A tough but necessary measure

India’s move to invalidate large currency notes will pay long-term dividends

People wait in line to exchange Indian five hundred and one thousand rupee banknotes at a Punjab & Sind Bank branch in New Delhi. Anindito Mukherjee/Bloomberg

It has been two weeks since Indian prime minister Narendra Modi made the bold decision to render 500- and 1,000-rupee notes worthless. For millions of Indians, this decision has created substantial heartache as many have been forced to deposit their entire life savings into new bank accounts and face considerable tax penalties. Since the world’s largest democracy has a largely cash-based economy, many have saved considerable amounts without a tax burden.

This has allowed corruption to run wild and give way to so-called black money. Ending this vicious cycle of tax evasion and corruption is critical to Mr Modi’s goal of bringing the Indian economy into the 21st century. With this currency move, the prime minister has demonstrated a willingness to make the critical reforms required to realise his vision.

A cashless society would have enormous benefits for India. Moving the country away from cash into an economic system that is based on bank accounts and mobile payment schemes is a proven way of rooting out corruption and equitably enforcing tax laws. Beyond the tax windfall, a regulated cashless society where the majority of Indians use banking infrastructure will, at least in theory, increase efficiency in society.

Commentators have focused on how the removal of these large notes will help eradicate the problem of black money, but that is only one short-term benefit of this decision. The only way that Mr Modi can thrust India’s economy into the 21st century is to “break the system”. In this case, that means getting India off its cash addiction and forcing the society to join the globally regulated banking system.

As in other economies that have endured structural reform, there must be a “big bang” moment in which the reforms bite. Mr Modi’s decision and the subsequent anger from large portions of society could very well prove to be that moment.

The challenges include following the currency reforms with additional measures to root out corruption. Mr Modi also has his work cut out for him in articulating how the short-term pain and chaos will ultimately set India on a path to progress and prosperity under an increasingly cashless society. Convincing a poor farmer who has seen his hard-earned life savings diminish dramatically due to taxation is a tall order for any politician. But in this case, the short-term pain will lead to long-term dividends.