When banks are awash with cash

Pulapre Balakrishnan
There are many lessons to be learned from the two months of turmoil that we have witnessed since November 8, but one stands out. The government not only underestimated the capacity for inefficiency and wrongdoing of our commercial banks, but also appears to overestimate their ability to turn around a shocked economy. Up until the deadline of December 30, from across the country, we have had reports of money meant for release to the public in exchange for the old notes being siphoned off to the influential and those with the capacity to pay for this. So, while the ordinary citizen queued for hours over days, India’s rich and powerful have had the newly issued currency notes in multiples of crores delivered at their doorstep. This could not have happened had bank officials not collaborated in this sordid exercise. On this score, the demonetisation, held out by the government as a means to ending corruption, faltered at the very outset. The diversion of notes meant for the public is only a variation on a theme that we have long witnessed in India whereby a commodity in short supply is cornered by those in charge of its distribution and sold to the highest bidder. During the Second World War it was food, then as the Indian economy quickened it was cement, and now, with the government reminding us that it is the fastest growing economy in the world, it is something as easy to manufacture as paper money.
Maximum government?
So the demonetisation meant to eliminate black money led directly to a black market for currency notes. A government claiming to provide “maximum governance” has lost credibility. What is far more unfortunate though is that the Reserve Bank of India (RBI) has got embroiled in the mess. Not only has it managed the transition with extraordinary incompetence, its Governor having announced on November 8 that it had “ramped up” production of the new notes, but its officers have had to be suspended for abetting money laundering. The public had viewed the RBI as above the sectarian calculations of the political class and the brazen corruption associated with the government machinery. This has now been shattered. The Narendra Modi government has succeeded in turning one of our most precious institutions into yet another government department.
If this government is unwilling to acknowledge its responsibility for governance, we may turn to a consideration of its grand strategy. In a flexible narrative following the exchange of much of the demonetised notes, which belied the hope of their extinction, we are told that the exercise is actually a grand success as its intention was to bring the money into the banking system! We may overlook the apologia and look only at the arguments made by the government’s spokespersons. Two are made. First, that a larger volume of deposits will spur lending and increase investment. And second, that once most of the cash has “come into the system”, financial transactions can be tracked by the government.
That with banks flush with funds their lending will increase is based on a fallacy. For, so long as the bank is not loaned-up, i.e. its loans-to-deposits ratio is not at the maximum permissible, the volume of lending will be determined by the demand for loans. In fact, it is not obvious that even a lowering of the interest rate will lead to this. The economics profession has long recognised this. It had first been noticed in the U.S. during the 1930s. The rate of interest fell but private investment did not increase, precisely because there was a paucity of willing borrowers. It is this that had led Keynes to characterise the use of monetary policy to revive an economy as “pushing on a string”. Or, you may recall the proverb, “you can take the horse to the water but you cannot make it drink”. Essentially, private investors compare the cost of capital, represented by the rate of interest, to the expected rate of return on the project. In times of uncertainty the expected rate of return would have to quite high for a project to be chosen. As there is so little that is objective to go by, expectations are now reduced to mere ‘animal spirits’. Recent experience should have given us some idea of what to expect at present. Credit growth had been sluggish even before November 8. In fact, private gross fixed capital formation has been depressed for a couple of years at least, even though the RBI has lowered the policy rate twice in 2016. This had led the World Bank to remark that recent growth in India was being driven, quite unusually, by public investment and private consumption. Unless firms are so impressed with the potential of the demonetisation, they are unlikely to unburden the banks of the deposits that have so copiously flowed into them since.
But let us return to the role of banks. Well before suffering the ignominy of having some of their officers found with hands in the till, so to speak, they had piled up bad loans termed non-performing assets (NPAs). L’affaire Vijay Mallya has shown them to be of poor judgment when not actually corrupt. Can we now expect them to wake up and start lending efficiently on a scale high enough to make a difference to the economy? The timing of the announcement of a lower lending rate by the State Bank of India (SBI) should leave us wary of the possibility that the government will exert pressure on the banks to lend to boost demand and raise the level of activity in the economy. A ‘political business cycle’ with government pump-priming the economy before elections is said to occur in western democracies. In India the government has an extra lever in the form of a nationalised banking sector that can be forced to dance to its tune. The very poor lending decisions of public-sector banks commencing in UPA II have resulted in a high level of NPAs. Hopefully at least now the RBI will caution banks against ‘throwing good money after bad’ to please their political bosses.
The current priority is to remonetise the economy, and fast. The RBI and the banks must eliminate the cash crunch that has resulted in livelihood loss, especially in rural India.
One would expect that this alone should keep them busy for much of the rest of the financial year. NPAs come in the way of banks expanding their loan portfolio.
The government is yet to address this issue or to give its view on one of the solutions proffered, that of a ‘bad bank’, which must perforce be a public undertaking.
A task cut out
In an environment characterised by slowing growth, poor investor sentiment and NPA-strapped banks, the government’s task is cut out. Dogma alone stands in the way of one recognising it. The macroeconomic strategy should now make use of fiscal policy. An occasion is presented by the budget for the year 2017-18. When private investment is skittish, one would reasonably expect public investment to step in. The budget for the present year did little for aggregate demand with the fiscal deficit down and the allocation for public investment merely inching forward. With the sops announced by the Prime Minister in his speech on New Year’s Eve, there is the possibility that in its eagerness to display commitment to fiscal consolidation, the government may cut public investment. This is not mere speculation. In the year 2015-2016 capital expenditure had ended up at less than what had been budgeted.
Altogether, this government appears reluctant to expand public capital even though it is in short supply in the economy. For every demonstration that India has a higher cash-to-GDP ratio compared to the rest of the world, we can point to its lower level of public services, not to mention human development compared to even some of our neighbours. The government’s zeal for squeezing cash out of the system is not based on any serious economic analysis of what the economy needs right now. Moreover, the Prime Minister had come promising minimum government. In this vein, he should leave the decision on the use of cash to the market, as his government is happy to do in some other crucial instances. There is nothing to say that the honest citizen should leave her money with the bank rather than under the mattress so long as she pays her taxes. The state must strive for accountability, always.
Pulapre Balakrishnan is Professor of Economics at Ashoka University, Sonipat, Haryana, and Senior Fellow, IIM Kozhikode, Kerala.

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