Indian Rupee notes are seen in this picture illustration taken in Mumbai June 12, 2013. REUTERS/Vivek Prakash/Files
Indian Rupee notes are seen in this picture illustration taken in Mumbai June 12, 2013. REUTERS/Vivek Prakash/Files

Indian shares fell over 5 percent, wiping out MSCI Index gains through end-October, in the immediate aftermath of the government’s sudden withdrawal of large denomination rupee notes in an effort to curb underground “black money” transactions.

Activist groups like US-based Global Financial Integrity estimate that hundreds of billions of dollars may be missing through illicit flows at home and abroad the past decade, and Prime Minister Narendra Modi and his team supported a crackdown as part of anti-corruption and fiscal deficit reduction pledges. Under the campaign, an income tax amnesty from June to September brought in US$10 billion, and the so-called “Mauritius loophole,” which allowed investors to park assets on the island to escape capital gains, was also closed. In 2015 parliament passed legislation to outlaw “illegal wealth concealment” abroad, and the Prime Minister vowed to bring it back for anti-poverty programs.

The abolition of 500 and 1,000-rupee bills for daily dealing set off a cash scramble among small traders and real estate firms in particular, as individuals and companies with bank accounts resorted to substitute internet and mobile, services to avoid ATM access limits. Critics argue the move was timed to coincide with upcoming state elections so the ruling BJP coalition can tout progress against the shadow economy, while fund managers worry it is a feint to cover otherwise sputtering banking and budget cleanup policies.

An estimated one-fifth of GDP is channeled informally and the government may be able to collect US$30 billion in additional revenue if it can flush out these proceeds, experts believe. However in the near term panic has ensued as ordinary savers rush to transfer bills into gold, and consumer sentiment will be dented, endangering the 7% growth registered the past quarter.

The last big-note elimination against the black money scourge was 30 years ago and had negligible impact, and post-Diwali holiday spending was already depressed by the massive school closure in New Delhi due to toxic smog. Foreign banks have also been singled out as havens for illicit cash without evidence by the Indian Bank Employees Association, at a time when inward portfolio and direct investment has slackened, and authorities must also repay US$25 billion in external borrowing from a special expatriate facility  created during the 2013 “fragile five” crisis.

International reserves are ample at over US$350 billion, but FDI at US$4 billion in the last quarter was half the average of recent periods. It will help offset the 1% of GDP current account gap, mainly due to lower gold imports before the surprise currency squeeze.  That trend could reverse as service exports and remittances have also each dropped 10%. The government’s “Make in India” push to establish a manufacturing export hub has yet to materialize with flat private sector investment, and a 5% corporate earnings drop through the March fiscal year. Profit margins have plunged at well-known stock exchange-listed conglomerates like Tata, where the outsider chief executive was ousted in October after a bitter struggle with family members.

Fiscal and monetary reforms invited skepticism that may have contributed to the note cancellation push. The national goods and service tax introduction due to begin next April has been complicated by a four-band structure for essential to luxury goods ranging from 5% to 25%. It will allow states leeway to impose other indirect levies and the central government promises to compensate for lost revenue, which may offset the expected consolidation advantages. Companies complain that sales tax rates could go even higher if the 3.5% of GDP fiscal deficit target is again off track, and propose state enterprise sale as an alternative backstop.

New central bank chief Urjit Patel, in his first official announcement, cut benchmark interest rates 25 basis points to 6.25% on below 5% consumer inflation as industry cheered. However economists pointed out that food prices were still increasing and the decision was premature. They also warned of lack of focus,  relaxing  his predecessor’s drive against bank bad debt, and now the abrupt sidetracking to black money has raised suspicions of masked restructuring lethargy.

Gary Kleiman

Pioneer and recognized expert in the field of global emerging economies and financial markets. Founder of first consulting firm dedicated to providing independent analysis and advice to public and private sector clients in 1987, and research coverage and firsthand experience covers 75 countries in all developing regions. Advisor on financial vulnerability issues, risk management, portfolio allocation, and financial sector and capital markets strategy and development.

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