“Forward ever, backward never: onwards with Breaking Through”

Growing Bank Deposits Post-Demonetisation Not a Sign of a Healthy Economy

The increase in deposits and the fall in lending rates is simply because the government has made it impossible to hold cash. When the economy does adjust to a new equilibrium, the fallout could well be significant.

If there is one sector that has done well as a result of Modi government’s demonetisation move, it is the banking sector. According to the RBI, amount of deposits grew by nearly Rs 6 trillion following the currency ban on November 8. This surge in deposits has led to a reduction in lending rates offered by certain banks since savings account deposits represent a cheap source of financing for banks.
The recent decision to ban over-the-counter exchange of notes – in an attempt to force people to open bank accounts – will lead to further liquidity in the banking system and possibly a further decrease in lending rates.
Proponents of the government’s decision would claim this to be a positive effect since it has brought crores of rupees into the formal banking net and has created a positive environment for investment.
However, it would be unwise to view this as beneficial for the economy since this represents a profound disequilibrium in the market. Bank deposits have increased simply because the government has made it impossible to hold cash. The public does not have a choice in deciding what form it wishes to hold its wealth.
Once the withdrawal limits have been removed, and the economy lurches back into equilibrium, there is no telling what the possible impacts on financial markets might be, and there is no reason to believe that the outcome will be positive.
Money demand, deposits and interest rate
According to the Keynesian macroeconomic theory, the demand and supply of money determine the interest rate. To keep the exposition simple, assume that wealth-holders have a choice of holding their wealth in the form of either money or bank deposits. If they express a strong desire to hold money, and if the supply of money is fixed, the interest rate offered on bank deposits must be remunerative enough to tempt people to hold deposits instead of cash. The interest rate can be thought of as the price of parting with money in order to facilitate investment.
If the supply of money reduces, money becomes much more valuable, and hence the interest rate must rise. This is why there exists an inverse relationship between the supply of money and the interest rate. The interest rates fall if the money supply increases since money becomes relatively less valuable at the margin and wealth-holders need a lesser reward to shift from cash to bank deposits.
What we are witnessing today is an anomalous situation where the supply of money has been restricted but the interest rates have actually fallen. This is not a situation of equilibrium for the wealth-holders are being forced to hold deposits instead of cash.
Banks do not need to incentivise people to exchange cash for deposits simply because the government has made it compulsory to hold bank deposits. An analogous situation would be where people are forced to buy less food, and the resultant increase in unsold stocks is hailed as the economy generating enough surpluses for future contingencies.
This is a classic situation of excess demand, where the price of the good is held artificially low in the midst of overwhelming demand meeting restricted supply. The economy is witnessing an artificially induced demand for bank deposits, and not a new equilibrium. To hold that, this is an overwhelming positive for the economy betrays a profound misreading of the situation.
As long as administrative restrictions remain in place, there will be no change in the situation. What is of grave concern is how the economy will react once these restrictions are removed.
Towards a new equilibrium
The situation can be resolved in two ways, through an increase in money supply or through a reduction in demand.
The easiest situation would be for the central bank to release enough money into the economy to make up for the shortfall. This would ensure no pressure on the interest rate as the desire of the people to hold cash would be satisfied.
A one-shot increase in money supply can bring about equilibrium at a stable interest rate, but in the absence of a timely action by the central bank, disequilibrium will persist in the economy.
The other move towards equilibrium can occur through changes in demand. If withdrawal limits were removed, the rush back to cash would reduce liquidity in the system and necessitate an increase in interest rates. This could have a negative effect on the economy as it could raise the costs of investment. If the investment were to contract following consumption, the short-run recession would snowball into a much larger crisis.
One possibility is the reduction in the desire of the people to hold cash so as to reduce the pressure on the money supply. Imagine a queue of people desperate to buy the latest iPhone, the stock of which is limited. Eventually, the long waiting time might frustrate buyers, leading to just as many buyers remaining in line as there are iPhones in stock.
This scenario is not feasible when it comes to essential items like food, medical attention or even cash. The long lines of people waiting at government hospitals are a testament to that fact. In fact, long lines are not even a deterrent for people who desire the latest iPhone.
If more people were to move towards cashless means of payment, then the demand for money would reduce. The same amount of transactions can take place with a limited stock of money only if there is a greater use of electronic means of payment.
But this is unlikely to happen because the infrastructure simply does not exist to reduce money demand on a scale commensurate with the drastically reduced supply. Moreover, the vast majority of people simply cannot access the cashless economy. The government is taking a huge gamble with the economy if it assumes that cashless means of payment would necessarily rise to a sufficient extent to prevent disruptions in the financial market.
Another way equilibrium can be brought about is through a reduction in income. If incomes are reduce, then demand for commodities consequently reduces, and the public would not need to hold as much money as before. Every day that money demand is rationed, which means further disruptions to consumption, and a reduction of incomes of those in the informal economy. This would reduce one major channel of money demand since informal activities are mainly transacted through cash.
A reduction in incomes in this sector would bring about a reduction in money demand, as meals are rationed, wages are not paid and food demand falls as workers are forced to go hungry. Economic stability might be achieved, but at what cost?
Will investment rise?
Demonetisation is no doubt a windfall for the banks. For every Rs 100 deposited in a bank, it is mandated to keep a portion as reserves, and the rest can be lent out. If the reserve ratio is 10%, they would keep Rs 10 and lend out the remaining Rs 90. Thus the large amounts of deposits in the system imply a potential increased supply of new loans, and since rates paid out on deposits are lesser than those on alternate sources of funding, banks find themselves in a healthier position.
If the investment does pick up, it would be purely out of a forced shift from consumption to investment brought about by financial repression on a massive scale. For a government that is ostensibly about rejuvenating the private sector, they seem to have no qualms about forcibly restricting demand of the majority.
There has been a massive increase in the amount of funds deposited by banks with the RBI, as banks pick up government securities in exchange for parting with liquidity. The returns accrued to banks through holding these securities are greater than what they have to pay out on deposits, implying a healthy profit for the financial sector. Yet, this does not benefit the economy, for there might be no increase in real investment, which depends on profit expectations of firms.
As export performance shows no signs of reviving, and consumption demand takes a hit due to the government’s move, there is no reason to expect an uptick in private sector investment demand.
If withdrawal limits are raised, and the demand for cash by the public increases, banks will find themselves under severe stress as they scramble to raise cash to meet the new demand. If they decide to do so by dumping securities on the market, interest rates would rise appreciably. The impact on investment would depend on how much interest rates would rise, but the extent of financial repression currently imposed by the government does not give one much confidence that the unwinding would be painless.
The ostensible signs of health in the banking sector should not distract one from what it really is, a situation of profound disequilibrium. When the economy does adjust to a new equilibrium – and it will – the fallout could well be significant.