Assessing Impact Of Demonetisation Remains A Moving Target: Gita Gopinath

Additional liquidity will only benefit banks if they can channel it into lending, says Gita Gopinath

A pair of scissors, a magnifying glass and other accessories are displayed on a tabletop (Photographer: Anindito Mukherjee/Bloomberg)  
A pair of scissors, a magnifying glass and other accessories are displayed on a tabletop (Photographer: Anindito Mukherjee/Bloomberg)  

India’s experiment with demonetisation, the largest such exercise ever undertaken, has caught the attention of global economists. From former U.S. Treasury Secretary Larry Summers, who raised questions about how successful the move will be in curbing corruption, to Harvard Professor Kenneth Rogoff, who advised emerging economies not to ‘try this at home.’

Gita Gopinath, professor of economics at Harvard University, has also argued against such a dramatic move, recommending instead, a more ‘gradualistic’ approach. Speaking to BloombergQuint during a visit to India, Gopinath said that the first order impact of the demonetisation remains uncertain and dependent on how quickly cash can be replenished in the system.

Assessing Impact Of Demonetisation Remains A Moving Target: Gita Gopinath

Data released since the government announced its decision to withdraw Rs 500 and Rs 1000 notes from circulation has suggested some hit to economic activity already.

The Nikkei India Services Business Activity Index sharply fell to 46.7 in November from 54.5 in October. The corresponding manufacturing Purchasing Managers’ Index also fell in November but remained above the level of 50, suggesting that activity continued to expand. Meanwhile retail inflation fell sharply in November to a two-year low of 3.63 percent but was driven down largely the price of perishable items. As such, the early data indicators are yet to give a clear clue on how deeply economic activity will be impacted by demonetisation.

Apart from the first order impact, Gopinath also highlighted the negative wealth shock that could follow if real estate prices fall sharply due to the spillover impact of demonetisation. Black money has long been a significant component of real estate sales and analysts expect prices to fall if sales need to take place entirely through accounted-for funds.

Assessing Impact Of Demonetisation Remains A Moving Target: Gita Gopinath

Other economists have also drawn attention to a possible negative wealth effect from the cash that does not come back to the banking system. However, since atleast 80 percent of the Rs 15 lakh crore has been deposited in banks, this risk has reduced.

In a report dated December 14, Pranjul Bhandari, chief India economist at HSBC noted that if a large part of the scrapped currency comes back to the banking system, the negative wealth shock may be limited.

Gopinath, who is also an adviser to the government of Kerala, also noted the impact of demonetisation on the cooperative banking sector, adding that the real impact of the withdrawal of currency notes on informal sectors of the economy may never be known.

The chief minister of Kerala, which has a strong network of cooperative banks, has strongly opposed the government’s policies. According to a December 11 report by the Press Trust of India, Pinarayi Vijayan, the state’s chief minister termed the decision as one that was “worse than emergency.”

For Banks: A Boon Or A Bane?

Just as the impact of demonetisation on the economy remains uncertain, how it plays out for the country’s banking sector is also a question mark.

Banks have been flooded with deposits, with Rs 13 lakh crore of old currency being deposited. While the RBI has sucked out excess funds through the issue of market stabalization scheme (MSS) bonds, liquidity remains comfortable. Analysts have also noted that even after withdrawal restrictions are lifted and deposits flow back out, demonetisation will end up being net positive for the banking sector.

Gopinath, however, argues that this will only be positive for banks if they can find productive ways to channel these funds. At present when demand for credit is low and investment demand remains weak, channeling excess deposits into well-earning assets may be tough for banks, suggested Gopinath.

Credit growth fell to 6.6 percent on a year on year basis in the fortnight after demonetisation, according to data released by the Reserve Bank of India (RBI).

Gopinath also questions the suggestion that the amount of new currency that the RBI will print will be lower than the currency in circulation before demonetisation. The government has suggested that the entire stock of currency may not be replenished and that may be one way in which citizens can be pushed towards greater adoption of digital payments.

I think it’s hard to force it and say that we are not going to remonetize. At some point, they will have to relax the norms on withdrawal. Once that happens, depending on the demand of cash in the economy, they will have to supply the currency notes...So, the statement that you are not going to remonetize is not completely clear to me. You can obviously encourage people to go towards digital forms of transactions but you cannot force them to do so. 
Gita Gopinath, Professor of Economics, Harvard University

RBI’s Credibility Dented?

The RBI’s handling of the demonetisation process has raised questions on the independence and the credibility of the country’s central bank. Questions have been raised on whether the demonetisation was recommended by the central board of the RBI or whether the central bank was pushed into accepting a decision taken by the government.

Since the announcement, there have been a number of flip-flops on deposit and withdrawal rules as well.

Gopinath, however, felt it is unfair to question the central bank’s independence based on this one instance. “I am not going to jump and say something about the RBI’s independence based on these actions taken,” she said.

Uncertain Global Environment

Commenting on the recent rise in global bond yields, Gopinath explained that the bond markets are catching up with expectations of more expansionary fiscal policies from the Donald Trump-led US administration. If this rise in bond yields continues, emerging markets could be at the receiving end of selling by foreign investors.

Foreign portfolio investors (FPIs) have sold Rs 44,785 crore in Indian debt since the start of this year, with most of the selling coming in November and December.

In the past when interest rates have gone up quickly in the US, that has usually been associated with severe weaknesses in emerging markets. There have been tantrums of all kinds in financial markets with capital flowing out. So if there is a rather quick jump in interest rates in US, which is not outside the realm of possibilities, that would certainly have a negative effect on emerging markets.
Gita Gopinath, Professor of Economics, Harvard University

Gopinath also cautioned that changes in US tax policies could incentivize capital to stay within the country’s borders, which in turn may impact even long term flows into economies like India.