Weekend Reads from India: Credit vs. Cash and the Season of Resets

The world over, it has been a season of resets.

In India, there has been an unprecedented stir in the country’s political economy following the government’s recent decision to ban a large proportion of circulating cash. On 8 November, the government canceled 86% of India’s circulating cash, or roughly $210 billion in rupees. TV shows, newspaper articles, and online media have been providing an incessant flow of expert insights and updates on the currency ban.

Economic and physical hardships, including long queues to withdraw money, have not dented public opinion so far. Many politicians around the world have channeled the problems posed by economic inequality into electoral success. The experience in India so far is no different. But does this currency ban matter? What should India watchers expect?

It is unclear how long it will take for the economic effect of the ban to play out. The immediately affected areas are noteworthy: Cash-dependent sectors such as real estate, hospitality, automobiles, and many others have a revenue shortfall. With currency returning to banks, the loss in purchasing power is expected to be less than 5%–10% of listed market cap. This would imply that the wealth effect, if any, will not be significant. Individuals and small businesses in the informal sector — representing roughly 80% of India’s workforce and 30% of GDP — however, are likely to face the strongest short-term financial distress.

On the monetary front, the central bank has temporarily hiked the cash reserve ratio as part of its response to the liquidity surge. But the combination of a lowered inflation trajectory and additional liquidity is expected to bring policy rates down. Lastly, national security has felt the effects as well. By drying up the pool of illicit funds, the currency ban may have brought about a mass surrender of Maoist rebels.

A developmental economist has compared the currency ban's effect on India’s fast growing economy to shooting out the tires of a race car. So far, about 60% of the banned currency has been returned to the banks. The pace at which money is returned opens up other possibilities for policy makers and economists to consider. What if economic forces are resilient enough to reflate and bring a large proportion of the money back into the system? Perhaps credit is more important, and cash in circulation matters only when credit dries up? In any case, for now the benefit of weeding out illicit money from the system appear to be overshadowed by the cost of the exercise.

The larger and more troubling question is how policy makers will close the operating channels of illicit money creation — the tax evaders and other sources of systemic corruption. Social learning theory demonstrates that reducing corruption depends on the willingness of those involved to start trusting non-corrupt behavior. Perhaps a combination of overall economic improvement, technological progress to a digital society, and behavioral changes are all required. The transition to a cashless society is difficult — but in the meanwhile, India's financial decision makers must demonstrate leadership in integrating the informal sector into the larger economy.

Insightful Thoughts on the Currency Ban

• "It Is Not Money but Credit That Makes the World Go Round" (Prof. Jayanth R. Varma's Financial Markets Blog)
• "Demonetization Dos and Don’ts" (Project Syndicate)
• "Currency Swap and the Reality Distortion Field" (Livemint)
• Subbarao on demonetization. (Livemint)
• Shooting the tires of a racing car. (The Economic Times)

Wisdom on Markets

• Kenneth Rogoff: "The Case Against Cash" (Project Syndicate)
• Paul Krugman: "Why Corruption Matters" (The New York Times)
• Bill Gross: "Populism Takes a Wrong Turn" (Janus Capital Group)
• "Could Article 127 Be Used to Keep the UK in a Single Market?" (Financial Times)
• "Why the Conventional Wisdom on Peak Oil Demand Is Wrong" (Financial Times)

Investing

• M&A in the UK mutual fund space. (Financial Times)
• The history and perils of discounted cash flow (DCF) valuation. (Financial Times)
• Brokerages striking it big in India? (Financial Express)
• Aswath Damodaran: "Myth 5.5: The Terminal Value Ate My DCF!" (Musings on Markets)
• "Akash Prakash: China after the Plenum" (Business Standard)

Game Theory, Behavioral & Other Fun Stuff

• Thoughts as shadows of emotions. (Speaking Tree)
• Game theory and the China-Pakistan corridor. (Livemint)
• A short history of wars: Who is fighting whom and for what? (Times of India)
• Gender inequality protests in Iceland. (Boing Boing)
• "The US Elections: The Games Politicians Play" (Livemint)

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.

Image credit: iStockphoto.com/JLGutierrez