Thursday, December 22, 2016

Demonetisation could transform Indian banking

Demonetisation, in my view, is not primarily about black money and corruption nor  about moving to cashless economy. It's about financial deepening. This could transform Indian banking and boost the Indian economy.

Here's my article in today's BS, 

Since the article is behind a pay wall, it's reproduced below:

Way back in 1969, Indira Gandhi decided to nationalise private banks.  She summoned I G Patel, then special secretary in the ministry of finance, and gave him 24 hours to prepare a Bill for Parliament, a Cabinet note and a speech Mrs Gandhi would make to the nation. Patel dutifully carried out madam’s orders.

In his memoirs, Patel records that he would have liked the move to have been better planned. Nationalisation should have been accompanied by restructuring to produce  one or two large national banks and multiple regional banks. Little of this has happened to this day. Mrs Gandhi judged correctly that planning every detail would take her nowhere.

Mrs Gandhi’s detractors denounced the move as politically motivated. They saw it as part of her battle against the old guard in the Congress and an attempt to weaken the Swatantra Party which was backed by the private owners of the banks. They said it was an effort on Mrs Gandhi’s part to portray herself as pro-poor and anti-rich — exactly what Prime Minister Modi’s critics are saying today.

All this was, of course, true. But, then, politicians will always be driven by political motives. The most important motivation is to acquire and hold on to power. The right question to ask is whether their political motivations are married to the larger good. Bank nationalisation passes this test — and there is every prospect that so will demonetisation.

Bank nationalisation marked a watershed in India’s post-independence history. Government-owned banks spread their branch network into the interior and mopped up small savings of millions. As a result, the household saving rate jumped from 8.1 per cent of GDP in 1968-69 to 14.4 per cent in 1978-79, causing the overall saving rate to jump from 12 per cent to 21 per cent. The rise in the saving rate set the stage for an increase in the growth rate from the Hindu rate of 3.5 per cent of the previous decades to 5.5-6 per cent in the eighties.

Public sector banks’ (PSBs) access to low-cost savings in the seventies and eighties enabled them to become profitable in the post-liberalisation era. Exposing PSBs to private competition while keeping over 70 per cent of banking in the public sector allowed efficiency to improve while maintaining banking stability.

Mrs Gandhi thus created a serious disruption that yielded benefits over a long period, thanks to financial deepening. Mr Modi has done exactly the same with demonetisation — and the outcomes are likely to be very similar.

Demonetisation is not primarily a drive against black money or even a change to a less-cash economy, although it has been packaged as such. Observers are right to be sceptical on both counts. Without follow-up measures, demonetisation is unlikely to make a big dent on black money. The role of cash can come down only over a long period.

Demonetisation is best seen as carrying forward the agenda of financial deepening that commenced with bank nationalisation. The gains to banking  promise to be  substantial.

Bank nationalisation brought a large number of individuals into banking on the liabilities side. It also brought in SMEs on the asset side. Demonetisation promises to deepen individual relationships on the liabilities side. It also promises to bring a large number of merchants, traders and SMEs into banking on both the liability and asset sides. It’s a great leap forward in terms of financial inclusion.

This has the potential to transform Indian banking and revitalise it precisely at a time when a large chunk of it is moribund. Banks will have access to more deposits and a larger proportion of low-cost deposits. This should cause interest rates to decline. The fall in interest rates will be gradual, given that we cannot afford a flight of foreign funds invested in the financial markets.

Once cash flows of small businesses begin to get routed through the banking system, their accounts will become far more transparent. This will translate into more lending to small businesses which carries higher yields than corporate loans. Banks have already woken up to the potential of microfinance. The two together will give a big boost to profitability in banking.

The decline in interest rates will lead to capital gains on banks’ holdings of government securities and help recapitalise PSBs. K V Kamath estimates that the banks have gained ~1 lakh crore in the last quarter. He thinks they will gain another ~1.5 lakh crore through a one per cent decline in interest rates in the next six months. This seems too optimistic but the basic point is valid: A fall in interest rates makes the job of recapitalising PSBs easier.  No wonder bankers are upbeat about demonetisation even as economists are divided on it.

Mr Modi’s critics say he should have planned better: More notes printed in advance, more of small-denomination notes, faster recalibration of ATMs, etc. Many of the criticisms are valid. The short-term distress is very real.

But the critics miss the larger point: The most serious distress the nation faces today is not creating new jobs. Two of the most important constraints to job creation are global economic conditions and the state of Indian banking. There isn't much we can do about the first. By revitalising banking, demonetisation promises to ease the second constraint and open a path to faster growth in the medium term.

For some two-and-a-half years now, Mr Modi has proceeded cautiously, allowing himself to be guided by those familiar with the Delhi durbar. He seems to have sensed that plodding along the familiar path would not yield much — in political or economic terms. A game-changer was required. This is the risk-taking Mr Modi of the Gujarat days.

The insight of the gifted politician can often bring about a transformation in ways that cannot be arrived at through a strictly analytical process. So it was with Mrs Gandhi and bank nationalisation. So it could well turn out to be with Mr Modi and demonetisation.


Unknown said...

The gung ho narrative about the windfall to banks is a trifle unfortunate when one looks at the distress caused in general. If the cumulative costs and real distress which has even aggravated the frail health conditions of some resulting in dozens of fatalities is taken into account then instead of this act of a gifted politician, frankly it is an act of crime. What were the force majeure conditions in existence that prompted such an act other than the megalomaniac need of a ‘gifted politician’. It’s a bit harsh to talk about the profits to accrue to the banking industry when they themselves have made a mess of the situation and run up so many NPA’s and what is it to prevent them being in the same situation in time from now considering the interference of political actors in the disbursement of loans and the need of prioritization. To top it all dozens of defaulters just have to walk across the borders and continue to live lavish lives with their ill gotten wealth which the banks have connived in providing them in the form of debt, debt that is savings of the ordinary person. Actually it is quite funny that not much is talked about how the government keeps transferring the country’s wealth to the bankers inspite of their rank bad performance.

One percent of india’s population holds 53 percent of the wealth and ten percent hold 85 percent or there therabouts. It would have been so much easier and justifiable in the light of the decision of this decision to enjoin this economically advantaged crowd to part with a decent amount of their wealth as a one time payment to save the banking system, rather than looting the vast multitude of disadvantaged countrymen of their time, wealth ( loss in work days, lack of work )and making them endure distress. And then garbing all of it as a ‘bit of distress’ is rather egregious.

There has to be the consideration of the ethical angle to any decision taken by the government especially in a democracy. It’s not always about the cash flow and profits. That’s how a business man thinks not a leader who bears responsibility to the millions of people in this country. For the business man more is always good and if it costs some lives in the bargain it sure is ok as long as it cannot be attributed to him. This is not the first time that this gifted politician has indulged in such an act for sure.

Unknown said...

A capitalisation of banks without change in bankers incentives would lead to crony socialism. Also wait for restrictions to ease and how much money stays in the system. Lots of laundered money has come in the system which will go out. Finding virtue in a disaster doesn't take care of cost benefit analysis.

Anonymous said...

Thanks Prof! ... Well balanced article, different perspective from what we see in the press ... But the moot point remains as to how to contain future black money generation and to bring back the black money from abroad which I am increasingly suspecting govt has started to give up.

Do you feel further lowering of tax rates would help in that? Mr. Modi also alluded to increasing taxes from capital markets in a recent speech. ... do you think that will help without much loss of revenue.


Suresh Korada said...

1. Who is a better allocator of capital - PSU banks or private individuals?

2. Will corrupt PSU bank officials lend to small traders and businessmen?

3. Can jobs be created with PSU money lending, do they lend efficiently or to the right industries/sectors?

Bhoopalan said...

Thanks Prof for a very fresh perspective.

What's Hindu about the growth/rates in the 1950s and 1960s... may be a good idea to call it Nehruvian-Leftist or Stalinist.


Sailesh C ROY said...

The approach points for bank nationalization was clear besides the role of DICGC also quite important as a harmony was needed to build confidence over small depositors for savings habit through banking channel besides asset creations through SMEs. The goal was well met no doubt about it with logical exceptions. The demonetization once again a game changer though the primary approaches i.e. black money and counterfeit currencies will find comfort in higher value smaller size currency so introduced. Counterfeit digital currencies are also now in the process of dream innovations definitely. Our respected PM has the power to function as a game changer. Though from 1969 to 2016 the Indian economy has been shaped itself in a much complex manner with disruptive technology. Change n ethics is the most important changes to stop all adverse actions. The major point thus is collaboration. Such collaboration at all level beginning with all state heads and down to take an applicable value statement. Our respected PM has the ability we believe. Actions should be beyond short-term political benefits. Indian common people already has expressed their loyalty towards demonetization. Now collaboration.

Anonymous said...


Unknown said...

The figures of currency not deposited in to the banks is yet to be assessed.That was also causing harm the to the assets by inflating it.

Unknown said...

The deepening of the financial services was long due.even in cities where there are enough Bank branches, it can be found that transaction in cash was preferred to avoid taxes. Now there is little curb on the same.