Modi’s Holy City Shows $1 Trillion Hidden Economy Is Stalled

(Bloomberg) -- In Prime Minister Narendra Modi’s political base of Varanasi, Hinduism’s holiest city, weaver Zainul Abedin stares at the uneven mud floor of his home. Behind him, more than a dozen handlooms lie idle.

Abedin is part of the collateral damage of Modi’s Nov. 8 decision to ban high-value currency notes, effectively canceling 86 percent of cash in circulation. The move was designed to stifle corruption and tax evasion, but many of the hardest-hit are workers in India’s vast and intricate informal economy -- the small businesses, shops, drivers and countless other basic industries and services that employ more than 90 percent of Indian workers.

Most are poor like Abedin, who earns 250 rupees ($4) a day, but collectively they account for almost half the economy. That’s some $1 trillion, or more than the GDP of Indonesia.

"Modi’s cash ban has broken our backs," said Abedin, 39, who makes Varanasi’s famous silk fabrics, shot with gold and silver, and says he can no longer feed his children. "We weavers won’t last if this continues for even another month."

The cash ban is a massive gamble for Modi, who is trying to persuade ordinary Indians that they will benefit in the long run as rich tax evaders are forced to surrender hidden hordes and pay their fair share toward government spending. Uttar Pradesh -- which houses Varanasi -- will be the acid test to see whether he’s succeeding. The nation’s most-populous state is ground zero for India’s shadow economy, with the largest share of the nation’s estimated 60 million non-farm, unincorporated enterprises according to the latest government data.

Elections due early next year in the state, which contributes about a seventh of lawmakers in parliament, will be considered a referendum on Modi’s demonetization drive, before national polls in 2019, with both ruling and opposition parties making it a key issue.

Successive governments turned a blind eye to India’s booming underground marketplace, giving it space to form intricate supply chains where commerce thrives even as account books record little industry. The reliance on cash helps avoid India’s byzantine regulations, fueling a unique approach to innovation called jugaad, now openly discussed in global business schools. Fewer than 5 percent of Indians declare their incomes and 1 percent pay income tax.

"These are precisely the kind of things Modi wants to change," said Hansraj Vishwakarma, who heads Modi’s Bharatiya Janata Party in Varanasi. "People may have to suffer a bit in the short term but it will help the economy in the long run."

Poor Suffering

The opposition Congress party, which governed India for most of its history, says the cash crunch is damaging the development of the economy and disproportionately hurts the poor, while the rich continue to salt away their wealth.

"The Prime Minister single-handedly decided to declare war on the world’s fastest-growing economy," Congress leader Rahul Gandhi said at a Dec. 2 briefing. "A huge portion of India’s poor people use cash. These are honest hardworking people. All cash is not black money and all black money is not cash."

Economists slashed growth estimates for the year to March but several, including analysts at the Asian Development Bank, forecast expansion to rebound in the following 12 months. The Reserve Bank of India has been more circumspect, suggesting that the cash ban’s impact seems transitory, but that more data must be analyzed. The process of replacing the amount of money lost -- either through new bills, digital payment systems or by boosting government spending -- could take months.

At the heart of the problem is the way informal businesses like the Varanasi weavers make payments. When the clothmakers deliver an order of saris, they get a “bearer check,” payable to whoever presents it at the bank. Like a parallel currency, these cash-checks are passed among a chain of suppliers to settle accounts until they reach the bank, often via a moneylender who provided the initial lump sum for bulk raw materials or new equipment.

“The small producer has borrowed from the informal sector, which means more often than not from the local moneylender,’’ said Pronab Sen, country director at London-based International Growth Centre and formerly India’s top government statistician. Now the moneylenders are saying “pay me back in new currency.” Daily wages are also paid in cash, which is then used to pay shopkeepers for food and other necessities.  

Moneylenders are a key part of India’s economy, charging higher, sometimes usurious interest rates but requiring few formal guarantees. The nation has just 13 bank branches per 100,000 people and only about one in four people have access to the internet. Single households run about 96 percent of the nation’s unincorporated non-farm enterprises and only 1 percent got loans from the government, latest data show.

Bank Queues

Modi’s cash decision has forced many families to spend as many as four days a week lining up to withdraw money or exchange old bank notes, costing them an estimated 615 billion rupees in lost business through Dec. 30. Modi has pleaded with the public to give him until the end of December to solve the problems created by the sudden shock of the ban.

“The lines are so long that my turn almost never comes on the same day," said Mumtaz Ahmed, 38, who has six looms lying idle a few houses away from Abedin’s. Yet, Mumtaz says he supports Modi’s move, which he believes will penalize the rich more than the poor.

That’s bad news for the Congress party, which traditionally claimed to champion the rights of the poor. Modi blames the Soviet-style policies of previous Congress-led governments for fostering India’s shadow economy. Former Prime Minister Indira Gandhi -- Rahul’s grandmother -- raised tax rates as high as 99 percent in the 1970s and largely controlled industrial development.

Separating illegal and legal payments in India’s cash economy isn’t easy. In Varanasi’s cloth markets on the banks of the Ganges, India’s holiest river, printed receipts are rare and purchases are recorded on handwritten slips of paper. The weavers are among the most famous of India’s 4.3 million handloom workers, the heart of a textile industry that is the country’s biggest sector employer after farming and contributes 13 percent of exports.

Shipments of man-made yarns and fabrics fell 11 percent in November from a year earlier as overall export growth slowed, data show. Most tanneries in the leather hubs of Agra and Kanpur -- also in Uttar Pradesh -- have halted export orders and are reporting a 60 percent drop in production as workers are laid off or unpaid, lobby group Associated Chambers of Commerce & Industry of India said in a Dec. 19 statement.

The Varanasi weavers, mostly Muslims, make the Banarsi sari, a 17-foot-long piece of silk that is a regular of Indian bridal trousseaux. More than 60 percent didn’t have a bank account as of Nov. 9, according to Shashikant, a 36-year-old project coordinator at the All India Artisans and Craftworkers Welfare Association, who goes by one name. The group has since helped more than 2,000 open no-frills accounts under Modi’s financial inclusion push, though they still require cash for many transactions.

Political Bribes

Poor workers and unscrupulous businessmen aren’t the only ones to benefit from the anonymity of cash. Currency in circulation normally spikes before elections as local leaders hoard bank notes to bribe voters. Even when it comes to electronic payments, the law requires political parties to declare only a few high-value transactions. Donations to Modi’s BJP more than doubled in the year he swept to power, of which almost 70 percent was from undeclared sources.

Modi should have tackled this political corruption first before he banned bank notes that so many ordinary Indians rely on for daily life, said Ravindra Chaurasia, 54, who has a little stall on the banks of the Ganges selling paan, a chewy combination of betel leaf, areca nut and tobacco.

“Why did Modi have to drain the entire pond to get a couple alligators?’’ said Chaurasia, who had to delay his daughter’s wedding due to a shortage of cash. “There’s no chance things will get better by the end of the month, no matter what the prime minister thinks.’’

--With assistance from Bibhudatta Pradhan To contact the reporters on this story: Archana Chaudhary in New Delhi at achaudhary2@bloomberg.net, Jeanette Rodrigues in Mumbai at jrodrigues26@bloomberg.net. To contact the editors responsible for this story: Ruth Pollard at rpollard2@bloomberg.net, Jeanette Rodrigues, Adam Majendie