NEW DELHI—In a surprise announcement Tuesday night, Prime Minister Narendra Modi said India will replace its largest-denomination bank notes with newly designed ones, a move aimed at curbing corruption, thwarting counterfeiters and dredging up what could be billions of dollars of taxable income currently stashed in the underground economy.
The new 500- and 2,000-rupee notes, worth around $7.50 and $30 respectively, will begin to circulate soon. Current 500- and 1,000-rupee bills ceased being legal tender Wednesday but can be redeemed at banks and post offices until Dec. 30.
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Banks will be closed Wednesday to help make the transition. According to India’s central bank, 86.4% of the value of all rupee bills in circulation was in 500- and 1,000-rupee notes as of March.
“It’s going to be very inconvenient, because everybody uses these notes,” said Sujan Hajra, chief economist at Anand Rathi Securities in Mumbai. But given the amount of fake cash in India, he said, “it’s a very good move.”
Indian Economic Affairs Secretary Shaktikanta Das, left, and Governor of the Reserve Bank of India Urjit R. Patel hold up a sample of the new 500-rupee note at a news conference in New Delhi Tuesday. ENLARGE
Indian Economic Affairs Secretary Shaktikanta Das, left, and Governor of the Reserve Bank of India Urjit R. Patel hold up a sample of the new 500-rupee note at a news conference in New Delhi Tuesday. Photo: Agence France-Presse/Getty Images
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Governments around the world have debated the merits of scaling back big bills to fight crime. The European Central Bank began phasing out the €500 ($552) note this year. India’s Ministry of Finance said that because the new rupee notes will look markedly different from current ones, the move would deal a blow to activities such as terrorism, drug smuggling and espionage that fake Indian currency helps finance.
The country’s central bank said 405,000 counterfeit 500- and 1,000-rupee notes were found in the banking system in the year that ended in March, representing around $4 million. But researchers at the Indian Statistical Institute estimated this year that the total value of fake bills in circulation, including those that go undetected by banks, may be as high as $60 million.
Requiring Indians, particularly the wealthiest, to come forward with their old bills could also force them to introduce into the banking system money that had been squirreled away to avoid taxes. Mr. Modi’s government, eager to find new revenue to fund its spending plans, has taken other steps to fight tax evasion, including allowing taxpayers this year to come clean about undeclared income without facing full penalties.
The potential windfall is huge. Only around 20 million individuals and families, or around 1.6% of India’s population, paid any income taxes in 2013, the most recent year for which data are available.
In India, the predominance of cash is also blamed for making it easier for businessmen to pay bribes to government officials and for political parties to buy votes during elections.
“This parallel economy has got to go,” said Shaktikanta Das, the secretary for economic affairs in the finance ministry, noting that the increase in circulation of high-denomination rupee notes had outpaced the economy’s growth over the past five years.
Authorities announced steps to head off the potential chaos of abruptly removing billions of bank notes from people’s pockets.
Old bills will continue to be accepted for the next few days at railway- and bus-ticket counters, as well as at state-run hospitals, crematoria and milk vendors. People who aren’t able to deposit their current notes before the December deadline can do so at special offices, after turning in a declaration form, until March 31.
“A move like this has to be abrupt,” said Madhavi Arora, chief economist at Kotak Bank in Mumbai. “If people can sense that it’s about to happen, they’ll find loopholes.”
Still, the news caused commotion Tuesday night. At Mumbai’s upmarket Cuffe Parade neighborhood, people were wandering from ATM to ATM in search of one that worked and was issuing 100-rupee notes, the next-largest after the 500. Most automated teller machines were closed or not in service.
Residents discussed the new daily limits on cash withdrawals during the changeover: 2,000 rupees a card at first, then 4,000 rupees after Nov. 19.
“I have a family. There is no way that is going to be enough,” said Hussain Petiwala, a restaurant owner. “How do you survive?”
The rush of money flooding into banks, said Ms. Arora, the economist, could mean a boost to liquidity in the system. But by removing one method for making large transactions—many real-estate purchases in India, for instance, are in cash—the change might cause the wheels of the economy to seize up temporarily, she said. “Right now, this is likely to have negative implications for growth.”
Pritha Murdeshwar, a French teacher in Mumbai, was surprised at the announcement but not worried. She doesn’t keep much money in cash.
“This is aimed at those people who are hiding cash in their walls behind the photographs,” she said.
She remembered when similar measures were taken earlier. India introduced 1,000-, 5,000- and 10,000-rupee notes in 1954, then discontinued them in 1978. It reintroduced the 1,000-rupee bill a few decades later.
People scrambled to redeem their large notes, Ms. Murdeshwar said, sometimes selling them at a discount to people with the paperwork needed to turn them in.
—Eric Bellman and Gabriele Parussini in Mumbai contributed to this article.
Write to Raymond Zhong at
raymond.zhong@wsj.com 
