What the RBI Should Do to Minimise the Impact of Demonetisation

People have lost their jobs, small businesses are closing down and the agricultural sector has been hit hard as a result of demonetisation. The RBI must increase the supply of cash to curb further fallout.

The constant tweaking of implementation policies does not suggest that the demonetisation was a well-planned government initiative. Credit: Reuters/Vivek Prakash/Files

Representative image of old notes. Credit: Reuters/Vivek Prakash/Files

Money is not cash. In fact, cash in circulation was just 14% of all money in 2015-16 according to the Reserve Bank of India (RBI). Measures of money also count close substitutes of cash including the amount bankers’ deposit with the RBI, as well as demand and time deposits. Notably, the recent demonetisation by the government has affected more than 85% of the cash in circulation and not other forms of stock of money. However, cash is extremely important for carrying out day-to-day transactions between people. While it is true that cashless transactions have increased over time across the world thanks to electronic money, in an developing country like India, the maximum proportion of small transactions take place in cash even today. The RBI is replacing the old notes with new notes and the government says it is expecting the cash crisis to be over very soon. However, over a month after the move was announced, it doesn’t look like this crisis will end anytime soon. About 130 crore people (17.5% of the world’s population) continue to suffer in this unprecedented manner due to this policy measure. The cash crisis is clearly not as temporary as the government seems to think.

The problem today essentially is that people have money in their bank accounts but they are not being able to withdraw it cash (for purchasing goods and services) from either banks or ATM machines. Most banks do not have enough cash to supply their customers. They are trying to satisfy as many customers as they can by ‘rationing’ or by constantly lowering the upper-limit of cash withdrawal. Even if people get some money after spending hours or even days waiting in queues, they remain uncertain about when they will get the opportunity to withdraw cash again. Because of this uncertainty, people are also demanding more cash – naturally, for precautionary purposes– than what they used to hold, on an average, before demonetisation. On the other hand, people are also trying to rationalise their expenditures to the best of their ability. Those who have the option of using credit or debit cards, net-banking or Paytm are executing the majority of their transactions through cashless forms of payment.

Even if people have enough money in the bank (for those who have it), their demand for cash is not being fulfilled by the banking system as a whole. Even if the monetary authority replaces the entire amount of cancelled old notes with new ones, and even if the entire amount reaches banks’ branches and ATMs quickly, the problem is not going to be completely solved. Because at an aggregate level, people are willing to hold relatively more cash now than they were before. Peoples’ confidence in other forms of money-holding has been shaken. If I need cash for paying my domestic helper’s salary or buying vegetables, then the amount of cash I can withdraw is more important than the number that appears in my passbook. Since it is uncertain when I would be able to withdraw next, I would try to withdraw little more, if possible, for precautionary purpose than my immediate need for cash for transaction motive. This extra demand for cash would not come down, irrespective of larger transactions carried out through cash-less means, unless people get back the confidence that they would be able to withdraw cash easily whenever they want either from ATMs or from various bank branches. Moreover, due to larger hoarding of cash, the speed with which cash circulates (how many times on an average cash changes hands within a particular period) would come down. As a result, to match up to the current level of economic activity, much more cash is required compared to what is currently available. 

Credit: Table 44, Components of Money Stock, Handbook of Statistics on Indian Economy, RBI.

Credit: Table 44, Components of Money Stock, Handbook of Statistics on Indian Economy, RBI.

Therefore, to overcome the current crisis of cash-shortage, the RBI has to supply more cash than before to satisfy the extra demand for cash in the economy as a result of demonetisation. Can the RBI do that? If yes, how? In the future, once the situation normalises, can the RBI syphon out that extra cash? Does the government have any role to play in all this? Would such a move cause inflation? Well, there are two ways to satisfy the present state of liquidity preference in the short-run. Firstly, the RBI can re-purchase some government bonds from the commercial banks or the primary dealers in the secondary market and supply currency (new notes) in return. Secondly, the RBI can directly lend cash to the government to finance its fiscal deficit. In turn, the government may choose to pay part of government employees’ salary, MGNREGA wage, old age pensions and other payments in new notes (instead of crediting their bank accounts). The receivers of new notes would either pay cash for transaction purposes or deposit them in bank accounts. Banks would get some new currency to satisfy non-government employees’ demand for new notes and to restock their ATM machines. This is called monetisation or seigniorage in economics – the first one is indirect and the second one is direct monetisation. We have not executed direct monetisation in India since 1996 – it was stopped in a different context to end the process of automatic monetisation without limits. The RBI cannot force commercial banks to reduce their excess government bond holdings, it may at most reduce the statutory liquidity ratio (the proportion of banks liabilities have to be held in terms of government securities by the banks). If the banks are unwilling to reduce their holdings of government bonds, given their risk-return calculations, then the RBI must re-explore the option of direct monetisation to inject more liquidity into the system in this crisis situation. It would control the damage in two ways. Firstly, by increasing the proportion of cash in total money supply and secondly, by enabling the government to undertake expansionary fiscal policy in the wake of a recession.

For the sake of argument, even if we believe in mainstream neo-classical monetarist economics for a moment, there is no possibility of  private investment getting crowded out in case of a monetised fiscal deficit. However, the monetarists may say that the rise in aggregate money supply may cause demand-pull inflation. If the aggregate stock of money remains the same and just the composition of aggregate money supply changes, then the question of inflation does not arise. Even if the aggregate money supply increases because of a larger fiscal deficit financed by monetisation, under a demand-constrained situation there is no reason to believe that it would necessarily cause demand-pulled inflation. Even if the RBI wants to reduce the amount of cash in circulation for some reason in the future, it can always do so either by selling some government securities or by reducing its excess foreign exchange reserves in the context of the rupee falling vis-à-vis the US dollar.

If printing more new notes per se is a problem, the government must undertake the required steps at the earliest to accelerate the speed of printing (at least, this preparation should have been done earlier) to save the economy from entering into a deep recession. Reduced aggregate domestic consumption due to scarcity of cash has led to lower production and it has also weakened the multiplier (earning of the receivers of spending and their expenditures and so on). Firms with small working capital are not in a position to pay labourers in cash. Many people have already lost their jobs – new job opportunities have come down drastically and many small and medium enterprises have been closing down. The agricultural sector is doomed – the farmers are throwing quintals of potatoes and tomatoes on the streets in protest. Small services provided by casual labourers and daily wage earners are not being sought out for the time being. The recession has already set in. In essence, the suggestion is to undertake monetisation in order to minimise the adverse effects of demonetisation.

Surajit Das is assistant professor at JNU’s Centre for Economic Studies and Planning.