How Narendra Modi of India Plans to Wipe Out ‘Black Money’

MUMBAI, India — In one of the most audacious experiments in India’s modern history, Prime Minister Narendra Modi banned the two largest bills — of 500 rupees, or about $7.50, and 1,000 rupees — which account for about 86 percent of the currency in a country where 78 percent of financial transactions are done in cash.

Under the plan, people are allowed to exchange the old bills for new ones of 500 and 2,000 rupees, but only at banks or post offices, where their exchanges will be monitored and anyone with a large amount of cash will have to explain its source. The changes, meant to combat corruption and tax avoidance, have thrown the country into chaos. Here are answers to a few basic questions about the changes.

Why did the government remove the bills from circulation?

The idea was to expose and penalize people holding huge amounts of cash they could not account for, primarily money on which taxes have not been paid. Most of the so-called black money is held in 500- and 1,000-rupee notes. Someone who goes to a bank or post office with more than 250,000 rupees in cash, or about $3,700, has to explain the source of the money to the tax authorities.

People who can explain how they earned the money and show that taxes were paid can keep it. But those without a good explanation will have to answer to the tax authorities.

Isn’t that disruptive?

It is. Overnight, people found themselves lacking the currency for basic transactions, like buying food, fuel and other necessities. Retail businesses came to a standstill because people hoarded the little cash they had for food and other needed supplies.

To avoid tipping off tax cheats, the government did not print the new bills until after the announcement, nor did it recalibrate automated teller machines to dispense the new 500- and 2,000-rupee notes. Long lines formed at the few A.T.M.s that were operating, and many ran out of bills, infuriating those who had stood in line for hours.

Since then, the printing presses have churned out more than $40 billion in currency, but the government was initially forced to limit A.T.M. withdrawals to 2,000 rupees, or about $30, at a time. The limits are now 2,500 rupees per A.T.M. withdrawal and 24,000 a week from a bank. The government says it will take three weeks to recalibrate India’s estimated 200,000 A.T.M.s.

Is black money really that big a problem?

Unaccounted-for cash, or black money, is a huge problem for the country, because it keeps money out of banks where it could be lent to others, helping businesses grow and driving economic growth. Black money also sharply reduces the taxes collected by the government, and hence services available to the public.

About a third of business in India is done with black money. In a heavily regulated economy, businessmen frequently bribe government officials into giving them licenses and other approvals. Government officials invest much of this money in real estate, then understate the amount they actually paid. So not only is the property purchased with black money, but the sellers pay less tax than they should because the prices have been understated. Routine transactions, like paying a hairdresser, are largely carried out off the books to avoid paying taxes.

Won’t people just start hoarding the new bills?

Economists say that in order to work, the plan has to inflict enough pain on tax avoiders that they change their behavior. If people are motivated to keep their money in banks, more will be available for lending and people will become accustomed to paying taxes.

But because many poor Indians do not have bank accounts or credit cards, the government could not dispense altogether with cash. If the public continues to hold most of its savings in the new notes, India may well find itself dealing with the same problem. Regardless, most economists believe that wiping out black money will also require an aggressive approach on the endemic bribery that propels the system.

Will Mr. Modi pay a political price?

Indians have exhibited remarkable patience with the currency ban, but only on the promise that it will actually accomplish what he says it will and the government can quickly get the new bills into circulation. The government is working feverishly to distribute them, but lines and public frustration are growing.

As business has been strangled by a lack of bills for routine transactions, there has even been concern that the currency ban will slow the economy.

If the inconvenience continues for more than a few days, public support for Mr. Modi could turn to fury toward him. And the ban could end up substantially damaging Mr. Modi’s own promise of jobs and economic development.