An interesting side effect here of India’s demonetization plan. As we know, the Rs 500 and Rs 1,000 notes have been cancelled as legal tender, to be replaced by other notes and designs. There are limits on how much cash can be changed for cash (Rs 4,000, soon to fall to 2,000) but no limits upon what can be deposited in bank accounts. Of course, large deposits are going to be subject to tax scrutiny, rather the point of the exercise in fact. But what is interesting is that the flood of cash being deposited is such that it’s actually bringing interest rates down. This is an interesting and welcome macroeconomic effect:
State Bank of India (SBI) reduced rates on deposits from one year to 455 days to 6.90%, down 15 basis points, while keeping the 7% rate for deposits between 211 days to one year unchanged. That may not be great news for those putting their money in banks but lending rates are likely to follow suit in a few weeks, possibly giving sluggish credit expansion a much-needed boost and shoring up growth. A basis point is 0.01
“All rates will fall,” said SBI Chairman Arundhati Bhattacharya. “The bank has seen huge inflow of deposits but demand for credit has slowed down. Therefore, lending rates too will fall but after a gap.”
Agreed, that’s not a large drop but it all helps. Lower interest rates should, all else being equal, produce a stimulus to the economy.
There’s also another interesting effect here, the money supply will be smaller as well. That of course is contractionary, just as that interest rate change is expansionary. But India does have inflation and as Milton Friedman told us, inflation is always and everywhere a monetary phenomenon:
Of the Rs 14 lakh crore worth of Rs 500 and Rs 1,000 notes that have been scrapped, roughly Rs 3 lakh crore are not likely to be exchanged for new notes ever. This entire extinguished or disappeared black money will be profit to the RBI, and will be transferred to the central government as dividend.
That does of course depend upon that estimation being correct. One lakh crore is, to those of us using the western notation system, one trillion, thus the current estimation is that 3 trillion rupees will be withdrawn from circulation. The total cash in circulation in the Indian economy is some 18 trillion Rs, meaning that the demonetization will reduce that money supply, the base money supply, by 16 or 17 % or so. Dependent upon that estimate being correct of course.