Asia Economy

Modi's currency swap won't root out tax cheats

Three weeks after Indian Prime Minister Narendra Modi shocked the country by announcing a major currency reform, doubts remain as to whether the aim of corralling tax evasion will work.

On Nov. 8, Modi announced that all 500 and 1,000 rupee notes in circulation would be cancelled by year-end and replaced with new notes as part of efforts to catch tax evaders holding undeclared cash, or "black money." The Reserve Bank of India (RBI) said on Monday that it has received 8.4 trillion rupees (around $120 billion) so far in old notes.

Supporters of The All India Trinamool Congress during a rally against demonetization of the Rs.500 and RS.1000 notes on November 28, 2016 in Kolkata.
Ashok Nath Dey / Hindustan Times / Getty Images

Currency controls can certainly hinder large-scale black money operators, including counterfeiters and financiers of terror networks, but they don't address the conditions that allow hidden wealth to flourish, economists told CNBC.

"If they want to solve problem of black money, they have go to source of the problem, which is the government," Steve Hanke, professor of applied economics at the Johns Hopkins University, told CNBC's "The Rundown" on Monday. "[Black money] is tangled up in Indian red tape, that's why you have to bribe anyone to get anything done."

Daily administrative tasks across public institutions like the police and judiciary can require bribes to civil servants in charge of the paperwork, a practice so rampant that both foreigners and locals see it as part of doing business in India.

Around 43 percent of citizens said they paid a bribe to get something done in the past one year, according to a national survey by community engagement platform Local Circles released earlier this month.

"The key issue at stake here is an improvement in overall governance...But the policies required to tackle governance issues on a lasting basis are much more substantive than just demonetization, you can't rely on that alone," said Dev Kar, chief economist at Global Financial Integrity.

India's 'day of rage'

Citizens have been scrambling to exchange their old bills for new ones, which include an upcoming 2,000 rupee note, amid limited stock, withdrawal restrictions, long queues and empty ATM machines. The chaos and frustration saw thousands join nationwide demonstrations on Monday against the cash shortage in a clear sign of trouble for Modi's ruling Bharatiya Janata Party.

So far, small businesses and poor wage earners, the bulk of whom lack bank accounts, have suffered the most and they may not reap the long-term rewards either.

"When the government re-monetizes and puts that money back into system, it'll be wealthy people with bank accounts in cities that benefit, not rural residents, so that will distort economic activity. The Reserve Bank didn't tell you that side of the story," Hanke warned.

To help eradicate corruption, the government should look to make the Central Bureau of Investigations truly independent and ensure police forces don't bend to state politics, Kar suggested. Hanke meanwhile believes Modi should have slashed regulations and embraced a free-market regime instead.

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