic Co-operation and Development. This is the lowest of any major developing country and about half the collection rate of Brazil, for example. This major handicap impedes the ability of the government to invest in growth-enhancing infrastructure and in education. 

‘The hope must be that if Modi can engender a broader sense of trust in the fairness of the tax system it will create a virtuous cycle in which compliance will improve,’ says Shah. ‘If this does occur, it would provide a boost to India’s public finances, and over the long run help supply the resources to fully modernise the Indian economy.’ Foreign investment could also rise if the experiment works. ‘Corruption has been the bane of India for years and this puts off some investors,’ he says. ‘Clamping down on this problem would be great news for the economy as a whole.’

The impact on bank liquidity is also being closely watched. In the first 10 days after the announcement economists estimated that bank deposits climbed by US$100bn. ‘It is too soon to say whether this money will stay in the system, or whether it will be taken out again in cash,’ says Shah. ‘And Indian banks have a problem with bad debt which may make them reluctant to lend out much more over the short term.’ However, in the long term, if Modi’s experiment pays off, the overall health of the banking system would be improved, and with it the potential for credit creation and economic growth. 

Potential for imitation

Such a success would be likely to inspire copycats. China’s government has also been clamping down on corruption, and the central bank has expressed an interest in experimenting with digital currencies. Other nations with large informal economies, such as Indonesia and Kenya, stand to benefit from an Indian-style cash bonfire, says Birch. 

Over the past few years India has come to be seen as an economic success story. It is the last of BRICs (Brazil, Russia, India and China) to retain its glow – with growth slowing in China, while Russia and Brazil have tipped into recession. Still, sceptics point out that much of India’s recent success has been due to good fortune. Highly reliant on imported oil, India has benefited from the slump in oil prices over recent years, which has helped tame inflation, narrow the current account deficit and improve public finances. But to fully modernise its economy, India still needs to reform the underlying structures of its economy. Modi’s audacious cash experiment could be part of the answer.

Christopher Fitzgerald and Fernando Florez, journalists