Six Months After Demonetisation Cash is King Again and Questions Still Remain


On November 8, 2016, the prime minister Narendra Modi announced his government’s decision to demonetise Rs 500 and Rs 1,000 notes, to an unsuspecting nation. The decision came into effect from the midnight between November 8 and November 9, 2016, and suddenly rendered 86.4 per cent of the nation’s currency in circulation, useless.

It’s been six months since then and more than four months since December 30, 2016, the last date for depositing the demonetised Rs 500 an Rs 1,000 notes, into bank accounts. But even after this period as far as the government is concerned, a few basic points remain.

a) How much demonetised money finally made it into bank accounts? When demonetisation was first announced, this number was shared regularly. Nevertheless, the last announcement on this front from the Reserve Bank of India(RBI) came on December 13, 2016. As of December 10, 2016, Rs 12.44 lakh crore of demonetised currency had made it back into the banks.
Given that Rs 15.44 lakh crore worth of currency notes had been demonetised, nearly 80.6 per cent of the currency had found its way back into banks, nearly three weeks before the last date to deposit demonetised notes into bank accounts.
Neither the Reserve Bank nor the government has told the nation how much money eventually made it back into the banks. This is an important question and needs to be answered.

b) The initial idea behind demonetisation was to curb fake currency notes and eliminate black money.
As far as fake currency goes the minister of state for finance Arjun Ram Meghwal told the Lok Sabha in early February 2017 that the total number of fake notes deducted in the currency deposited into banks after demonetisation stood at 2.46 lakhs. This amounted to a total value of Rs 19.5 crore.
As mentioned earlier, the total value of demonetised notes had stood at Rs 15.44 lakh crore. Given this, the proportion of fake notes deducted is almost zero and can be ignored. Hence, as far as detecting and eliminating fake notes was concerned, demonetisation was a total flop.
How did it do as far as eliminating black money is concerned? The hope was that the black money held in the form of cash will not make it back into the banks, as people wouldn’t want to get caught by declaring it. But by December 10, 2016, more than four-fifth of the demonetised notes had already made it back into the banks. Since then the government and the RBI have not given out any fresh numbers. It’s surprising that it has been more than four months since December 30, 2016, and this number is still not out in the public domain.
Also, it is important to point out here: “High denomination notes are known to facilitate generation of black money. In this connection, it may be noted that while the total number of bank notes in circulation rose by 40% between 2011 and 2016, the increase in number of notes of Rs.500/- denomination was 76% and for Rs.1,000/- denomination was 109% during this period.”
If high denomination notes facilitate generation of black money, then why replace Rs 1,000 notes with Rs 2,000 notes. Given that a Rs 2,000 note is twice the value of a Rs 1,000 note, it makes black market transactions even more easier. It also makes storage of black money in the form of cash easier, given that it takes less space to hide the same amount of money.
Again, this is a basic disconnect in what the government planned to achieve through demonetisation and what it eventually did. No effort has been made to correct this disconnect.

c) The government has still not offered a good explanation of what prompted it to demonetise. There has been no similar decision taken by any other country in a stable financial situation like India currently is, in the modern era. The best that the government has done is blamed it on the RBI. As Meghwal told the Lok Sabha in early February 2017: “RBI held a meeting of its Central Board on November 8, 2016. The agenda of the meeting, inter-alia, included the item: “Memorandum on existing banknotes in the denomination of Rs 500 and Rs 1000 – Legal Tender Status.””
Anybody who has studied the history of the RBI would know that the RBI would never take such an extreme step without extreme pressure from the government.

d) Other than eliminating black money and fake currency notes through demonetisation, in the aftermath of demonetisation, the government wanted to promote cashless transactions. As Modi said in the November 2016 edition of themann ki baat radio programme: “The great task that the country wants to accomplish today is the realisation of our dream of a ‘Cashless Society’. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a ‘less-cash society’? Once we embark on our journey to create a ‘less-cash society’, the goal of ‘cashless society’ will not remain very far.”

How are things looking on that front? Look at the following table. It shows the volume of digital transactions over the last few months.

Month Volume of digital transactions (in million)
Nov-16 671.5
Dec-16 957.5
Jan-17 870.4
Feb-17 763.0
Mar-17 893.9
Apr-17 843.5

Source: Reserve Bank of India

While digital transactions picked up in December, they have fallen since then. The total number of digital transactions in April 2017 is higher than it was in November 2016. Nevertheless, it is worth asking, whether this jump of 25 per cent was really worth the trouble of demonetisation.

e) Falling digital transactions since December 2016 tell us that cash as a mode of payment is back in the system. There is another way this can be shown. Between November 2016 and February 2017, banks barely gave out any home loans. During the period, the banks gave out home loans worth Rs 8,851 crore. In March 2017, they gave out total home loans of Rs 39,952 crore, which was 4.5 times the home loans given out in the previous four months. It also amounted to 35 per cent of the home loans given out during the course of 2016-2017.

A major reason why people weren’t taking on home loans between November 2016 and February 2017 was demonetisation. There simply wasn’t enough currency going around. With this, the real estate transactions came to a standstill because without currency it wasn’t possible to fulfil the black part of the real estate transaction. Those who owned homes (builders and investors) were not ready to sell homes, without being paid for a certain part of the price, in black.

By March 2017, nearly three-fourths of the demonetised currency was replaced. This basically means that by March 2017, there was enough currency in the financial system for the black part of the real estate transactions to start happening all over again. Also, the Rs 2,000 note makes this even more convenient.

To conclude, six months after the declaration of demonetisation it is safe to say that demonetisation has failed to achieve what it set out to achieve i.e. if it set out to achieve anything on the economic front.

The column originally appeared on Firstpost on May 9, 2017

Viral Acharya is Right About Re-privatising Public Sector Banks


Late last week Viral Acharya, a deputy governor of the Reserve Bank of India (RBI), said: “Perhaps re-privatising some of the nationalised banks is an idea whose time has come … this would reduce the overall money government needs to inject as bank capital.”

Regular readers of the Diary would know that we have said several times in the past that public sector banks should be privatised and the government should get out of the banking business, which it is clearly inept at.

Of course, the question is why has Acharya used the term re-privatising rather than privatising. Indira Gandhi nationalised 14 private banks on July 19, 1969. These banks had deposits of Rs 50 crore or more and among them accounted for 90 per cent of the banking business in the country. The funny thing is that at the time this happened, the then RBI governor LK Jha had no clue about it.

As TCA Srinivasa Raghavan writes in Dialogue of the Deaf—The Government and the RBI: “Volume three of RBI’s official history says that on July 17 she [Indira Gandhi] asked LK Jha, the RBI governor to come over to Delhi. Jha thought he was being asked to discuss social control and he took with him a comprehensive note on the subject. When he offered it to Mrs Gandhi she told him ‘that he could keep the note on her table and go to the next room and help in drafting the legislation on nationalising the banks.’”

In 1980, six other private banks were nationalised. This time the recommendation came from the then RBI governor, IG Patel.

Now getting back to what Acharya said, re-privatising is something we have advocated in the past. And it makes sense at multiple levels. We now have nearly two decades of evidence that suggests that the new generation private sector banks which were first set up in the mid-1990s, are much more efficiently run than their public-sector counterparts. Yes, there have been cases like the Global Trust Bank, but on the whole private banks are better run than their public sector counterparts. Even the old generation private sector banks, which are very small, are reasonably well run.

Take the case of the bad loans situation that currently plagues the Indian banking sector in general and the public sector banks in particular. As on December 31, 2016, the total bad loans of the public sector banks (gross non-performing assets (NPAs)) had stood at around Rs 6.46 lakh crore.

For the private sector banks, the same number stood at Rs 86,124 crore. Of this, two banks, ICICI Bank and Axis Bank, accounted for bad loans of Rs 58,184 crore. Of course, given that public sector banks give out more loans, it is not surprising that their bad loans are more.

The total loans of public sector banks are 2.9 times the total loans of private sector banks. But their bad loans are 7.5 times that of private banks. If both these set of banks were equally well run, then the two ratios just referred to, wouldn’t have been different.

Between 2013-2014 and 2015-2016, the total net profit made by the public sector banks stood at Rs 56,567 crore and that of private banks stood at Rs 1,13,801 crore. This, even though public sector banks are significantly bigger than India’s private banks.

These data points tell us that India’s public sector banks are inefficiently run. And this inefficiency has cost the government a lot of money over the years. Between 2009 and March 2017, the government has had to invest close to Rs 1.5 lakh crore in these banks to keep recapitalising their capital, in order to keep them going.

Indeed, this is a lot of money and could have gone towards other worthy causes. The basic problem with public sector banks is political meddling. Every government has its favourite set of industrialists and this ultimately leads to the public sector banks and in the process the taxpayer, picking up the bill for this politician-businessman nexus.

As Acharya writes in a paper titled Is State Ownership in the Indian Banking Sector Desirable?: “One, state ownership creates severe moral hazard of directing bank lending for politically expedient goals and of bailouts when such lending goes bad. Second, state ownership restricts the ability of state-owned banks from raising arm’s length capital against state’s stake, strangling their growth and keeping these banks—and certainly their private capital base—smaller than it need be.”

What does this mean in simple English? The economist Alan Blinder in his book After the Music Stopped writes that the “central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.” Hence, managers of government owned banks know that if loans given to businessmen close to politicians go bad, the government will ultimately pick up the tab by recapitalising the public sector bank to an adequate extent. Hence, they go easy on giving loans to borrowers who are likely to default. Of course, there is always the threat of transfers, which works very well. This has happened for years at end.

Secondly, given that the government has to continue owning a certain proportion of shareholding in these banks, the banks cannot raise as much capital as they require. They have to continue to be dependent on the government for capital. And the government of course does not have an unlimited amount of cash. This limits the ability of the government owned banks to raise as much capital as they may require at any point of time.

So, what are the actual chances of the government re-privatising some of the public sector banks, as suggested by Acharya? Zero. While Acharya, I and others, might think that the basic problem with public sector banks is government ownership, politicians don’t think so. This comes from the belief that if you own banks then you can direct lending to areas that you want to. But this as we have seen comes with its own set of costs.

The column originally appeared on Equitymaster on May 3, 2017.

Will RBI’s Latest Rescue Act Clean the Mess in Public Sector Banks?


Late last week, the Reserve Bank of India(RBI) unleashed yet another weapon to clean up the mess that India’s public sector banks are in. The RBI reviewed and revised the preventive corrective action (PCA) framework for banks.

At a very simplistic level, the PCA framework essentially will restrict the ability of any bank to go about their normal business, in case they don’t meet certain performance parameters. The idea is to ensure that banks do not get into a further mess.

The RBI has basically set three risk levels for the PCA framework to kick-in. Take the case of bad loans or net non-performing assets(NPAs) of banks. (NPAs are essentially loans which borrowers have defaulted on and are no longer repaying. These NPAs are referred to as gross NPAs. Against, the gross NPAs, the banks set aside a sum of money referred to as provisions. Once these provisions are subtracted from gross NPAs what remains are net NPAs).

Let’s say the net NPA of a bank is greater than or equal to 6 per cent but less than 9 per cent. In this case, the bank will face a restriction on dividend distribution. This is the first risk level of the PCA framework. In case, the net NPA is greater than or equal to 9 per cent and less than 12 per cent, along with dividend restrictions the bank will also face a restriction on branch expansion and at the same time will have to increase its provisions or the money it sets asides against gross NPAs. This is the second risk level of the PCA framework.

If the net NPA is greater than or equal to 12 per cent, then along with the dividend restrictions, restrictions on bank expansion, greater provisioning, the banks will have to limit the management compensation and directors’ fees. This is the third risk level of the PCA framework.

Along with net NPAs, the other performance parameters that the RBI plans to take a look at as a part of the PCA framework are the capital adequacy ratio, return on assets and the leverage of the bank. If the bank does not meet the RBI set levels of these parameters, the actions highlighted above will kick-in.

Over and above this, there are other actions that can kick-in. These include:

  1. Special audit of the bank
  2. A detailed review of business model in terms of sustainability of the business model of the bank.
  3. RBI to actively engage with the bank’s Board on various aspects as considered appropriate.
  4. RBI to recommend to owners (Government/ promoters/ parent of foreign bank branch) to bring in new management/ Board.
  5. RBI to supersede the Board.
  6. Reduction in exposure to high risk sectors to conserve capital.
  7. Preparation of time bound plan and commitment for reduction of stock of NPAs.
  8. Preparation of and commitment to plan for containing generation of fresh NPAs.
  9. Strengthening of loan review mechanism.
  10. Restriction of staff expansion.
  11. Restrictions on entering into new lines of business.
  12. Restrictions on accessing/ renewing wholesale deposits/ costly deposits/ certificates of deposits.
  13. Reduction in loan concentrations; in identified sectors, industries or borrowers.

If you look at the above actions, other than the RBI superseding the board of the bank, the other steps are more or less what any bank which is in trouble would undertake. The question is will the PCA unravel the mess that the Indian banks, in particular the government owned public sector banks, are currently in.

The biggest problem for the public sector banks has been the fact that their gross NPAs have been increasing at a very rapid rate. Between December 2014 and December 2016, the gross NPAs of public sector banks increased by 137 per cent to Rs 6.46 lakh crore.

What is the reason for this huge and sudden increase in gross NPAs? A major reason lies in the fact that banks have been recognising their bad loans as bad loans at a very slow speed. The question is the recognition of bad loans as bad loans over? Have all bad loans been recognised as bad loans? Or are banks still resorting to accounting gimmicks and postponing the recognition of bad loans? This is a question which only the banks or the RBI can answer.

The most important step in cleaning up the balance sheets of Indian banks is ensuring that all the bad loans have been recognised as bad loans. A problem can be solved only after it’s properly identified. The tendency not recognise bad loans as bad loans and project a financial picture which is incorrect needs to end.

The second biggest problem for Indian banks has been the poor recovery rate of bad loans (i.e. net NPAs in this case). Data from RBI shows that in 2015-2016, the recovery rate fell to 10.3 per cent of the net NPAs. In 2014-2015, it was at 12.4 per cent. In 2013-2014 and 2012-2013, the recovery rates were even better at 18.4 per cent and 22 per cent, respectively.

This basically means that the ability of banks to recover bad loans has gone down over the years. Will the PCA framework be able to help on this count? It doesn’t seem so. A greater portion of the bad loans need to be recovered from corporate India. As the Economic Survey points out: “The stressed debt is heavily concentrated in large companies.” Hence, any major recovery from large companies will need a lot of political will something, which is something the RBI cannot do anything about.

The PCA framework will kick-in depending on the performance of banks as on March 31, 2017. But taking the net NPA numbers as on December 31, 2016, how does the scene look like for public sector banks? There are 21 public sector banks which currently have a net NPA ratio of greater than 6 per cent. Hence, the PCA framework will apply to all of these banks. The first risk level of the PCA framework will apply to all these banks.

Of these ten banks have an NPA of greater than 9 per cent. The second risk level of the PCA framework will apply to these banks. Two banks have an NPA of greater than 12 per cent. The Indian Overseas Bank is the worst of the lot at 14.3 per cent. The State Bank of Patiala came in next as of December 2016. This bank has since been merged with the State Bank of India.

The PCA framework will essentially limit the ability of these banks to carry out business and hence, limit further damage to the bank and the financial system.

Nevertheless, there is no way the framework will clear up the mess that these banks are in. For that what is needed is a lot of political will to go after corporates and recover the bad loans that are outstanding. The question is do we have that kind of political will?

The column originally appeared on Firstpost on April 19, 2017 

Public Sector Banking is Now in a Bigger Mess


The break at writing the Diary turned out to be much longer than I had expected. The main reason for it will become obvious in the days to come.

A lot has happened during this period, including the Modi government’s defence of demonetisation, which has grown by leaps and bounds. Nevertheless, I thought of giving writing on demonetisation a break for the first piece for the Diary in 2017.

One thing that has got side-lined in the entire discussion on demonetisation is the fact that Indian public sector banks continue to remain in a mess. In fact, as we shall see the mess has only grown bigger in the recent past. As the RBI Financial Stability Report for December 2016 points out: “The stress on banking sector, particularly the public sector banks (PSBs) remain significant… PSBs as a group continued to record losses.”

The gross non-performing assets ratio or the bad loans of the PSBs, increased to 11.8 per cent as on September 30, 2016. This is a whopping increase
220 basis points from 9.6 per cent as of March 31, 2016. One basis point is one hundredth of a percentage.

The overall stressed assets of public sector banks jumped to 15.8 per cent of total loans. It had stood at 14.9 per cent as on March 31, 2016.

The stressed asset figure of 15.8 per cent was obtained by adding bad loans of 11.8 per cent with restructured assets of 4 per cent. This basically means that for every Rs 100 that the PSBs have given out as a loan, Rs 15.8 are in a dodgy territory, on an average.

Out of every Rs 100 of loans made by the banks, borrowers have stopped repaying loans worth Rs 11.8. Over and above that loans worth Rs 4 for every Rs 100 of loans given by the banks have been restructured. A restructured loan essentially implies that the borrower has been given a moratorium during which he does not have to repay the principal amount. In some cases, even the interest need not be paid. In some other cases, the tenure of the loan has been increased.

This is clearly a reason to worry. Nevertheless, there is a small good sign here as well. Unlike earlier, when banks were using the restructuring route to not recognise bad loans, that doesn’t seem to be happening much now. As on March 31, 2016, the restructured loans had stood at 4.9 per cent of total loans. This has fallen to 4 per cent of total loans as of September 30, 2016. Banks are now recognising bad loans as bad loans. The first step towards solving a problem is recognising that it exists.

The increase in bad loans of public sector banks can also be seen in the bad loans figure of large borrowers. The Reserve Bank of India categorises large borrowers as borrowers with an outstanding loan amount of Rs 5 crore or more. The Financial Stability Report points out: “The large borrowers registered significant deterioration in their asset quality.”

However, the report does not mention a clear bad loans figure for the large borrowers. As the RBI Financial Stability Report for June 2016 pointed out: “The gross non-performing assets(GNPA) ratio of large borrowers increased sharply from 7.0 per cent to 10.6 per cent during September 2015 to March 2016.” This basically means that as on September 30, 2016, the gross non-performing assets ratio or the bad loans of banks would have stood at greater than 10.6 per cent.

If we look at Figure 1, the bad loans ratio for the large borrowers seems to be greater than 15 per cent as of September 30, 2016.

Figure 1:


This basically means that the large borrowers are the ones who continue to create problems for public sector banks. Take a look at Figure 2.

Figure 2:

The large borrowers form 56.5 per cent of the total loans given by banks. Nonetheless, they form 88.4 per cent of the total bad loans of banks. And this is where the basic trouble is. The rate of recovery of bad loans by banks is also not good enough.

As a recent report in The Indian Express points out: “The rate of recovery of non-performing assets (NPAs) was 10.3 per cent, or Rs 22,800 crore, out of the total NPAs of Rs 221,400 crore during fiscal ended March 2016, against Rs 30,800 crore (12.4 per cent) of the total amount of Rs 248,200 crore reported in March 2015, data from the Reserve Bank of India (RBI) has said.”

Indeed, what is worrying is that the RBI points out that the bad loans of the PSBs could increase further. As the report points out: “Among the bank groups, PSBs may continue to register the highest GNPA ratio. Under baseline scenario, the PSBs’ GNPA ratio may increase to 12.5 per cent in March 2017 and then to 12.9 per cent in March 2018 from 11.8 per cent in September 2016, which could increase further under a severe stress scenario.”

Interestingly, the June 2016 Financial Stability Report had pointed out: “Among the bank-groups, PSBs may continue to register the highest GNPA ratio. Under the baseline scenario, their GNPA ratio may go up to 10.1 per cent by March 2017 from 9.6 per cent as of March 2016. However, under a severe stress scenario, it may increase to 11.0 per cent by March 2017.”

We have already crossed the severe stress level in September 2016, something which was forecast only for March 2017. This basically means that the government will have to keep pumping more and more capital into these banks in the years to come in order to keep them going. And that means a lot more money of taxpayers will essentially go down the drain.

Postscript: I would like to thank all readers who supported my recent petition to the President. I am in the process of planning the dispatch of the responses received to the President.

The column was originally published on Equitymaster on January 11, 2017


Mr Modi, Here’s What to Do Next in Fight Against Black Money


Prime Minister Narendra Modi’s address to the nation on the New Year’s Eve turned out to be a damp squib. While people were looking for specific answers on demonetisation, what they got instead was a long list of generalities.

Sample this: “Over the last ten to twelve years, 500 and 1000 rupee currency notes were used less for legitimate transactions, and more for a parallel economy.” This is something that the ministry of finance press release accompanying the demonetisation decision had also pointed out.

As the press release said: “Use of high denomination notes for storage of unaccounted wealth has been evident from cash recoveries made by law enforcement agencies from time to time. High denomination notes are known to facilitate generation of black money.” The term unaccounted wealth essentially means black money. Black money is income which has been earned through legal or illegal means but on which tax has not been paid.

Both Modi and the ministry of finance were essentially saying the same thing. High denomination notes facilitate the black economy. Take the case of a real estate transaction. A home is sold. The buyer and the seller carry out a part of the transaction in cheque and the rest is carried out in cash.

There is no record of the transaction being carried out in cash. Hence, the buyer does not pay a stamp duty on that part of the transaction and the seller does not pay a capital gains tax. The cash that is paid, is in high denomination notes. Hence, high denomination notes facilitate a black economy transaction on which taxes are not paid.

Further, individuals keep a part of the black money they have earned, in the form of high denomination notes. Demonetisation was supposed to hurt them by rendering the Rs 500 and Rs 1,000 notes useless overnight. That hasn’t happened. But we will not get into that.

The idea that high denomination notes facilitate the black economy is well accepted internationally. Take the case of the United States. The highest denomination note is $100. In Britain, the highest denomination note is £ 50. Hence, the highest denomination note in United States is 100 times the lowest denomination note of $1. In Britain, it is 50 times. In India, up until demonetisation happened, the highest denomination note was Rs 1,000, which was 1,000 times in value the lowest denomination note of Re 1.

Given this, one would have appreciated the decision to demonetise Rs 500 and Rs 1,000 notes, if a new note of Rs 2,000 wouldn’t have been issued. If Rs 500 and Rs 1,000 were facilitating black market transactions, so will Rs 2,000.

As on November 8, 2016, 685.80 crore Rs 1,000 notes were in circulation. These notes have been replaced by the Rs 2,000 note. As on November 8, 2016, the RBI had printed and kept around 247 crore Rs 2,000 notes in its kitty. Since then it would have printed more. 247 crore Rs 2,000 notes can replace 494 crore Rs 1,000 notes. It is safe to say that more than 72 per cent of the Rs 1,000 notes have already been replaced by Rs 2,000 notes.

Now these notes can be used for facilitating the black economy transactions like Rs 1,000 notes were. So, what is the way out of this? Some economic commentators have suggested that in the time to come the Rs 2,000 note should be demonetised as well. As we have come to know by now demonetisation is very disruptive.

The best way to go about this is to phase out Rs 2,000 notes gradually. This idea has been suggested by the economist Kenneth Rogoff in his new book The Curse of Cash in a different context. Paper money has a limited shelf life. As Rs 2,000 notes run through their lifecycle, they need to be replaced by Rs 500 notes and not by new Rs 2,000 notes.

This won’t happen overnight and will take time. Meanwhile, the government, unlike this time around, can be ready for it, and print enough Rs 500 notes in advance. It will take four 500 rupee notes to replace a Rs 2,000 note. Over a period of few years, the Rs 2,000 notes can be replaced by Rs 500.

Of course, all this is subject to the condition that the government genuinely wants to attack black money and not just talk about it.

The column originally appeared in the Bangalore Mirror on January 4, 2017

Why the New Rs 500 Note is Missing from Your Pocket


Yesterday, the Reserve Bank of India, put out an interesting set of numbers. Between November 10, 2016 and November 27, 2016, the banks reported deposits of Rs 8,11,033 crore. Over and above this, Rs 33,948 crore of exchange of notes was carried out.

The deposits and exchange became necessary in the aftermath of the Narendra Modi government deciding to demonetise notes of Rs 500 and Rs 1,000, respectively. People have time till December 30, 2016, to deposit these demonetised notes into their bank accounts or their post office accounts. Earlier a certain amount of money could also be exchanged for new notes or notes which continue to be legal tender, but that has since been stopped.

Data from the Reserve Bank of India(RBI) shows that in 2015-2016 the total amount of paper notes in circulation amounted to Rs 16.4 lakh crore. Of this, the high denomination notes of Rs 500 and Rs 1,000 amounted to Rs 14.2 lakh crore. The Rs 500 notes amounted to Rs 7.9 lakh crore whereas Rs 1,000 notes amounted to Rs 6.3 lakh crore.

Between March 2016 and November 2016, the number of Rs 500 and Rs 1,000 notes would have gone up. Using “econometric model factoring in inter alia, real GDP growth prospects, rate of inflation and denomination-wise disposal rate of soiled notes,” the RBI places orders for new notes every year. But given that we don’t have exact numbers for the number of Rs 500 and Rs 1,000 notes printed between April 2016 and November 8, 2016, when these notes were demonetised, it is best to stick to the March end numbers.

Hence, Rs 500 and Rs 1,000 notes, forming 86 per cent of the total currency by value have been demonetised. Against the Rs 14.2 lakh crore worth notes that were demonetised, Rs 2,16,617 crore has made it back into the financial system between November 10, 2016 and November 27, 2016. People have withdrawn this money from their bank accounts as well as ATMs.

What this means that withdrawals of Rs 2,16,617 crore from banks and ATMs have replaced the Rs 14.2 lakh crore of currency that has been rendered useless due to demonetisation. Of course, some portion of the currency that has been demonetised may have been hoarded in the form of black money.

The estimates of this black money in the form of cash that I have seen, vary anywhere from 6-20 per cent. Hence, even at the upper end of 20 per cent, more than Rs 11 lakh crore of currency (Rs 11.36 lakh crore to be very precise. Rs 14.2 lakh crore minus 20 per cent of Rs 14.2 lakh crore) was out there in the economy, helping people carry out transactions.

Hence, around 19.1 per cent, or a little under one fifth, of the demonetised currency which was in circulation, has been replaced. This best explains why transactions across markets in the country have collapsed. People just don’t have enough currency going around.

It is easy to ask that why are they not moving towards wallets and netbanking. The point is that more than 80 per cent of the transactions in India by value are still carried in cash and that number cannot disappear overnight. This is an economic reality and needs to be taken into account in the political decision making process.

Assurances have been made about banks having enough new notes, both by politicians as well as the RBI. But that as we all know by now is really not true. The reason for that is straightforward. There aren’t enough new Rs 500 notes going around simply because they haven’t been printed. Some basic maths tells us that it will take at least another five to six months to print enough new Rs 500 notes and get them out there.

I had first discussed this issue in the November 25, 2016, edition of The Vivek Kaul Letter. But given the importance of this issue, the whole point is worth repeating here.

The question is why is the rate of currency replacement been so slow? The simple explanation for this lies in the fact that the government hasn’t printed enough new notes to replace the old ones. There is only so much printing capacity going around at the printing presses of the government.

In total, around 1571 crore 500 rupee notes have become useless due to the demonetisation. Media reports suggest that the capacity of the government is to churn out around 300 crore notes per month. It is interesting to see how they have arrived at this number. In the last three years, the printing presses have supplied around 2200 crore notes a year, on an average. This number can be arrived at by looking at data in the RBI annual report.

A Mint newsreport points out that the total capacity of the printing presses is around 2400 crore notes per year. This is achieved by running two shifts. Adding a third shift can increase production by 50 per cent to 3600 crore notes per year. This essentially means a production of 300 crore notes per month.

What if we work with the supply number of 2200 notes per year? A third shift would lead to a jump of 50 per cent to 3300 crore notes per year. This would mean a production of 275 crore notes per month.

To get back to the point, around 1571 crore 500 rupee notes need to be exchanged. At 300 crore notes per month, this will take around 5.2 months to print, the new Rs 500 notes to replace the old ones. At 275 crore per month, it will take around 5.7 months.

So, just to replace Rs 500 notes can take a period of up to five months. Over and above this, there is the Rs 1,000 note that also needs to be replaced. In total, around 633 crore, 1000 rupee notes have become useless due to the demonetisation.

Assuming the new Rs 2,000 notes directly replace the Rs 1,000 note, then that would mean printing 316.5 crore new notes of Rs 2,000 (633 crore divided by 2). At the rate of 275 crore or 300 crore notes a month, this would mean a little over a month. If all the currency is printed, it will take a little over six months to print it.

Also, we can clearly see that the problem is with the Rs 500 note and not the Rs 2,000 note. Further, media reports suggest that most of Rs 2,000 notes that need to be printed have already been printed. There are a reasonable number of Rs 2,000 notes going around but they are of no use because nobody has enough change to return. They become useful only if a purchase of more than Rs 1,500 is to be made. Only then is it possible to get change from the merchants.

Of course, all this currency may not have to be printed given that all of it may not make it the banks, given that some of it is black money held in the form of cash. And some people may prefer letting their money become useless pieces of paper than generate an audit trail for the bank. That part of the detail will come clear only after December 30, 2016, the last date for depositing old notes to banks.

Current assumptions on black money held in the form of notes are in the range of 6-20 per cent. If, the total amount of black money held in the form notes is 20 per cent, then at least one-fifth of the demonetised notes will not make it to the banks. This would mean around a month less of printing new notes.

This one month less of printing new notes is nullified by the fact that we are considering Rs 500 notes in existence only until March 31, 2016. In 2016-2017, the RBI had asked the printing presses to print 572.5 crore of old Rs 500 notes to be printed, during the course of the year.

Assuming that half of the lot has already been printed, it would mean that close to 300 crore old Rs 500 notes would have been printed during the course of this financial year. These notes are over and above the 1,571 crore Rs 500 notes in existence as on March 31, 2016. They will also have to be replaced by the new Rs 500 notes and this would mean an extra one month of work, given the printing capacity of 300 crore notes per month. This would in effect neutralise the impact of around 20 per cent of the old Rs 500 notes not making it back to banks or post offices.

Taking these factors into account, it is likely to take at least five months for the situation to get back to normal, when there will be enough new notes going around in the financial system. And this with the assumption that all Rs 1,000 notes are replaced by Rs 2,000 notes.

If that is not the case, and Rs 500 notes also replace Rs 1,000 notes, then it will take even longer. Of course, all this comes with the assumption that during this period the low denomination notes of Rs 10, Rs 50 and Rs 100 are not printed at all. I don’t know how feasible that is.

Also, we are assuming here that the government printing presses are working full steam here. Now that as well know is an unrealistic assumption. A report in the Quint points out that only 1 crore Rs 500 notes have been printed up until now. That is less than 0.1 per cent of the total number of Rs 500 notes that need to be printed. Further, I don’t know whether the government printing presses are in a positon to run a third shift.

Other than printing the new notes, they should also reach the different parts of the country, quickly enough.

To cut a long story short, this mess will take some time to sort out.

(The column originally appeared on November 29,2016, on Vivek Kaul’s Diary)

The Biggest Challenge for the New RBI Governor Urjit Patel is…



On Saturday, August 20, 2016, the Narendra Modi government appointed Urjit Patel, as the 24th governor of the Reserve Bank of India(RBI). He will take over fromRaghuram Rajan, on September 4, 2016.

Since Patel’s appointment two days back, a small cottage industry has emerged around trying to figure out what his thinking on various issues is. The trouble is that Patel has barely given any speeches, or interviews, for that matter, since he became the deputy governor of the RBI, in January 2013.

A check on the speeches page of the RBI tells me that he has given only one speech (you can read it here) and one interview (you can read it here) in the more than three and a half years, he has been the deputy governor of the RBI.

You can’t gauge much about his thinking from the speech which is two and a half pages long. As far as the interview goes, Patel has answered all of three questions. Some of his thinking can be gauged from the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework¸ of which he has the Chairman. The report was published in January 2014 and ultimately became the basis for the formation of the monetary policy committee, which will soon become a reality.

There are also a few research papers that he has authored over the years.

Given this, Patel’s thinking on various issues will become clearer as we go along and as he interacts more with the media in the days to come. While he may have managed to avoid the media in his role as the deputy governor that surely won’t be possible once he takes over as the RBI governor. He may not make as many speeches as his predecessor did (which is something that the Modi government probably already likes about him), but there is no way he can avoid interacting with the press, after every monetary policy statement, and giving interviews now and then.

Given this, the policy continuity argument being made across the media about Patel being appointed the RBI governor, is rather flaky. There isn’t enough evidence going around to say the same. The only thing that can perhaps be said from what Patel has written over the years is that his views on inflation seem to be in line with Rajan’s thinking. Also, some of the stuff that is being cited was written many years back. And people do change views over the years. There is no way of knowing if Patel has.

The Challenges for the new RBI governor

While, his thinking on various issues may not be very clear, it doesn’t take rocket science to figure out what his bigger challenges are. Take a look at the following chart. It maps the inflation as measured by the consumer price index since August 2014.

Inflation as measured by the consumer price index

The chart tells us very clearly that the inflation as measured by the consumer price index is at its highest level since August 2014. In August 2014, the inflation was at 7.03 per cent. In July 2016, it came in at 6.07 per cent.

Why has the rate of inflation as measured by the consumer price index, spiked up? The answer lies in the following chart which shows the rate of food inflation since August 2014.


Food Inflation


Like the inflation as measured by the consumer price index, the rate of food inflation is also at its highest level since August 2014. In August 2014, the food inflation was at 8.93 per cent. In July 2014, the food inflation was at 8.35 per cent. Food products make for a greater chunk of the consumer price index.

What this tells us is that the inflation as measured by the consumer price index spikes up when the food inflation spikes up. And that is the first order effect of high food inflation. This becomes clear from the following chart.


But what can the RBI do about food inflation?

There is not much that the RBI can do about food inflation. And this is often offered as a reason, especially by the corporate chieftains and those close to the government (not specifically the Modi government but any government), for the RBI to cut the repo rate. The repo rate is the rate of interest that the RBI charges commercial banks when they borrow overnight from it. It communicates the policy stance of the RBI and tells the financial system at large, which way the central bank expects interest rates to go in the days to come.

The trouble is that things are not as simplistic as the corporate chieftains make them out to be. While, the RBI has no control over food inflation (and not that the government does either), it can control the second-order effects of food inflation.

As D Subbarao, former governor of the RBI, writes in his new book Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: “What about the criticism that monetary policy is an ineffective tool against supply shocks? This is an ageless and timeless issue. I was not the first governor to have had to respond to this, and I know I won’t be the last. My response should come as no surprise. In a $1500 per capita economy-where food is a large fraction of the expenditure basket-food inflation quickly spills into wage inflation and therefore into core inflation…When food has such a dominant share in the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.”

Given this, the entire logic of the RBI cutting the repo rate because it cannot manage food inflation is basicallybunkum. Food inflation inevitably translates into overall inflation and that is something that the RBI has some control over, through the repo rate. If this is not addressed, second order effects of food inflation can lead to an even higher inflation as measured by the consumer price index. And this will hurt a large section of the population.

As Subbarao writes: “The Reserve Bank of India cannot afford to forget that there is a much larger group that prioritizes lower inflation over a faster growth. This is the large majority of public comprising of several millions of low-and-middle-income households who are hurt by rising prices and want the Reserve Bank to maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you are, the more you are hurt by rising prices.”

But one cannot expect corporate chieftains who have taken on a huge amount of debt over the years, in order to further their ambitions, to understand this rather basic point. Given this, this hasn’t stopped them from demanding a repo rate cut from the new RBI governor. (You can read more about it here). The government has also made it clear over and over again that it wants the RBI to cut the repo rate. Given that, it is the biggest borrower, this is not surprising. Since January 2015, the RBI has cut the repo rate by 150 basis points to 6.5 per cent. One basis point is one hundredth of a percentage.

As Subbarao writes: “The narrative of our growth-inflation debate is also shaped by what I call the ‘decibel capacity’. The trade and the industry sector, typically a borrower of money, prioritizes growth over inflation, and lobbies for a softer interest-rate regime.”

The people who invest in deposits unlike the corporate chieftains are not in a position to lobby. But it is important that the RBI does not forget about them.

Hence, it is important that people are offered a positive real rate of interest on their fixed deposits. The real rate of interest is essentially the difference between the nominal rate of interest offered on fixed deposits and the prevailing rate of inflation. A positive real rate of interest is important in order to encourage people to save and build the domestic savings of India, which have been falling over the last few years.

This was one of the bigger mistakes made during the second-term of the Manmohan Singh government.

As outgoing governor Raghuram Rajan told NDTV in an interview sometime back “When inflation was 9 per cent they [i.e. depositors] were getting 9 per cent. This meant earning nothing in real terms and losing everything in inflation.”

This wasn’t the case for many years. As Rajan explained in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

Inflation up, savings down

Take a look at the following chart clearly shows that between 2008 and 2013, the real rate of return on deposits was negative. In fact, it was close to 4 per cent in the negative territory in 2010.


Inflation as measured by the consumer price index


High inflation essentially ensured that India’s gross domestic savings have been falling over the last decade. Between 2007-2008 and 2013-2014, the rate of inflation as measured by the consumer price index, averaged at around 9.5 per cent per year. In 2007-2008, the gross domestic savings peaked at 36.8 per cent of the GDP. Since then they have been falling and in 2013-2014, the gross domestic savings were at 30.5 per cent of the GDP, having improved from a low of 30.1 per cent of GDP in 2012-2013.

This fall in gross domestic savings has come about because of a dramatic fall in household financial savings. Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. The household financial savings in 2014-2015, stood at 7.5 per cent of GDP. Chances of this figure having improved in 2015-2016 are pretty good given that a real rate of return on deposits is on offer for savers, after many years.

If a programme like Make in India has to take off, India’s household financial savings in particular and overall gross domestic savings in general, need to be on solid ground. And that is only going to happen if people are encouraged to save by ensuring that they make a real rate of return on their deposits. In fact, if India needs to grow at 10 per cent per year, an estimate made in Vijay Joshi’s book India’s Long Road suggests that the savings rate will have to be around 41 per cent of the GDP.

As Rakesh Mohan and Munish Kapoor of the International Monetary Fund write in a research paper titledPressing the Indian Growth Accelerator: Policy Imperatives: “In the near future, we expect financial savings to be restored to the earlier 10 per cent level, as inflation subsides, monetary conditions stabilize and households begin to obtain positive real interest rates on their deposits and other financial savings. Financial savings are then projected to increase gradually to around 13 per cent by 2027-32.”

And how is this going to happen? As Mohan and Kapoor point out: “A sustained reduction in inflation that leads to the maintenance of low nominal interest rates, but positive real interest rates, will help in restoring corporate profitability, while encouraging household savings towards financial instruments.”

The point is that a scenario where a positive real rate of return is available to depositors is very important. But is that how things will continue to be? Take a look at the following chart, which plots the repo rate and the consumer price inflation.

Inflation as measured by the consumer price index

As can be seen from the graph, the difference between the repo rate (the orange line) and overall inflation (i.e. inflation as measured by the consumer price index) has narrowed considerably and is at its lowest level in the last two years. This effectively means that the real rate of return on fixed deposits offered by banks has been falling as the rate of inflation has been going up. (Ideally, I should have taken the average rate of return on fixed deposits instead of the repo rate, but that sort of data is not so easily available. Hence, I have taken the repo rate as a proxy).

This is not a good sign on several counts. In a country like India where deposits are a major way through which people save, high inflation leading to lower real rates of interest which effectively means that they are not saving as much as they should. This is something that most people do not seem to understand.

The economist Michael Pettis makes a very interesting point about the relationship between interest rate and consumption in case of China. As he writes in The Great Rebalancing: “Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

Now replace China with India in the above paragraph and the logic remains exactly the same. Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates (as the corporate chieftains regularly demand) should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Given this, the biggest challenge for Urjit Patel will be to not taken in by all these demands for lower interest rates and ensure that the deposit holders get a real rate of interest on their fixed deposits.

Further, it is unlikely that he will cut the repo rate given that as the monetary policy committee comes in place, the RBI needs to maintain a rate of inflation between 2 to 6 per cent. In July 2016, the rate of inflation was over 6 per cent.

The column originally appeared in Vivek Kaul’s Diary on August 22, 2016