If the Eurozone crisis was a Greek tragedy, demonetisation risks becoming an India farce

Nervous wait
Nervous wait
Image: Reuters/Rupak De Chowdhuri
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During the Greek economic crisis of the late 2000s, some of the most striking images witnessed were those of long lines outside banks and before automated teller machines (ATMs) as customers rushed to pull out cash from the country’s weak banking system. There’s been a virtual replay of the same scenes in India following the Narendra Modi government’s decision to replace currency notes of higher denominations.

Though the outcomes are similar, the forces leading up to the situation are different. In Greece, it was a result of a severe crisis, while in India, a deliberate economic policy has caused it. And this is one of the biggest worries that the recent demonetization move has led to; it calls for the economy to be put through the exact same stresses it would face under a severe crisis.

Furthermore, there is no guarantee that the system would take such a shock to consumer demand in its stride. The risks posed to the macroeconomy are high indeed.

Economic crises and bank runs

The amount of currency in an economy is always far lesser than the sum total of the value of goods and services produced every year. India’s cash-to-GDP ratio is only 12%—so, Rs12 is used to circulate goods and services worth Rs100 through the economy—but is much higher than that of most other countries. Banks hold a fraction of deposits in cash, under the assumption that not every account holder will turn up at the same time for withdrawals.

During a severe economic crisis, if ever the deposit holders begin doubting the bank’s health, they would rush to withdraw their savings before the bank collapses. The trouble would arise if everyone decides to do it at the same time, for the bank does not hold enough cash to pay up every account holder.

Thus, long lines get formed while withdrawal limits are imposed when there is a paucity of money supply relative to demand. This is known as a “bank run” and can result in the rationing of money demand. So, for instance, people who wish to exchange their holdings of cash will not get as much money as they desire; they demand Rs1,000 but are forced to accept only Rs 50 in currency.

This results in severe problems. Consumer demand and economic activity get curtailed for want of a medium of transaction. Small business owners are not able to pay wages in cash and banks have to divert their attention from other pressing matters. Local government bodies that collect payments in cash face difficulty in raising revenue.

While a traditional bank run implies that people doubt the value of their bank assets and move to currency, demonetisation results in the opposite move: Wealth-holders realize that their stocks of cash are worthless and make the shift to new currency—intermediated through banks—and bank deposits. Because no bank carries that much currency with it, withdrawal restrictions are imposed, even when the government ensures that it will make good on providing as much currency as needed.

This is not to accuse the government of deliberately creating a crisis.

In a normal bank run, only weak banks and those who hold accounts in these banks are affected. Because the stock of high-denomination notes in India is widespread, comprising nearly 86% (in value) of currency, the Modi government’s move has meant that every single bank and every single holder of high denomination notes, which is pretty much the majority, will be affected.

Demonetisation implies that even the unbanked are forced into a rationing of their money demand. The entire banking system, and not just a few banks, face heightened demand for cash. So, efficient implementation is absolutely vital, for any delay in ensuring availability of cash will imply a significant negative shock to an already stressed system.

Irrespective of this, however, the rationing of money demand due to demonetization will result in the same negative consequences to the consumer economy as a normal bank run.

Implications of a shift to deposits

Anyone wishing to exchange old notes can only withdraw Rs4,000 over the counter, with the rest being deposited in their account. This is in contrast to a bank run, where the profitability of the bank is threatened. Regardless of whether they withdraw the entire amount later, this move represents a forced shift from currency to bank deposits.

To the extent that a reduction in cash hoards affects consumer demand, this could reduce inflation. Some would laud this as a positive step, but monetary policy objectives cannot be achieved through forceful means. The independence of the central bank is supposed to imply controlling inflation through the use of appropriate monetary measures to incentivise wealth-holders, rather than frustrating their money demand.

Some also argue that an increase in bank deposits would mean higher profits for banks because deposits represent a cheaper source of raising funds as compared to other measures. The economy could be aided through greater investment as deposits in the financial system increase and interest rates correspondingly reduce.

These arguments are untenable. Firstly, coercing a shift from consumption to investment is problematic, the burden of which will largely fall upon the unbanked poor.

Secondly, it assumes that investment will always rise as rates decrease and deposits increase. The experience of the US economy should militate against adopting such a simplistic view. If demand determines whether companies will invest, and if consumer demand falls further as a result of a shortfall in the means of transaction, investments might be further hit. With industrial and export growth already sluggish, the government is taking a huge risk in constraining consumer demand.

Demonetisation has put the banking and consumer economy under severe stress. One fervently hopes that the benefits prove worth the risks.

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