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Remonetisation

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On 8th November 2016, at around 8pm, the Prime Minister of India, in a shock announcement, declared that 86% of currency notes in circulation—notes denominated ₹500 and ₹1,000—are no longer legal tender from midnight. Instead new notes with denominations ₹500 and ₹2,000 will be issued. The press is calling this “demonetisation”, although “remonetisation” seems to be a better word.

rbi-2000-rupee-note

Picture source: RBI on Twitter. Click picture for higher resolution

These notes are worth about $7.37 and $14.75 (at today’s exchange rate USDINR = 67.811). Although this is not much for people resident in the advanced world, it is quite a lot for Indians, especially the poor.

Holders of these currency notes are given time till 30th December to either

  1. exchange these currency notes with banks who will provide the holders with old currency notes denominated ₹100, ₹50, ₹50 or ₹10, or
  2. deposit them in their bank accounts.

The reasons provided were that there is a lot of counterfeiting happening from across the border and there is a lot of “black money” with Indians. Now there is a lot of political rhetoric around “black money” but Indians have this imagery that everyone doing immoral or illegal things with their finances has hidden a lot of currency notes in the water tanks of their homes. Before the Prime Minister’s Bhartiya Janata Party, won the elections, he promised to bring in “black money” worth $40 trillion (no typo!) from abroad and promised that every poor Indian will easily get around $30,000. But having failed in this, he feels pressured to do something about it.

Now, as Pronab Sen points out in Mint, that is hardly the case. The one doing shady things with their financial statements may hold wealth in various forms such as real estate, gold, foreign exchange, foreign accounts, via Panama etc. Moreover, people have been standing in queues in banks and ATMs for the whole day, just to exchange their notes. This is because the Indian government and the central bank didn’t make the new notes immediately available. Since there is a liquidity shortage, and that since a lot of people live in daily wages, there have been delays in payments of wages. People have postponed their expenditures to subsistence levels because it’s not clear how long the shortage will last.

How does the Indian government hope to gain from this operation? Currently, currency notes equivalent of around $222 bn of old notes are no longer legal tender. India’s annual GDP was $1.51 tn in 2015 for comparison with the US (where the currency in circulation is $1.48 tn and annual GDP was $18.44 tn, annualized in Q2 2016 and India’s population is 1.25 bn while US population is 319 mn). When notes are returned and new currency is issued, the Reserve Bank’s liabilities changes because some people won’t return their currency notes in the fear that their finances will be investigated. How much it is is anybody’s guess. But let’s say currency notes equivalent of $210 bn is returned. The RBI will see this as income from this operation and will pay an additional dividend of $12 bn to the government. The government can raise its expenditure because of higher tax revenues.

But since all this was poorly implemented and 11 people have died so for this political propaganda of the government. It’s not like in the Western world here in India. There is a parallel “informal economy” in India and a large population is extremely poor. It is difficult to calculate the loss of output.

I want to distract here to Monetarism and the relevance of this to monetary theory especially the causality from money to prices and output. It’s usually argued by Post-Keynesians that the causality is from price and output to money but as central bank asset purchases (“QE”) have highlighted, there is causality in the reverse direction also via rise in prices of financial assets causing a wealth effect.

Right now in India, there’s a drop of liquidity and from the story above, I hoped to convince you that there is a causality from money to output. People’s wealth hasn’t dropped but liquidity has. So Monetarism can have some truth to it, in selected cases. In standard Post-Keynesian theory, it is assumed that all demand for “money” is accomodated. But right now, this isn’t the case, leading to the reverse-reverse causality.

rbi-500-rupee-note

Picture source: RBI on Twitter. Click picture for higher resolution

Manmohan Violet Singh

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In a short recent speech, the Indian Prime Minister – the great man who steered the direction of the Indian economy in the early 1990s – says:

The purpose of the study of economics is not to provide settled answers to unsettled and difficult questions, but sometimes to warn economists and the world-at-large, how not to be misled by clever governments.

which is similar to what Joan Robinson once:

The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.

– in “Marx, Marshall And Keynes”, Occasional Paper No. 9, The Delhi School of Economics, University Of Delhi, Delhi, 1955.

I’d say Manmohan Singh doesn’t go as far as Robinson in putting the blame on economists themselves but I guess there is some amount of influence. But what Singh says is true – governments of advanced nations mislead the less advanced ones.

Also in the short speech:

I would like to say, that when we study economics, our impulse is not the philosopher’s impulse – knowledge for the sake of knowledge – but for healing that that knowledge may help to bring. These are the words of past thinkers: Wonder is the beginning of philosophy; but it is not wonder, but social enthusiasm, which revolts against the silence of fixed life, and the orderliness of the mainstream, which is the beginning of economic science.

Which is not not surprising since Manmohan Singh is influenced by Joan Robinson and Nicholas Kaldor. Here is a nice interview by the BBC’s Mark Tully from 2005 Architect Of The New India published in the October 2005 issue of the Cambridge University Alumnus Magazine. 

Here is an excerpt from the interview:

The thinking behind his solutions to India’s financial problems was first shaped at Cambridge by the theories of John Maynard Keynes. The great man had died almost 10 years before Manmohan Singh arrived but his legacy was still very much alive. ‘At university I first became conscious of the creative role of politics in shaping human affairs, and I owe that mostly to my teachers, Joan Robinson and Nicholas Kaldor. Joan Robinson was a brilliant teacher but she also sought to awaken the inner conscience of her students in a manner that very few others were able to achieve. She questioned me a great deal, and made me think the unthinkable. She propounded the leftwing interpretation of Keynes, maintaining that the state has to play more of a role if you really want to combine development and social equity.’

‘Kaldor influenced me even more; I found him pragmatic, scintillating, stimulating. Joan Robinson was a great admirer of what was going on in China, but Kaldor used the Keynesian analysis to demonstrate that capitalism could be made to work. So I was exposed to two alternative schools of thought. I was very close to both teachers, so the clash of thinking sometimes got me into difficulties. But that made me think independently.’

In Other News

The Reserve Bank of India announced some measures recently to curb the instability of the Indian Rupee:

The first announcement – effectively raising short term interest rates and which caught everyone by surprise – was on 15 July 2013:

The market perception of likely tapering of US Quantitative Easing has triggered outflows of portfolio investment, particularly from the debt segment. Consequently, the Rupee has depreciated markedly in the last six weeks. Countries with large current account deficits, such as India, have been particularly affected despite their relatively promising economic fundamentals. The exchange rate pressure also evidences that the demand for foreign currency has increased vis-a-vis that of the Rupee in part because of the improving domestic liquidity situation.

Against this backdrop, and the need to restore stability to the foreign exchange market, the following measures are announced:

…

On 23 July it further tightened monetary policy:

Over the last two months, the Reserve Bank of India (RBI) has undertaken several measures to contain the volatility in the foreign exchange market. Among them, some measures intended to check excessive speculation adding to undue volatility in market conditions were instituted vide the RBI’s Press Release No.2013-2014/100 dated July 15, 2013. These measures have had a restraining effect on volatility with a concomitant stabilising effect on the exchange rate. Based on a review of the measures, and an assessment of the liquidity and overall market conditions going forward, it has been decided to modify the liquidity tightening measures as follows:

…

The (Almost) Irrelevance Of Reserve Requirements

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Earlier this week, the Reserve Bank of India reduced banks’ reserve requirements by 50bps. It’s called Cash Reserve Ratio and the RBI reduced it from 6.00% to 5.50% with effect from the following week.

The Reserve Bank of India is one of the most backward central bank in liquidity management and sometimes panics and changes the reserve requirements. Typically this happens when taxes flow into the government of India’s account at the RBI and since this is not smooth, the RBI simply doesn’t know what to do.

To me this confusion was good, because three years back when someone asked me to read about this in office, I came across this Reuters article and after reading it (and slightly before when I became interested in macroeconomics after the Federal Reserve announced a Large Scale Asset Purchase Program, popularly known as “QE”) I started having suspicions on the way economists seem to describe banking and economics. This ultimately led me to some Neochartalists’ blogs and finally to Post-Keynesian Economics.

In many countries central banks have a zero-reserve requirement, such as in the UK, Canada, Sweden, Australia and New Zealand. In the United States, the Federal Reserve imposes a requirement of 10% with additional complications.

Basil Moore in his 1988 book Horizontalists and Verticalists goes into the details of central banking operating procedures and provides a fantastic account of central banking. See pages 63-65 and 95-97 for reserve requirements.

From page 63-65:

… Fed non-interest earning reserve requirements put member banks at a disadvantage relative to non-members, who were generally allowed to hold interest-earning assets as reserves and who in addition typically had lower reserve requirements. Because membership in the Federal Reserve system is voluntary under the dual banking system tradition, as interest rates rose an increasing number of banks withdrew from the system. In desperation the Federal Reserve finally proposed to pay interest on required reserve balances. Congressional reaction to this potential erosion of seigniorage from reserve earnings was loud and swift and led rapidly to the Monetary Control Act of 1980. Its solution, to make reserve requirements universal and uniform for all depository institutions, whether members of the Federal Reserve or not, was, as revealed in the 1979 hearings before the Senate Banking Committee, a compromise clearly designed to safeguard the volume of Fed-Treasury transfers and at the same time reduce membership attrition for the Fed.

Contrary to conventional wisdom, changes in reserve requirements imposed by the central bank do not directly affect the volume of bank intermediation. A change of required reserve ratios influences the volume of bank intermediation only indirectly, by affecting the required reserve markup or spread. A rise (reduction) in reserve requirements raises (lowers) the cost of obtaining funds to place in loans financed via  additional reservable deposits, in the manner of an indirect tax. The banks will therefore raise (lower) the markup of their lending rates over their borrowing rates. As a result, depending on the interest elasticity of demand for bank credit, the volume of bank intermediation will be indirectly reduced (increased).

From pages 95-97:

… In practice the Federal Reserve fully compensates for any excess reserves created by a lowering of reserve requirements by open-market sales so as to maintain free reserves at some target level. This evidence is clearly consistent with the notion that nominal money stock is demand-determined …

There are other effects. The ECB governing council decided in December to reduce reserve requirements to 1% from 2%  January 18. This “freed up” a lot of collateral banks in the Euro Area needed to pledge to the Eurosystem, thereby providing some relief to the banking system in crisis.

Chart Source: ECB

On 18 January, reserve requirement was €103.33bn as compared to €207.03bn on the previous day.