Dashed expectations

The government’s move to demonetise high-value currency notes is imposing significant costs on the economy. No matter, its advocates say. There will be benefits, some immediate and some that will show up over the long run.

The costs are becoming apparent. Millions standing in queues to get cash, individuals unable to buy essentials, the disruption of small business, trade, transport and agriculture. Many analysts think GDP growth will drop below 7 per cent in 2016-17. Some think it will be significantly lower.

The important question is whether the move will deliver benefits that outweigh the short-term costs. Let us focus for now on one immediate benefit we were asked to expect: a decline in lending rates in the economy.

Banks have been flooded with deposits. Most of it will be withdrawn for use. But even if 10 per cent of the deposits were to stay, it was argued, it would suffice for banks to cut lending rates. Lower rates would boost spending and help offset the huge shock to aggregate demand caused by the withdrawal of 86 per cent of currency from the system at one stroke.

Dealing with plenty

With its decision on November 26 on incremental cash reserve ratio (CRR) for banks, the Reserve Bank of India (RBI) has poured cold water on such hopes, at least for now. Banks will have to park with the RBI, at zero return, all the deposits they got in the period September 16 to November 11. The period mostly pre-dates demonetisation, which was announced on November 8., 2016

The RBI wants to ensure that deposits that have flowed into the system thereafter do not lead to “excess liquidity”, that is, more funds than banks know what to do with. As a result of the RBI move, the banking system will be left with lesser deposits than thought earlier. This diminishes the prospects of a cut in lending rate, and it certainly limits the extent to which lending rates can be cut in the near future.

The reason given for the move is that the RBI does not have enough stock of securities to absorb the excess liquidity. The RBI says that issuing additional Market Stabilisation Scheme bonds in order to absorb liquidity can’t be done in a hurry.

But we need to ask why banks want to park so much of the deposits coming to them in government securities in the first place. Why would they not want to use the extra deposits to give out more loans? According to reports in the media, as much as Rs.4 lakh crore out of the Rs.6 lakh crore that has come to banks after demonetisation has been invested in government securities.

Capital position and lending

The answer, quite simply, is that public sector banks (PSB), which account for nearly 70 per cent of banking assets, are unable or unwilling to sharply increase loan growth. They are unable to give out more loans because many are constrained by lack of capital. Some PSBs are operating close to the minimum capital requirement of 9 per cent. The average capital at PSBs has fallen well below the level of 13 per cent they had only a few years ago. Regulations limit loans to a certain multiple of the capital that banks hold. The lower the capital that banks hold, the lesser their ability to make loans.

Even PSBs whose capital position is relatively comfortable are unwilling to sharply increase loan growth. All PSBs are wrestling with high levels of non-performing assets (NPA). They lack the appetite for making fresh corporate loans, certainly big-ticket project finance. In such a situation, it is unrealistic to expect that a surge in deposits would translate into higher credit growth. We need to fix the problems of capital and NPAs at PSBs first — and little has happened on those fronts.

Most of the incremental deposits in recent months has gone into government securities (G-Sec). This has caused yields on G- Secs to plummet. Before the RBI move, the yield on 10-year G-secs fell to below 6.25 per cent, a drop of over 1.2 percentage points from a year ago and 2 percentage points from two years ago. Given that rates on loans tend to be at a certain premium over risk-free G-Secs, you would think that a decline in G-Sec yields was welcome.

It is, but only up to a point. In an economy that is open to capital flows, we have to take into account the effect of a decline in interest rates not just on domestic investors in the real economy but also on foreign investors in Indian debt securities. Any decline in interest rates has to be carefully managed, taking into account the differing preferences of the two constituents. If the difference between the rate on Indian securities and that on dollar securities becomes too narrow, foreign investors will want to exit. There could be large, destabilising capital outflows. This must be the RBI’s big worry now.

Selling Indian debt

Trends in Foreign Portfolio Investment (FPI) in debt in the current year are already a cause for concern. In 2015-16, there was a net outflow of Rs.4,004 crore from FPI investment in Indian debt. In 2016-17, up to November 29, the outflow has increased to Rs.12,842 crore.

FIIs have been selling Indian debt furiously after demonetisation. They turned net sellers on November 15, a week after demonetisation was announced. They have continued selling since. Total outflows from the debt market between November 15 and November 28 amounted to a staggering Rs.19,089 crore. These huge outflows have offset the net inflows of some of the previous months. A narrowing of interest rate differentials between India and the U.S. would lead to even heavier selling.

The RBI’s worry must be especially acute following Donald Trump’s victory in the U.S. presidential polls. Mr. Trump’s ambitious spending plans and tax cuts spell a higher U.S. fiscal deficit and higher interest rates. In anticipation of this, there have already been large inflows into the dollar.

The expectation is that the U.S. Federal Reserve will announce an increase in its policy rate at its next meeting on December 14. With this in mind, the RBI should be treading warily on any cut in the policy rate at its monetary policy announcement on December 7. Consequent to the CRR announcement, some analysts have revised their forecast for an RBI rate cut downwards from 0.5 per cent to 0.25 per cent. Others are betting that there will not be a rate cut at all.

This, of course, does not take away from the fact that demonetisation can result in lower interest rates over the long run. Greater financial inclusion and digitisation of payments will cause deposits to swell and help lower lending rates once the problems in the banking sector are fixed.

Tackling black money

Demonetisation can potentially confer other benefits as well. There could be changes in behaviour, not just of individuals but of businesses, which leads to better tax compliance and a higher tax to GDP ratio. Cash and black money are not synonymous but, yes, a lower use of cash can indeed help reduce black money in the economy. A serious assault on black money, however, would require measures aimed at real estate, gold, holdings abroad, donations to political parties and significant improvements in the tax, law enforcement and judicial systems.

The short-term costs of demonetisation are steep and plain enough. Whether it turns out to be a transformative measure that delivered substantial long-term benefits and whether those benefits were worth the short-term pain is too early to judge.