Demonetisation - disabling the ability to say "I dont know"?

The raging debate around demonetisation has an interesting relief - the inability of the commentariat (bankers, media, economists, astrologers, bhakts - in no particular order or mutually exclusive category) to say, "I dont know". We have had revised GDP forecasts (an investment bank predicted a 3% hit, based on a bizarre conflation of high powered money and broad money. Ex-PM Manmohan Singh predicted a 2% hit, basis, well nothing that he cared to elaborate). We have also had pop sociology in full flow, with assorted bhakts claiming this is a "revolution" of society and economy together - recently departed Castro would approve!

Issue though is, economically, demonetisation in this scale (and economic stage) is so unprecedented that its difficult to see how any of these numbers are even ca lculated, forget being credible. As Niranjan Rajadhyaksha described in his column, demonetisation is a natural experiment, albeit one on a very large scale and hence inherently risky. What are the issues in this case in deriving assumptions on economic outcomes? Lets see it at a basic level.

The essential monetarist view of GDP is explained by the following equation:

M X V = P X Q, where
M: Money supply in the economy (the total amount of currency notes and bank deposits circulating in the economy)
V: Velocity of Money (number of times a rupee of cash/deposit circulates in the economy per year)
P: Price levels in the economy
Q: Volume of Output in the economy

From a monetarist perspective, how inflation (P) and GDP (output, Q) behave is a function of the changes in M and V.

Now lets see what happens as a result of demonetisation to each of these variables.

Money supply (M) gets an upfront negative shock, as the RBI on 8th Nov withdrew ~14 lac crores of banknotes, accounting for ~12% of total M in the economy. This, taken on its own is a significant monetary contraction, and should result in interest rates shooting up (interest rate is the price of M, if supply of M goes down, price should go up). However, on the other hand, withdrawal of banknotes has been accompanied by a huge accretion of deposits as people have been asked to swap their banknotes for deposits in the bank. Now, a rupee in deposits adds a lot more to M than a rupee in banknotes (due to a concept called money multiplier). As a result, interest rates should decline (as M goes up with banknotes being replaced by deposits). Net net, we have two counteracting forces - one that is pulling M down, while the other is pushing M up. As of now, interest rates have actually come off drastically (and somewhat counter-intuitively), but how things will stabilise in the medium term - there isnt sufficient data yet to conclude.

Velocity of money (V) gets an upfront negative shock too, with cash being such an important medium of commercial transaction in the economy. Additionally, with new banknotes primarily coming in the form of the new 2000 rupee notes (that are difficult to "break"), V declines further, as the new notes are circulated less number of times than the same value of old notes could be. A reduction in V causes a decline in GDP (given all other things constant). However, a move, both forced and behavioral towards more cash-less modes of transaction (UPI/wallets/cards etc) tend to increase V, as electronic cash has greater V than physical cash. Increase in V accelerates GDP. There again, we have two counteracting trends emerging. Net net, how will this play out? We dont know (yet), too early to conclude in absence of data.

The most ubiquitous principle used by economists is that of ceteris paribus, or, all other things remaining constant. The ability to predict outcomes is dependent on the ability to fix the level of input variables. In the best of situations its an impossible condition to meet (a prime reason why astrology is often said to have better predictive powers than economics). In a massive real-time natural experiment of the sort we have in demonetisation, it is really besides the point to even consider.

In effect, the biggest point is, whether on interest rates, or inflation, or GDP growth - the impact is undetermined and as yet, undeterminable. The best answer that most folks could credibly have is "I dont know". But saying "I dont know" requires a level of humility missing entirely from our 24/7 commentariat.

To be or not to be - RBI should directly recapitalise banks

The biggest kerfuffle going around on the demonetisation debate is on the use of currency that is expected to be "extinguished", ie, those old 500/1000 rupee notes that are never tendered back to the banking system. There is a general consensus that around 3-3.5 lac crores is the number.

The big question is whether this is money that is income for RBI that can be repatriated to the government as a special dividend, resulting in a fiscal bounty. Opinion is sharply divided on this. While there is a strong (financial market participant) view that it can be done, there are others like ex-governors D.Subbarao and C Rangarajan as well as perceptive columnists like Bloomberg's Andy Mukherjee (who wrote a strong column on the issue, though basis a seeming non-sequitur) who think otherwise.

In terms of  global precedent, the situation is equally murky. Previous instances in Germany and Israel (partly covered in this KPMG report) involved scales much smaller than what is being talked about here (3 lac crores would be just short of ~10% of RBI's balance sheet).

There's also the point on prudential accounting - typically large gains on balance sheet net worth arising out of revaluation isnt taken as "Income" in P&L (while losses usually are). And this effectively, is a gain arising out of revaluation of RBI's liabilities.

Is there a solution? Can the "money" be put to use? There is perhaps an answer, though it would raise a few hackles with purists. First, lets examine the RBI Balance Sheet (RBI annual report 2015-16)

As can be seen, the 2 biggest items on the Liability side are 1) notes issued and 2) Revaluation account. On the Asset side, the two biggest items are Foreign Currency Assets (FCA) and Domestic Investments (primarily G-secs held by RBI to facilitate Open Market Operations).

The Reval Accounts, comprising of a number of different accounts (Currency and Gold Reval Account-CGRA, Investment Reval Account-IRA etc) essentially capture Mark-to-Market (MTM) movements in the various Assets (and Liabilities) positions of RBI. Effectively, this reserve acts as the valuations buffer for RBI while carrying out market interventions (both foreign currency and domestic money market).

So, what happens if the total currency extinguished is (say) 3 lac crores? One, Notes issued goes down by the same amount. Two, the Reval a/c (RBI could create a special, different a/c to teat this) gets bumped up by the same amount. Note that the Reval a/c would now be ~30% of the size of RBI's balance sheet.

Now, given that a dividend cheque to the government is ruled out, what next? A simple exercise would be the  following:

1. Out of the ~7 lac crores of G-Sec holdings, RBI takes out (say) 2.5 lac crores and swaps it with a bunch of PSU banks for a special equity issuance.

2. Technically, it effectively means RBI sells 2.5 lac crores of G-Secs in the market to raise cash and uses it to buy equity in PSU Banks.

3. Normally, this could mean a fair amount of market impact. However, done as a straight swap with banks, and accounting for the very high level of liquidity available to banks (estimated to be 6-7 lac crores incremental deposits as a result of demonetisation), market disruption would be minimal.

4. From a balance sheet perspective, RBI will now have 2.5 lac crore of equity on the Asset side, against a 3 lac crore increase in Reval a/c on the Liability side, effectively providing a MTM cushion of 50k crores for the equity exposure. 

This, effectively would obviate the need for RBI to pay a dividend to the government, while achieving the aim of recapitalising banks. 2.5 lac crores of additional equity, plus incremental revenues out of system liquidity going up will likely cover 50-60% of incremental capital required by banks today for Basel III.

Issues? Biggest one is of moral hazard of the regulator owning equity in banks. While this is valid, the fact is RBI held the sovereign stake in State Bank of India till very recently. The government can in unison also start work on a series of legislative actions to facilitate a transfer of this equity from RBI to government in a reasonable amount of time. 

Is this the best solution? Given the circumstances, and given the enormous disruption to the economy due to demonetisation, it would be a shame if this opportunity was not taken to clean up banks and make the financial system ready for a fresh trajectory of growth.

Demonetisation Bikini - forget black money (its superficial), real impact is a banking bailout (vital)!

Its been called India's 9/11, surgical srtike on black money. But in reality, demonetisation is India's version of TARP, the post financial crisis (2008) US bank bailout programme. Black money is really a superficial sideshow. How?

Black money - the superficial

Look at the numbers. At a macro level, total currency in circulation (C) in India, per RBI is ~17 lac crores. 500/1000 rupee notes constitute ~85% of this stock, or ~14.5 lac crores (USD 220 billion). Estimates of black money, whether Baba Ramdev (70 lac crores, or USD1.2 trillion), or World Bank (which estimates it to be ~20% of GDP annually, or USD400 billion annually), are a very large multiple of any putative number derived from the stock of currency in circulation. Ergo, the black money discussion is really rhetoric, and only for public consumption.

Bank bailout - its vital, its big

Again, look at the numbers. 14.5 lac crores of demonetised notes can be classified into 3 categories.

1. X: Genuine, tax-paid currency in circulation required to grease the wheels of the economy. How much should this be? Currency in circulation constitutes ~13% of total money supply (M3). Comparable economies (China, Malaysia, Indonesia) have a ratio close to half of this. Ergo, lets say that half, ie, ~7 lac crores would be reconverted into new notes in the system.
2. Y: Tax-avoided money, but used in legitimate businesses. Typically, there is seamless flow of this liquidity to and from the "white" economy.
3. Z: Tax-avoided money, either from illegitimate sources (laundering, corruption, terror etc) or as stores of tax-avoided wealth.

Lets assume, for want of any better data right now, that Y and Z will be equally split, ie, ~3.5 lac crores each. Now, what happens to the money?

X would be tendered back to the banking system, either to exchange back into new notes, or bringing that part of the business in the "cash less" domain. Y too would largely come back into the banking system, either by making it legal (paying penalty/tax) or through various jugaad means.

Z, on the other hand, will be partly converted into alternate stores of value (Gold, Real Estate), but a large chunk will simply be burnt up in the air. Lets assume at least 60% of this, ~2 lac crores, blows up in thin air.

Impact on bank capital/finances

Given the restrictions on withdrawals expected to be in place for some time, bulk of X+Y (10.5 lac crores), say 75%, will lie as bank deposits for at least 6-7 months. At a modest NIM of 4%, that translates to ~16,000 crores of extra profits for the banking system. In the longer run, even if a modest 30% of these deposits (or 3 lac crores) remain in the banking system for good, it generates incremental 12,000 crores of profits for the system. As a comparison, the total budget for recapitalisation of banks this fiscal is 25,000 crores.

Next, Z. The money that is "burnt away"(2 lac crores as estimated above), or doesnt get tendered back into the banking system, extinguishes a concomitant liability in RBI's balance sheet. Extinguishing of the liability without any change in assets means RBI's reserves go up by the same amount. Whether this money can be paid as dividend to the government is up for debate, but there is no doubt that RBI will have a higher reserve that could be deployed. An obvious use could be to recapitalise banks, as CEA Arvind Subramaniam suggested in the last economic survey. Whether as a fiscal boost or as a straight capital injection into banks, the impact is large and meaningful.

Last, bond yields. Demonetisation imparts a deflationary shock to the economy. With 13% of M3 effectively withdrawn for a period, demand for a variety of goods and services will go down, thus reducing prices. Additionally, enhanced liquidity with banks and a fiscal boost for government both impact yields positively (downwards). Biggest beneficiaries of downward trending bond yields are banks, that can make large treasury gains out of their holdings of SLR securities (government bonds, which is ~25% of the total balance sheet of banks). Again, its a positive blow for bank finances.

Net net, whichever way you carve the data or assumptions, this isnt about black money. This is all about a banking system bailout, intended or otherwise. Bankers working hard over the weekend would do well to remember!