In a country with a huge informal economy and where large sums of black money are converted to non-cash assets, or leave the country through hawala channels or offshore tax havens, policy makers have long sought to reduce the market for black money.

India has tried demonetisation before, most recently in 1978 when the effects on the black market were short-lived and the effort perceived as a symbolic intervention aimed at political gain. More recently still, the government held an amnesty for tax evaders that resulted in declarations worth US$10 billion by the time it ended on 30 September this year.

Six months before coming to power in 2014, India’s Bharatiya Janata Party (the party of current Prime Minister Narendra Modi) argued that demonetisation was anti-poor. It claimed that people who stash their savings under mattresses would be most affected, rather than those with larger sums who have the means and capacity to quickly convert their cash into gold, property or foreign currency.

So what explains this apparent U-turn? It could be political: demonetisation will hit opposition parties hard as they struggle to fund their upcoming state election campaigns. And yet by some estimates, 75% of the funding for all Indian political parties comes from unknown sources. Money that has gone offshore is easily funnelled back to political parties that face very little regulation.

If the aim is to stop tax evasion, demonetisation can only ever be partially successful.

In the short term, the move to a cashless economy encourages more creative alternatives for laundering.

With the window for converting now-redundant banknotes closing on 30 December, middle-men and gold traders are laundering notes through their own channels, for a fee, splitting it up through trusted associates and depositing into separate accounts (you can deposit roughly US$3600 until the end of the year without alerting income tax authorities). 

In the long-term, the policy will surely prompt more sophisticated forms of white collar tax evasion, like inflating costs or under-reporting sales, from which the poor benefit less.  Effective demonetisation thus can’t be separated from the need for regulatory reform that both increases legislative reach and simplifies tax rules and processes.

Ultimately, compliance-based mechanisms to tackle the black economy can only go so far to foster a stronger social contract between state and society. At the heart of the challenge is the need to empower all citizens – rich and poor – to demand and act with integrity.

A prime motivation behind Modi’s move was to make tax enforcement easier, by shrinking the cash economy that is largely beyond the reach of tax inspectors.

Greater use of banks and electronic payment systems generates paper trails (or perhaps ‘bit trails’) for tax inspectors to follow. Readily available means of verifying income statements is widely credited with enabling high levels of taxation in western economies.

In developing countries, the vast majority of people work in the informal economy. Debates rage about whether that means policy should try to help informal producers or concentrate on growing the formal sector.

The evidence suggests that informal producers tend not to grow into formality but rather disappear when out-competed by formal firms. For most informal firms, the costs of formality (largely, having to pay taxes and worker benefits) tend to outweigh the benefits (access to credit and different customers) – here is some evidence from Brazil.

However, what’s in the interests of incumbent producers is not necessarily what is in the interest of the economy at large. A lot hangs on how well governments spend additional tax revenues, but there is reason to believe (pdf) that the benefits of better tax enforcement outweigh the costs (although that’s of little comfort to those who bear the costs).

An interesting question is the extent to which the mere threat of replicating Modi’s cash destruction would be enough to encourage some formalisation.

Even in these days of WhatsApp, it might be hoping a bit much for informal traders in Jakarta to keep up with Indian policy experiments. But if other governments start hinting that they might follow Modi’s lead, that might bring some of the benefits – with rather less pain.  

This decision partly aimed to control counterfeit money and the informal economy. Indian policymakers have noted that it will increase India’s GDP as it brings more transactions into the formal economy.

However, demonetisation could reduce India’s inflation rate from its current 4.2%, below the Reserve Bank of India’s 4% target that could prompt more interest rate cuts if activity also slows unexpectedly. This will depend, in part, on the extent to which India’s lower supply of money contributes to sustained deflationary pressure.

The macroeconomic impacts of the policy move are multifaceted, and uncertain, at this early stage. However, the short-term decline in liquidity will likely reduce India's economic activity. With the government’s demonetisation having removed 86% of the rupee currency from circulation, lower transactions, the likelihood of reduced domestic demand and employment will impact the economy through various channels.

As a result, India’s demonetisation could significantly reduce economic activity and the hit to economic growth in 2016-17 could be conservatively put at 0.5 % of GDP, which could in turn offset the gain from the demonetisation, according to India’s National Institute of Public Finance and Policy.

India’s demonetisation, by making people put their savings into bank accounts, could have two effects. It could further increase bank account ownership, and it could increase the use of accounts by changing how people save.

But this assumes that every Indian has access to a bank account. Latest government statistics claim that 100% of Indian households are now ‘financially included’, meaning at least one person in every household has a bank account. More than 250 million new accounts were opened since the end of August 2014, when Modi launched a new financial inclusion programme, the Pradhan Mantri Jan-Dhan Yojana (PMJDY). 

This doesn’t mean people are using their accounts. Recent survey data suggests that nearly 60% of bank account owners had not used their account in the past 30 days.

And of those who do not have a bank account, just 2% report that they can use someone else’s, calling into question the underlying assumption behind the PMJDY scheme. A household account doesn’t necessarily translate into access for all household members. Those with less power – often women – won’t enjoy the same benefits of account ownership. What will this mean for people’s savings after they put all their high value notes into an account that is not their own?

Nearly 72% of people surveyed save in cash ‘under the mattress’. And the now-redundant 500 and 1,000 rupee notes make up 86% of total bank notes in circulation. To regain control over their savings, people may withdraw the recently deposited money from the bank soon after. In many developing countries, bank account holders merely use their accounts to withdraw all their funds after receiving transfers.

So while this intervention may have aimed to increase the use of formal banking in India, large-scale behaviour change may be unlikely without more information on the benefits of using bank accounts.

Manuela Kristin Günther is an ODI Fellow for Financial Inclusion in India.