13 Reasons RBI Shouldn’t Allow Large Corporates/Industrial Houses to Own Banks

Apna hi ghar phoonk rahe hain kaisa inquilab hai.

— Hasrat Jaipuri, Mohammed Rafi, Mukhesh, Ravindra Jain and Naresh Kumar, in Do Jasoos.

Should large corporates/industrial groups be allowed to own banks? An internal working group (IWG) of the Reserve Bank of India (RBI), thinks so. I had dwelled on this issue sometime last week, but that was a very basic piece. In this piece I try and get into some detail.

The basic point on why large corporates/industrial groups should be allowed into banking is that India has a low credit to gross domestic product (GDP) ratio, which means that given the size of the Indian economy, the Indian banks haven’t given out enough loans. Hence, if we allow corporates to own and run banks, there will be more competition and in the process higher lending. QED.

Let’s take a look at the following chart, it plots the overall bank lending to GDP ratio, over the years.


Source: Centre for Monitoring Indian Economy.

The above chart makes for a very interesting read. The bank lending grew from 2000-01 onwards. It peaked at 53.36% of the Indian GDP in 2013-2014. In 2019-20 it stood at 50.99% of the GDP, more or less similar to where it was in 2009-10, a decade back, at 50.97% of the GDP. Hence, the argument that lending by Indian banks has been stagnant over the years is true.

But will more banks lead to more lending? Since 2013, two new universal banks, seven new payment banks and ten new small finance banks have been opened up. But as the above chart shows, the total bank loans to GDP ratio has actually come down.

Clearly, the logic that more banks lead to more lending is on shaky ground. There are too many other factors at work, from whether banks are in a position and the mood to lend, to whether people and businesses are in the mood to borrow. Also, the bad loans situation of banks matters quite a lot.

In fact, even if we were to buy this argument, it means that the Indian economy needs more banks and not necessarily banks owned by large corporates/industrial houses, who have other business interests going around.

Also, the banks haven’t done a good job of lending this money out. As of March 2018, the bad loans of Indian banks, or loans which had been defaulted on for a period of 90 days or more, had stood at 11.6%. So, close to Rs 12 of every Rs 100 of loans lent out by Indian banks had been defaulted on. In case of government owned public sector banks, the bad loans rate had stood at 15.6%. Further, when it came to loans to industry, the bad loans rate of banks had stood at 22.8%.

Clearly, banks had made a mess of their lending. The situation has slightly improved since March 2018. The bad loans rate of Indian banks as of March 2020 came down to 8.5%. The bad loans rate of public sector banks had fallen to 11.3%.

The major reason for this lies in the fact that once a bad loan has been on the books of a bank for a period of four years, 100% of this loan has been provisioned for. This means that  the bank has set aside an amount of money equal to the defaulted loan amount, which is adequate to face the losses arising out of the default. Such loans can then be dropped out of the balance sheet of the banks. This is the main reason behind why bad loans have come down and not a major increase in recoveries.

This is a point that needs to be kept in mind before the argument that large corporates/industrial houses should be given a bank license, is made.

There are many other reasons why large corporates/industrial houses should not be given bank licenses. Let’s take a look at them one by one.

1) The IWG constituted by the RBI spoke to many experts. These included four former deputy governors of the RBI, Shyamala Gopinath, Usha Thorat, Anand Sinha and N. S. Vishwanathan. It also spoke to Bahram Vakil (Partner, AZB & Partners), Abizer Diwanji (Partner and National Leader – Financial Services EY India),  Sanjay Nayar (CEO, KKR India), Uday Kotak (MD & CEO, Kotak Mahindra Bank.), Chandra Shekhar Ghosh (MD & CEO, Bandhan Bank) and PN Vasudevan (MD & CEO, Equitas Small Finance Bank).

Of these experts only one suggested that large corporates/industrial houses should be allowed to set up banks. The main reason behind this was “the corporate houses may either provide undue credit to their own businesses or may favour lending to their close business associates”. This is one of the big risks of allowing a large corporate/industrial house to run a bank.

2) As the Report of the Committee on Financial Sector Reforms (2009) had clearly said:

“The selling of banks to industrial houses has been problematic across the world from the perspective of financial stability because of the propensity of the houses to milk banks for ‘self-loans’ [emphasis added]. Without a substantial improvement in the ability of the Indian system to curb related party transactions, and to close down failing banks, this could be a recipe for financial disaster.”

While, the above report is a decade old, nothing has changed at the ground level to question the logic being offered. Combining banking and big businesses remains a bad idea.

3) Let’s do a small thought experiment here. One of the reasons why the government owned public sector banks have ended up with a lot of bad loans is because of crony capitalism. When a politician or a bureaucrat or someone higher up in the bank hierarchy, pushes a banker to give a loan to a favoured corporate, the banker isn’t really in a position to say no, without having to face extremely negative consequences for the same.

Along similar lines, if a banker working for a bank owned by a large corporate or an industrial house, gets a call from someone higher up in the hierarchy to give out a loan to a friend of a maalik  or to a company owned by the maalik, will he really be in a position to say no? His incentive won’t be very different from that of a public sector banker.

4) As Raghuram Rajan and Viral Acharya point out in a note critiquing the entire idea of large corporates/industrial houses owning banks: “Easy access to financing via an in-house bank will further exacerbate the concentration of economic power in certain business houses.” This is something that India has had to face before.

As the RBI Report of Currency and Finance 2006-08 points out:

“The issue of combining banking and commerce in the banking sector needs to be viewed in the historical perspective as also in the light of crosscountry experiences. India’s experience with banks before nationalisation of banks in 1969 as well as the experiences of several other countries suggest that several risk arise in combining banking and commerce. In fact, one of the main reasons for nationalisation of  banks in 1969 and 1980 was that banks controlled by industrial houses led to diversion of public deposits as loans to their own companies and not to the public, leading to concentration of wealth in the hands of the promoters. Many other countries also had similar experiences with the banks operated by industrial houses.”

This risk is even more significant now given that many industrial houses are down in the dumps thanks to over borrowing and not being able to repay bank loans. Hence, the concentration of economic power will be higher given that few industrial houses have their financial side in order, and they are the ones who will be lining up to start banks.

5) Another argument offered here has been that the RBI will regulate bank loans and hence, self-loans won’t happen. Again, this is an assumption that can easily be questioned. As the RBI Report of Currency and Finance 2006-08 points out: “The regulators temper the risk taking incentives of banks by monitoring and through formal examinations, this supervisory task is rendered more difficult when banking and commerce are combined.”

This is the RBI itself saying that keeping track of what banks are up to is never easy and it will be even more difficult in case of a bank owned by a big business.

6) The ability of Indian entrepreneurs to move money through a web of companies is legendary. In this scenario, the chances are that the RBI will find out about self-loans only after they have been made. And in that scenario there is nothing much it will be able to do, given that corporates have political connections and that will mean that the RBI will have to look the other way.

7) There are other accounting shenanigans which can happen as well. As the RBI Report of Currency and Finance cited earlier points out:

“Bank can also channel cheaper funds from the central bank to the commercial firm. On the other hand, bad assets from the commercial affiliate could be shifted to the bank either by buying assets of the firms at inflated price or lending money at below-market rates in order to effect capital infusion.”

Basically, the financial troubles of a large corporate/industrial house owning a bank can be moved to the books of the bank that it owns.

8) If we look at the past performance of the RBI, there wasn’t much it could do to stop banks from bad lending and from accumulating bad loans.  This is very clear from the way the RBI acted between 2008 and 2015. Public sector banks went about giving out many industrial loans, which they shouldn’t have, between 2008 and 2011. The RBI couldn’t stop them from giving out these loans. It could only force them to recognise these bad loans as bad loans, post mid-2015 onwards, and stop them from kicking the bad loans can down the road. So, the entire argument that the RBI will prevent a bank owned by a large corporate/industrial house from giving out self-loans, is on shaky ground.

9) Also, it is worth remembering that the RBI cannot let a bank fail. This creates a huge moral hazard when it comes to a bank owned by a large corporate/industrial house. What does this really mean? Before we understand this, let’s first try and understand what a moral hazard means.

As Alan S Blinder, a former vice-chairman of the Federal Reserve of the United States, writes in After the Music Stopped: “The central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains ( and incur costs) to avoid it. Here are some common non financial examples: …people who are well insured against fire may not install expensive sprinkler systems; people driving cars with more safety devices may drive less carefully.”

In the case of a large corporate/industrial house owned bank, the bank knows that the RBI cannot let a bank fail. This gives such a bank an incentive to take on greater risks, which isn’t good for the stability of the financial system.

As the Currency Report points out:

“The greatest source of risk from combining banking and commerce arises from the threat to the safety net provided under the deposit insurance and ‘too-big-to-fail’ institutions whose depositors are provided total insurance and the mis-channeling of resources through the subsidised central bank lending to banks. Because of the safety net provided, the firms affiliated with banks could take more risk with depositors’ money, which could be all the more for large institutions on which there is an implicit guarantee [emphasis added] from the authorities.”

Other than incentivising the other firms owned by the same large corporates/industrial houses to take on more risk in its activities, it also means that now the RBI other than keeping track of banks, will also need to keep track of the economic activities of these other firms. Does the RBI have the capacity and the capability to do so? 

10) Another argument offered in favour of large corporates/industrial houses owning banks is that they already own large NBFCs. So, what is the problem with them owning banks? The problem lies in the fact that banks have access to a safety net which the NBFCs don’t. RBI will not let a bank fail and will act quickly to solve the problem. And that is the basic difference between a large corporate/industrial house owning a bank and owning an NBFC. Also, the arguments that apply to large corporates/industrial houses owning a bank are equally valid in case of them owning NBFCs, irrespective of the fact that large corporates already own NBFCs. Two wrongs don’t make a right.

11) We also need to take into account the fact many countries including the United States, which has much better corporate governance than India, don’t allow the mixing of commerce and business. As the Report of the Committee on Financial Sector Reforms (2009) had pointed out: “This prohibition on the ‘banking and commerce’ combine still exists in the United States today, and is certainly necessary in India till private governance and regulatory capacity improve.”

The interesting thing is that in the United States, the separation between banking and commerce has been followed since 1787.

As the Currency Report points out:

“Banks have frequently tried to engage in commercial activities, and commercial firms have often attempted to gain control of banks. However, federal and state legislators have repeatedly passed laws to separate banking and commerce, whenever it appeared that either (i) the involvement of banks in commercial activities threatened their safety and soundness; or (ii) commercial firms were acquiring a large numbers of banks.”

Also, anyone who has studied the South East Asian financial crisis of the late 1990s would know that one of the reasons behind the crisis was allowing large corporates to own banks.

12) This is a slightly technical point but still needs to be made. Banks by their very definition are highly leveraged, which basically means the banking business involves borrowing a lot of money against a very small amount of capital/equity invested in the business. The leverage can be even more than 10:1, meaning that the banks can end up borrowing more than Rs 100 to go about their business, against an invested capital of Rs 10.

On the flip side, the large corporates/industrial houses have concentrated business interests or business interests which are not very well-diversified. Hence, trouble in the main business of a large corporate can easily spill over to their bank, given the lack of diversification and high leverage. This is another reason on why they should not be allowed to run banks.

13) As Raghuram Rajan and Viral Acharya wrote in their recent note: “One possibility is that the government wants to expand the set of bidders when it finally sets to privatizing some of our public sector banks.”

This makes sense especially if one takes into account the fact that in recent past the government has been promoting the narrative of atmanirbharta.

In this environment they definitely wouldn’t want to sell the public sector banks to foreign banks, who are actually in a position to pay top dollar. Hence, the need for banks owned by large corporates/industrial houses looking to expand quickly and willing to pay good money for a bank already in existence.

Given this, the government wants banks owned by large corporates/industrial houses in the banking space, so that it is able to sell out several dud public sector banks at a good price. But then this as explained comes with its own set of risks.

 

To conclude, the conspiracy theory is that all this is being done to favour certain corporates close to the current political dispensation. And once they are given the license, this window will be closed again. Is that the case? On that your guess is as good as mine. Nevertheless, if this is pushed through, someone somewhere will have to bear the cost of this decision.

As I often say, there is no free lunch in economics, just that sometimes the person paying for the lunch doesn’t know about it.

Aa gaya aa gaya halwa waala aa gaya, aa gaya aa gaya halwa waala aa gaya
— Anjaan, Vijay Benedict, Sarika Kapoor, Uttara Kelkar, Bappi Lahiri and B Subhash (better known as Babbar Subhash), in Dance Dance.

Raghuram Rajan’s 10 Solutions to Get Economy Going Again


Summary: This one is for all of you, where are the solutions wallahs. Of course, I have offered many of the solutions that Rajan has offered in a column, but never put them together in one place.

One of the perils of writing on the Indian economy in the last six years has been the repeated comment from a few, don’t tell us about the problems, but give us the solutions. I mean how do you discuss solutions without highlighting problems. How do you come up with a prognosis without coming up with a diagnosis in the first place?

It’s not that one hasn’t highlighted solutions in what one has written over the years, but it’s just that where are the solutions wallahs, don’t seem to notice them. This belief that economics has solutions to everything (particularly among the non-economists, which means most of us), is very strong.

Over the years, I have come to believe that this is primarily because almost all of us are brought up writing exams where every question has an answer and every problem (in the mathematical sense of the term) has a solution. Life and economics don’t work like that. If everything had a solution, the word problem wouldn’t exist in the first place.

Nevertheless, this piece is all about solutions; things that the central government can do right now (and should have been doing by now) to get the economy going again. I have just finished reading Dr Raghuram Rajan’s piece on the Indian GDP (Gross Domestic Product) collapse. GDP is a measure of the economic size of a country.

Dr Rajan, who was the governor of the Reserve Bank of India (RBI), has offered many solutions. These are things that the government can do to get the economy going again. I have offered many of these solutions in my writing as well, though never gotten around to writing about all the solutions together at one place.

Let’s take a look at these solutions, one by one.

1) The government needs to expand its resource envelope in every way possible, Rajan writes. At the cost sounding like a broken record, it needs to sell its stakes in many public sector enterprises (how many times have I said this). In fact, in a sense it has already missed out on the current buoyant state of the stock market. The total amount of money collected through the disinvestment route during this financial year, remains close to zero.

Rajan also suggests that the government should be ready for on tap sale of its stakes in public sector enterprises, to take advantage of every period of market buoyancy.

2) Many public sector enterprises own land, in prime areas of India’s cities. And this land needs to be sold (Again, how many times have I suggested this). In fact, in a city like Ranchi, where I come from, the Heavy Engineering Corporation (a public sector enterprise) sits on acres and acres of government land. All this land across all these companies needs to be sold and money be raised. Of course, this isn’t going to happen overnight.

But that’s not the point here. If the government shows serious intent on this front by announcing a time-table to do this, as well as making preparations for the sale, this is something that the bond market will notice and be happy about.

3) Why is it important to keep the bond market happy? With tax collections collapsing by 30%, between April and July 2020 in comparison to the same period in 2019, it is but natural that the government will end up borrowing more. This is likely to push up the return (or the yield) that the market demands on the government borrowings, given that there is only so much financial savings going around. Other factors that will give confidence to the bond market is the publishing of the correct fiscal deficit numbers unlike the massaged numbers that are currently declared (well, well, well, I have been saying this for a couple of years now). Fiscal deficit is the difference between what a government earns and what it spends.

Another important reform suggested by Rajan is the setting up of an independent fiscal council, which can keep an eye on the deficit numbers (This is something that the former deputy governor of the RBI, Viral Acharya, has also been suggesting).

All in all, the government should seem like making serious moves towards restoring fiscal stability, which is currently lacking.

4) The world will recover faster than India, given that the covid-curve has been flattened across large parts of the world. Given this, economic demand in many of India’s bigger trading partners will recover faster than in India (Again, a point I made in a piece I wrote for the Mint on September 7, 2020). This means that faster exports growth can be a way for India to recover, suggests Rajan. But the trouble is that we are looking at import substitution as a policy more and more and imposing tariffs on imports. This raises the cost of inputs that go into goods that are ultimately exported.

Of course, the intermediary goods that go into the making of goods that are exported, can be produced in India, but this will happen at a higher price. Hence, this makes us uncompetitive at the global level (A point I made in a piece I wrote for the Mint in February). Also, reversing the entire import substitution bogey will mean going against the current atmanirbharta campaign, a very successful perception management campaign. (In economics, just because something sounds good, doesn’t mean it is necessarily good). Economics is not the only thing that any government is bothered about.

5) Rajan suggests that the focus on Mahamta Gandhi National Rural Employment Guarantee Scheme (MGNREGS) as a way of putting money directly into the hands of the poorest, should continue. If this means spending more money under the scheme, then so be it. (Okay, I had suggested this as far back as March in a piece I wrote for the Mint, even before the government had taken this route.)

6) While, MGNREGS takes care of the lack of economic activity in rural areas, the urban areas get left out under the scheme. Hence, the government should be making more efforts to put money into the hands of the urban poor, suggests Rajan.
One of the things that the government has done is to put Rs 1,500 over a period three months into female Jan Dhan accounts. This cost the government around Rs 31,000 crore. I think it is time to put money into male Jan Dhan accounts as well (Again, I have been saying this for months now). This will take care of the urban poor to some extent. I know this isn’t the perfect solution because proper targeting will continue to remain a problem, but it is better than doing nothing.

7) Rajan further suggests that the government and public sector enterprises should clear their dues as fast as possible. This will put more money into the economy and particularly into the hands of corporations and help them survive. (Something I had said in March). A newsreport in The Financial Express today points out that the total amount of money owed by the central government and the public sector enterprises, amounts to Rs 9.5 lakh crore, or a little under a third of the Rs 30.4 lakh crore that the central government plans to spend this year. Of the Rs 9.5 lakh crore, Rs 2.5 lakh crore is owed to the Food Corporation of India (FCI). The remaining Rs 7 lakh crore is a large amount on its own. Even if a portion of this is cleared, the economy will get some sort of a stimulus.

As far as a real stimulus goes, focusing on physical infrastructure is the need of the hour, leading to creation of demand for everything from steel to cement. One area that can really get the Indian economy going again is real estate. I have discussed this so many times before. But for that to happen, so many other things need to happen, including many of the current real estate firms going bust and banks losing a lot of money. Creative destruction needs to be unleashed. Of course, the deep state of Indian real estate is not ready for something like this and will not let it happen.

8) Rajan also suggests that firms below a certain size could be rebated the income tax and the goods and services tax, they paid last year (if not the whole amount, but at least a part of it). This could be an easy and direct way of helping smaller businesses, which have faced the brunt of the pandemic all across the world. (Okay, I haven’t suggested anything like this anywhere, from what I remember).

9) Rajan recommends that public sector banks need to be properly recapitalised as the extent of losses due to covid are recognised. I feel that if the government doesn’t have the money to do so, then it needs to let these banks raise money from the market and in the process, the government should be okay with the idea of diluting its stake. (I have written a book on this )

10) And finally, as the moratorium on repaying loans taken from banks and non-banking finance companies has come to an end, there are bound to be defaults. Here, the government should have a variety of structures in place to deal with the emanating problems, and not have a one size fits all approach. Also, in my opinion, dilution of the entire insolvency and the bankruptcy process, is really not the right way to go forward.

So, to all the where are the solutions wallahs, these were 10 solutions that Dr Raghuram Rajan has offered to the government (Actually, there are more solutions in the piece he has written, but I have stopped at ten. Some of these solutions are about land reforms, labour reforms, genuine ease of doing business reforms, etc., to improve India’s competitiveness, which keep getting made endlessly over and over again). Rajan has also said that the time to do these things is now and not wait for things to get worse.

In my writing over the last few months, I have recommended eight or nine of these solutions as well, though never put all these solutions at one place. One important solution that I think needs to be quickly implemented, is a reduction of the goods and services tax on two-wheelers.

The trouble is that most of these solutions need money to start with. And for that the government needs to come out of its comfort zone and start raising money in ways that it has never done before (like selling land). Also, all reforms need intent and communication clarity to be able to explain these things to the junta at large. Plus, they may not lead to electoral gains immediately, something like a focus on an actor’s suicide may.

You see the government just doesn’t have the incentives to do the right things.

PS: I sincerely hope this should satisfy the appetite of all the where are the solutions wallahs, out there.

Viral Acharya is Right About Re-privatising Public Sector Banks

vacharya

Late last week Viral Acharya, a deputy governor of the Reserve Bank of India (RBI), said: “Perhaps re-privatising some of the nationalised banks is an idea whose time has come … this would reduce the overall money government needs to inject as bank capital.”

Regular readers of the Diary would know that we have said several times in the past that public sector banks should be privatised and the government should get out of the banking business, which it is clearly inept at.

Of course, the question is why has Acharya used the term re-privatising rather than privatising. Indira Gandhi nationalised 14 private banks on July 19, 1969. These banks had deposits of Rs 50 crore or more and among them accounted for 90 per cent of the banking business in the country. The funny thing is that at the time this happened, the then RBI governor LK Jha had no clue about it.

As TCA Srinivasa Raghavan writes in Dialogue of the Deaf—The Government and the RBI: “Volume three of RBI’s official history says that on July 17 she [Indira Gandhi] asked LK Jha, the RBI governor to come over to Delhi. Jha thought he was being asked to discuss social control and he took with him a comprehensive note on the subject. When he offered it to Mrs Gandhi she told him ‘that he could keep the note on her table and go to the next room and help in drafting the legislation on nationalising the banks.’”

In 1980, six other private banks were nationalised. This time the recommendation came from the then RBI governor, IG Patel.

Now getting back to what Acharya said, re-privatising is something we have advocated in the past. And it makes sense at multiple levels. We now have nearly two decades of evidence that suggests that the new generation private sector banks which were first set up in the mid-1990s, are much more efficiently run than their public-sector counterparts. Yes, there have been cases like the Global Trust Bank, but on the whole private banks are better run than their public sector counterparts. Even the old generation private sector banks, which are very small, are reasonably well run.

Take the case of the bad loans situation that currently plagues the Indian banking sector in general and the public sector banks in particular. As on December 31, 2016, the total bad loans of the public sector banks (gross non-performing assets (NPAs)) had stood at around Rs 6.46 lakh crore.

For the private sector banks, the same number stood at Rs 86,124 crore. Of this, two banks, ICICI Bank and Axis Bank, accounted for bad loans of Rs 58,184 crore. Of course, given that public sector banks give out more loans, it is not surprising that their bad loans are more.

The total loans of public sector banks are 2.9 times the total loans of private sector banks. But their bad loans are 7.5 times that of private banks. If both these set of banks were equally well run, then the two ratios just referred to, wouldn’t have been different.

Between 2013-2014 and 2015-2016, the total net profit made by the public sector banks stood at Rs 56,567 crore and that of private banks stood at Rs 1,13,801 crore. This, even though public sector banks are significantly bigger than India’s private banks.

These data points tell us that India’s public sector banks are inefficiently run. And this inefficiency has cost the government a lot of money over the years. Between 2009 and March 2017, the government has had to invest close to Rs 1.5 lakh crore in these banks to keep recapitalising their capital, in order to keep them going.

Indeed, this is a lot of money and could have gone towards other worthy causes. The basic problem with public sector banks is political meddling. Every government has its favourite set of industrialists and this ultimately leads to the public sector banks and in the process the taxpayer, picking up the bill for this politician-businessman nexus.

As Acharya writes in a paper titled Is State Ownership in the Indian Banking Sector Desirable?: “One, state ownership creates severe moral hazard of directing bank lending for politically expedient goals and of bailouts when such lending goes bad. Second, state ownership restricts the ability of state-owned banks from raising arm’s length capital against state’s stake, strangling their growth and keeping these banks—and certainly their private capital base—smaller than it need be.”

What does this mean in simple English? The economist Alan Blinder in his book After the Music Stopped writes that the “central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.” Hence, managers of government owned banks know that if loans given to businessmen close to politicians go bad, the government will ultimately pick up the tab by recapitalising the public sector bank to an adequate extent. Hence, they go easy on giving loans to borrowers who are likely to default. Of course, there is always the threat of transfers, which works very well. This has happened for years at end.

Secondly, given that the government has to continue owning a certain proportion of shareholding in these banks, the banks cannot raise as much capital as they require. They have to continue to be dependent on the government for capital. And the government of course does not have an unlimited amount of cash. This limits the ability of the government owned banks to raise as much capital as they may require at any point of time.

So, what are the actual chances of the government re-privatising some of the public sector banks, as suggested by Acharya? Zero. While Acharya, I and others, might think that the basic problem with public sector banks is government ownership, politicians don’t think so. This comes from the belief that if you own banks then you can direct lending to areas that you want to. But this as we have seen comes with its own set of costs.

The column originally appeared on Equitymaster on May 3, 2017.

Is the RBI Telling Us Something That the Govt Isn’t?


One of the things that we have learnt in the business of economic forecasting is to highlight the forecasts that we get right and tom-tom about it. The new Reserve Bank of India deputy governor Viral Acharya said something two weeks back that we seemed to have missed (you know with the media expanding at the rate it has, it is difficult to keep track of everything).

Nevertheless, here we go. Acharya said on March 6, 2017, a few days after his birthday: “I think everyone should keep in mind that the remonetisation is taking place at a very fast pace. We have some way to go, but I think we expect that within two to three months we will reach full currency in circulation. It will be slightly lower, but it is in that ballpark (number).”

What Acharya was basically saying was that by May 2017, the currency in circulation will come to a level around what prevailed before demonetisation rendered Rs 500 and Rs 1,000 notes useless. This is something we have maintained from the very beginning, even though we have been ridiculed about it more than once, as we have gone along. (You can read the pieces here and here).

In fact, if the Modi government is to be believed there was never any problem because of demonetisation. In fact, the finance minister Arun Jaitley, said in early February: “At no point of time, not for a single day, was the currency inadequate.” Around the same time the economic affairs secretary Shaktikanta Das, who reports to Jaitley, said something along similar lines when he said that the remonetisation process was complete. Remonetisation essentially refers to the process of printing money and pumping it into the financial system.

We live in Mumbai and not in Delhi. And we don’t know Das. But if we did, we would have definitely asked him, if the remonetisation was almost complete in February, why is the RBI deputy governor, who knows a thing or two about such things, saying that remonetisation will be completed only in May 2017.

Now let’s get back to look at what Acharya is saying. Take a look at Figure 1. It shows the currency in circulation every week, through late January 2016 to March 10, 2017, the latest data point that is available.

Figure 1Figure 1

What does Figure 1 show us? It shows us that the currency in circulation fell dramatically in the aftermath of demonetisation. This is not surprising given that more than 86 per cent of the currency in circulation was rendered useless overnight. And it has been rising since early January 2017, as the RBI prints and pumps more new currency into the financial system. The average increase in currency in circulation per week since January 6, 2017, has been Rs 38,645 crore.

At this pace of increase, over a period of 10 weeks, i.e. two and a half months (the average of two to three months that Acharya said), the total currency in circulation by May 19, 2017 (10 weeks after March 10, 2017), will stand at Rs 16.32 lakh crore (Rs 12.46 lakh crore as on March 10, 2017 + Rs 3.86 lakh crore added over the 10 week period). If we go for the full three months, then the total currency in circulation as on June 2, 2017(12 weeks after March 10, 2017) will stand at Rs 17.10 lakh crore.

The currency in circulation before demonetisation was announced stood at Rs 17.98 lakh crore (as on November 4, 2016). If we end up with a currency in circulation of Rs 17.10 lakh crore after remonetisation is complete, the total currency in circulation would have fallen by around 4.9 per cent. If we end up at Rs 16.32 lakh crore, then the currency in circulation would have fallen by around 9.2 per cent.

If the currency in circulation is expected to come down by around 5-9 per cent, then what was the point in disrupting the economy in such a big way, is a question worth asking. Of course, the way things are these days, we won’t get answers. All we will be told is that in the long term, demonetisation will be beneficial.

Further, in this age of relentless media, people have forgotten by now that going digital wasn’t on the original list of aims of demonetisation. It was subtly introduced only once the original aims of tackling black money and fake notes, went out of the window.

What does Acharya’s comment and our analysis accompanying it, tell us? It tells us, something we have been saying recently, that Indians are going back to cash. The brief spurt in digital transactions has been reverted and this shall become more and more obvious as we go along. It also means that the RBI will have to print and remonetise a greater portion of the demonetised currency. If it does not do that then there is the risk of not enough currency going around in the economy and that will have an impact on the total number of economic transactions.

The RBI of course recognises this. It recognises the fact that an adequate amount of currency is needed in the economy. It also recognises that digital transactions despite all the hype around them haven’t really taken off. In this scenario, more and more new currency will have to be introduced into the economy.

Having said that the RBI, under the new dispensation of Urjit Patel, can’t say this in a very direct way. Nevertheless, sometimes we do have to read between the lines to understand the real message behind what is being said.

The column originally appeared in Equitymaster on March 21, 2017.