Friday, December 02, 2016

Demonetisation and interest rates

Demonetisation was widely expected to bring about a sharp fall in lending rates on account of the surge in deposits in the system. The RBI's move to impound 100 per cent of incremental deposits starting from September 16 to November 11 has raised doubts over such a decline.

The RBI has said it will review its decision on December 9 (when it announces its quarterly monetary policy). The removal of currency is hugely deflationary and the economy could do with a monetary stimulus. However, we're seeing an exit of FIIs from the debt market and the currency has fallen. Given the knock to GDP and earnings and a forecast increase in the Fed rate mid-December, the RBI will have to be careful about dropping the policy rate. It would be a surprise if it cut the rate by 50 basis points as analysts had forecast and it would not surprise me if held firm.

Over a long period, however, we can expect demonetisation to usher in lower rates. Various other benefits will also kick in, notably greater financial inclusion and a reduced use of cash. I cannot resist noting how many respected bankers are upbeat about the  move in a way in which economists are not.

My guess is that more measures to attack black money will be forthcoming after December 31. What's being attempted is a paradigm shift- or, if you like, Big Bang reform. This is what economists have long been clamouring for but they couldn't have imagined it would happen this way.

More in my article in the Hindu, Dashed expectations.

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