By Neha Dasgupta and Rajendra Jadhav
NEW DELHI/MUMBAI (Reuters) - Indian banks called in thousands of police on Thursday to manage huge queues outside branches, as people tried to exchange bank notes abruptly pulled out of circulation by Prime Minister Narendra Modi in a crackdown on "black money".
Modi announced the shock move on Tuesday night to ditch 500 and 1,000 rupee notes - worth a combined $256 billion - that he said were fuelling corruption, being forged and even paying for attacks by Islamist militants against India.
Lines formed before banks reopened after being shut on Wednesday to prepare for the change, as people tried to swap the worthless cash for smaller bills or new 2,000 rupee notes being rushed into circulation and made to be harder to counterfeit.
Some people frustrated by the long wait got into arguments at Canara Bank near the parliament building in New Delhi, as people barged into queues that wound through the branch and on to the street outside.
"Why is there no-one here to manage anything?" shouted one man, as he jostled with others in the line.
Branch manager S.K. Verma, unable to get through to the local police station, called an emergency hotline for help.
"I want two policemen deputed outside my branch!" he said. Twenty police stood outside a nearby outlet of the Reserve Bank of India, the central bank, letting in customers a few at a time.
Economists and some businesses, especially those involved in cashless payments, have welcomed the "demonetisation" scheme as a vital step toward broadening the formal economy and improving tax compliance.
But it has disrupted the daily lives of hundreds of millions of Indians who live in the cash economy that is estimated to account for a fifth of India's $2 trillion gross domestic product and who have low confidence in banks or plastic cards.
Fresh produce prices dropped sharply in food markets as people ran out of cash, or vendors were unable to give change, while the government ordered hospitals and filling stations to accept the old money for a few days longer.
Although a few people were able to exchange their old money for new notes, there were strict caps on account withdrawals and most came away with bundles of lower-denomination bills.
People were allowed to make a one-time exchange of 4,000 rupees in cash and one-time account withdrawals of 10,000 rupees, capped at 20,000 rupees per week.
Cash dispensers remained closed and were due to reopen on Friday.
It was the same story for senior bureaucrats in the capital's government district and daily laborers in Old Delhi, where youths reserved places in lines to earn some cash.
Trading of farm commodities around the country was disrupted for the second day on Thursday and in many markets farmers were struggling to sell their produce.
Prices of perishable fruit and vegetables have fallen by up to a quarter as traders were unable to sell them to vendors, who pay in cash.
"Most transactions of farm commodities are conducted in cash and since cash is not available we are not able to sell," said Rohan Ursal, a trader based in Pune in the western state of Maharashtra.
In television interviews, Finance Minister Arun Jaitley defended the switch, saying India was moving to a "cleaner system", and rebutting criticism that the government was resorting to arbitrary and authoritarian methods of running the economy.
But he said it would take two or three weeks for new 500 and 2,000 rupee notes to be put into circulation, replacing old notes worth 17 trillion rupees ($256 billion) that can be exchanged until Dec. 30.
The old 500 and 1,000 rupee notes - until now India's highest denomination bills worth $7.50 and $15 respectively - accounted for 86 percent of all cash in circulation, analysts at Citi have estimated.
One economist said that Modi, by fixating on black money in the form of physical cash, had failed to recognize how tax evasion and financial crime works - for example by under-invoicing to create illicit wealth, using informal hawala networks to move offshore or buying gold and real estate.
"This very conception of 'black money' is absurd," left-leaning economist Prabhat Patnaik wrote in The Citizen, an online daily.
(Additional reporting by Cathal MacNaughton in New Delhi and Sankalp Phartiyal in Mumbai; Writing by Douglas Busvine)