The economics of currency reform

The challenge now is to minimize the pain of currency swap—to the economy as a whole but especially to the informal sector

The serpentine queues outside banks across the country have quite naturally grabbed public attention in the past few days. The massive task of exchanging old currency notes for new is taking more time than expected. Many economists have begun to worry about the impact of a persistent cash crunch on the Indian economy.

The value of currency notes that have been pulled out is worth around a tenth of the Indian gross domestic product (though some eager commentators have mistakenly assumed that a tenth of the Indian economy has been immobilized). What does this mean for the economy?

There are two sets of concerns. The first is that the lack of adequate cash will hurt transactions across the economy, and especially in the informal sector, which is profoundly dependent on cash. Think of the traditional taxi driver rather than the Uber driver. Second, the decline in real-estate values could create a negative wealth effect that will eventually hurt consumer demand. Or, families that see the value of their homes come down could respond by trying to save more.

Let us take a closer look at Indian monetary statistics, both base money as well as broad money. The stock of base money in the books of the Reserve Bank of India (RBI) on 4 November was Rs22.5 trillion. There are three components of base money—currency in circulation, bankers’ deposits with the central bank and other deposits. Currency accounts for an overwhelming 80% of the total stock of base money in the Indian economy.

The withdrawal of cash is undoubtedly a severe monetary shock to the economy. It could have an impact on aggregate demand. Much now depends on how much new cash is pumped in to lubricate the economic machine, or the minimum amount needed as a medium of exchange rather than a store of value. We hope policymakers have a forecasting model to guide them. The release of Rs500 rather than Rs2,000 notes is especially important in this regard.

However, it is also important to understand that what matters is not base money alone but also the credit flowing through the economy. The stock of broad money is about five times larger than base money. Currency accounts for only 13.7% of broad money in India, which is dominated by bank deposits. The proportion of currency in broad money is likely to fall as idle cash stashed in homes flows into bank coffers as part of the ongoing currency exchange. One possibility: Money supply could increase in case banks lend out their deposit bonanza at perhaps lower interest rates. The monetary impact is thus more complicated than many believe.

Now comes the wealth effect. The expected decline in the value of real estate could hurt consumer demand in a country where people prefer physical assets over financial assets as their main mode of saving. It will be very difficult to compute the extent of this negative wealth effect. The decline in home prices will not have much effect on the consumer price index, where rental values are an important component.

The main impact will be on economic growth. A decline in building activity could have a multiplier effect in industries such as cement, steel and white goods.

Most economists believe that economic growth could come down by around 0.5 percentage point over the next two quarters—not trivial but far from a deflationary economic collapse. It is now up to the policy authorities to respond.

There are three decisions that can be taken. First, it is important that new cash must be released rapidly over the next fortnight, and shorter queues for currency exchange will be a good way to judge how well the government is doing on this front.

Second, moral suasion should be used to convince banks to step up lending at lower interest rates so that the surge in deposits leads to more credit creation.

Third, the government may need to step up the roads programme so that the impact of the anticipated decline in construction activity is reduced.

The textbook response to any demand shock is a stimulus—either monetary or fiscal. The RBI should not fiddle with interest rates right now but focus on liquidity management in the economy. It would be better if the government used the fiscal lever by front-loading spending for the year, especially in road-building because of the large multiplier effect.

The Narendra Modi government has given an exogenous shock to the economic system through its bold decision to replace old currency notes with new. The challenge now is to minimize the pain—to the economy as a whole but especially to the informal sector. And remember that the new agricultural season is just around the corner.

What impact do you think the currency swap is having on the Indian economy?