Are banks expecting that some kind of restriction on cash withdrawals could become a more permanent feature of our system?
During the sixties, seventies and eighties, many socialist-minded governments in developing countries adopted a highly state-controlled banking sector that kept interest rates fixed at artificially low levels. The commonly stated objective behind this policy was to channelise low cost funds towards more productive activities. Unfortunately, this policy did not lead to any significant development in the financial markets, particularly in the banking sector of these economies. Economists who were curious to understand the reason behind this failure found that this was mainly due to three reasons. First, low interest rates encouraged investment in projects that were too risky or even unproductive. This resulted in the accumulation of non-performing assets (NPAs) in the banks. Second, a large part of these funds would be loaned to the government at a low cost, where they were again used for less productive activities. Finally, the artificially fixed low interest rates discouraged people from saving more. This led to a smaller supply of funds going into the banking system and as a result the sectors could not grow very fast.
This policy of artificially manipulating the financial system came to be known as financial repression. When many developing countries moved towards economic liberalisation during the eighties and nineties, one of the most important reforms that they adopted was financial liberalisation, which implied an end to financial repression and allowing interest rates to be market determined.
Following the Modi government’s demonetisation move in India, there has been a deluge of deposits into the Indian banking system. The reason for the buildup of deposits is that very limited amounts of old notes were allowed to be exchanged for new notes and the withdrawal of new notes from the deposit accounts have also been largely restricted. This essentially means that these large deposits are the result of a mismatch of the amount of cash that people want to withdraw from the banks and the amount that they are actually permitted to withdraw. Irrespective of the reasons behind these rising deposits, they pose a challenge to the banking system, as interest payments have to be made on these stock of liabilities. It was initially thought that this was a very temporary phenomenon, brought about by the lack of supply of new notes. As soon as an adequate number of new notes were printed, the restrictions on cash withdrawal would be removed. This would allow the public to withdraw as much cash as they had held before the demonetisation and hence the burden of large deposits would simply go away.
Recent announcements by the major banks however, seem to indicate that they do not expect this to be a temporary situation. Most of these banks have come out with significant cuts in their lending rates, particularly on home loans, signaling that they wish to increase credit to this sector. This can only mean that they do not expect a large part of these deposits to be withdrawn by the public anytime soon.
There could be two explanations to this change in thinking by the banks. First, the banks may feel that the public now has a lower demand for cash as they have voluntarily moved towards a digital and low-cash economy. However, given that there are a number of genuine reasons, including lack of a cybersecurity safeguards and adequate digital infrastructure that ails the development of the digital economy, this explanation, even if it is partially true, cannot lead to a very significant lowering of the demand for cash. A second, and more plausible, reason is that banks expect that some kind of restriction on cash withdrawals could become a more permanent feature of our banking system. If this expectation comes to be true, then the Indian economy is moving towards something that resembles policies of financial repression.
Usually, financial repression channelises low cost funds to the borrowers by targeting the intermediary, i.e., the banks. This happens by fixing interest rates at a low level or by fixing statutory ratios and stipulating priority lending. However in the current Indian case, the target could be the saver, who could be forced to hold a higher proportion of her wealth in bank deposits, than what she would have held in the absence of these restrictions on cash withdrawal. This is clearly a non-market control of the asset portfolio of the public and will lead to a one-time increase in bank deposits, resulting in lowering of lending rate and cheaper loans to borrowers. These two factors, i.e., the use of non-market controls and the provision of low cost fund to borrowers has remarkable similarity to policies of financial repression.
Unfortunately, such a policy has a high chance of triggering all the three harmful effects of financial repression. First, a sudden and large increase in the volume of low-cost funds can lead to funding of more risky projects. This is exactly the kind of scenario that led to the sub-prime crisis in the US. In a developing country, there is the additional risk of lending to crony-capitalists and not being able to recover their loans. Secondly, banks might opt for a safer route by lending the funds to the government. As the past has shown, the government does not always invest such low-cost funds in the most productive activities. Moreover, it will destabilise the government’s finances by increasing the fiscal deficit. If the government is disinclined to increase its borrowings in order to control its deficit, the other option for banks is to lend to the RBI at the reverse repo rate. This will bring down the RBI’s profits and hence the non-tax revenues of the government. Thus, one way or the other, this leads to pressure on the fisc. These two effects have an adverse impact on the productive use of the wealth accumulated by the public. The third adverse effect is on the growth of this wealth in the economy. As interest rates become lower, savings rates have a strong chance of falling, and this will result in a lower growth of wealth over time. Incidentally, the Indian economy has in recent times showed signs of being a supply-constrained economy, particularly due to rigidities in the agricultural sector. In such an economy, a combination of lower saving and an increase in investment demand brought about by the availability of lower-cost credit, can result in strong inflationary tendencies.
Given the probability of these adverse effects, the RBI would do well to consider these factors before they take any decision on the rules relating to withdrawal of cash from bank deposit accounts.
The author is professor at the Institute of Economic Growth, Delhi University