Though the origins of India's informal economy doubtless trace back centuries — 400 years of foreign rule under the Mughal and British empires did not foster a strong culture of civic duty — today's problems have more recent roots. Shortages and restrictions during World War II gave rise to a black market in India. Then, after the country gained its independence in 1947, the black market blossomed as a result of the socialist economic model that the country's rulers introduced. The new country was held together only loosely; it had poor communications infrastructure and rugged terrain, and many of its larger regions had been independent principalities for hundreds of years before. A poorly designed tax code, high levels of bureaucratic corruption and weak central control encouraged tax evasion on a massive scale, and the informal economy grew.
All That Glitters
In the 1970s, the black economy ballooned. The 1973 oil crisis pushed inflation over 30 percent, bumping many Indian workers into a higher tax bracket. Citizens looking to escape the bonds of inflation and surging tax bills turned to a tried-and-true solution: gold. For most of the two millennia before the British arrived, India was one of the world's two dominant goods exporters, along with China. The country, which during much of that time imported only horses, steadily amassed gold from Chinese, European and Arab traders in payment for spices and other materials. A thousand years apart, the Roman and Ottoman empires each complained that they were losing all their gold to India. When faced with a demanding government and high inflation levels, Indians turned to precious metals for protection, smuggling foreign gold into the country despite the ban that the government instated in 1947. (India's government legalized the thriving gold importing industry during the economic liberalization campaign of 1991.) Some estimates put the amount of gold imported since 1947 as high as 10,000 metric tons, half of the country's total holdings in 2015, according to Indian Finance Minister Arun Jaitley. With one-eighth of the world's gold in their coffers, India's citizens have had a substantial source of wealth that New Delhi has historically had trouble tracking.
Today, cash fuels the informal economy. Untraceable capital is used even for big-ticket purchases, such as real estate, another source of independent wealth in India. An estimated 30 to 40 percent of all real estate transactions in the country involve black money, an arrangement that actually proved advantageous during the 2008 global economic crisis. Though inflated prices plagued Indian real estate in the run-up to the crisis, as they did in Western economies, India's preference for cash purchases over loans spared the country the banking crisis that the United States and Europe suffered.
Nevertheless, the large informal economy has caused far more problems for the government in New Delhi than it has solved. Transactions in the black economy go untaxed, depriving the government of hefty quantities of revenue that it could otherwise use to improve infrastructure or sanitation. The public's propensity to convert money into gold rather than leaving it in the bank also has undesirable consequences. During another period of high inflation in 2012-13, Indians en masse again invested in gold. The spike in gold imports upset India's trade balance and created a rising current account deficit just as the United States announced that it would taper its quantitative easing program. India became one of the "Fragile Five" economies deemed most exposed to the capital flight that ensued, and the Reserve Bank of India had to restrict gold imports to stabilize the economy.
Modi's arrival in office in May 2014 signaled a new era for India's informal economy. The administration enacted regulations in December 2015 that required buyers to furnish identity numbers when purchasing real estate or large quantities of gold. Jewelers experienced more frequent police raids and an overall decrease in business, according to a May report from Indian investment bank Ambit Capital. Gold imports have dropped since 2014, and declines in housing prices seem to indicate a new reluctance among the Indian public to invest in property, perhaps as a result of the government's crackdown. In addition, the amount of cash held by the public increased markedly this year, suggesting that individuals have been squeezed out of gold and real estate.
Having tackled these troublesome investment areas, the government launched a four-month Income Declaration Scheme in June, giving people an opportunity to pay their outstanding taxes, along with a 45 percent penalty. The initiative drew in $9.6 billion in black money from 64,000 declarants — a good start but a just drop in the bucket for India, a country with 1.25 billion people and a black economy worth an estimated $460 billion. However, the measure turned out to be just one facet of Modi's strategy to salvage lost tax revenue. Now, cash-holders must turn in their 500- and 1,000-rupee notes or else forfeit the money, putting benefactors of India's informal economy — who could face jail time for hoarding untaxed cash — in a tricky position.
A Costly Endeavor
Replacing 86 percent of the cash in circulation in just 50 days would be a tall order for any country, but for India, it has proved a recipe for chaos. The country has the second-largest population in the world, spread over a vast and largely rural territory. To preserve the element of surprise — thereby keeping people from swapping out their banknotes ahead of the designated exchange period — the government did little to prepare for the process. This has made for gargantuan logistical challenges. Reports of hourslong lines have emerged since Modi announced the initiative, along with accounts of ATMs running out of money, banks paying out thousands of rupees in coins and citizens growing increasingly frustrated with the ordeal.
Despite New Delhi's stealth in devising the measure, meanwhile, many people are finding ways to sidestep the government's trap. Outside India's banks, the discontinued bills are reportedly trading at a steep discount, and sales of gold and jewelry across the country jumped immediately after the program's unveiling. The surge in gold purchases subsided after police began keeping a closer eye on jewelers to ensure compliance with the sales restrictions. Still, bankers around the country suspect that the upheaval will last much longer than the two or three weeks that Jaitley, the finance minister, predicted.
Beyond the logistical headaches that Modi's cash-replacement scheme has caused, there will be political consequences, as well. Though the Indian public may eventually hail the initiative as a bold and beneficial effort to correct India's economic ills, for now, it is a nuisance. Some disgruntled members of the electorate had the opportunity to make their displeasure known in West Bengal's by-elections Nov. 19. Modi will be hoping the tumult will have blown over by the time legislative elections are held in Uttar Pradesh, India's largest state, in 2017. Winning Uttar Pradesh was a crowning achievement of the prime minister's 2014 campaign, and a poor performance for his Bharatiya Janata Party in the legislative vote could slow his momentum into the 2019 general elections. Opposition parties are already taking advantage of the situation; one leader made a show of hopping in a bank line himself.
Then there are the economic repercussions. The initiative, which has interrupted workdays and left citizens without cash to spend, albeit temporarily, will doubtless hinder GDP growth until at least the next quarter. As the disturbance continues, local businesses may find themselves starved for cash and unable to pay their bills, perhaps forcing them into bankruptcy. Furthermore, in reducing the amount of cash in the economy after the 50-day deadline, the plan will drive down prices until enough money has been printed to make up for the discontinued notes. Since India's growth rate was a robust 7 percent and its inflation near target when the country embarked on this experiment, it has a cushion to absorb the economic shock — provided it does not last too long.
A Measure of Success
Notwithstanding the risks, the initiative could be a boon for the Modi administration. In steering citizens to the bank, the experiment has not only increased deposits but also given India's nascent electronic payment companies a boost. (Reports indicate that business has been booming for these companies since the campaign began.) This is a welcome development for the government, which will have an easier time accruing tax revenue and implementing effective monetary policies in a country that keeps its money in the bank. The initiative could also bring New Delhi a big step closer to one of its long-term goals: a cashless society.
Once the deadline for exchanging the old notes has passed, New Delhi can assess the success of its experiment. By that time, most of the 500- and 1,000-rupee notes that have not been exchanged can be considered "black," allowing the government to measure the initiative's effect on the informal economy. (Their calculations will also have to account for people — for instance, those without government identification cards — who were unable to exchange their money.) If the figure turns out to be substantial, and the damage to India's economy controlled, the government should come out of the campaign in a stronger position. Even though the participants in India's informal economy could resume their shadow trade with the new bills and attain the same level of illicit wealth in a few years' time, they will have good reason not to. Should the experiment succeed, it will have cost the beneficiaries of the black economy enough to give them pause going forward and perhaps encourage them to do business through legitimate channels. After all, Modi's administration has proved itself a formidable foe, systematically closing off the havens where people once stashed their lucre. And so, if all goes as planned, Modi's daring experiment will have been a worthwhile — if inconvenient — endeavor, leaving India with a more coherent and functional government and economy.