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Watch out for more financial

The recent surge in bank deposits has lowered bond yields, even as
global rates are rising. This could trigger capital outflows
A week after the announcement of demonetisation (a misnomer, given that
highdenomination currency notes have not really been withdrawn and
merely replaced), the jury is still out on its effects.
The Government would want the common man to believe that the pain is
limited only to the short run. In the medium to long run, with banks being
flush with funds, interest rates will be lowered.
Further, it would like us believe that there are definitive gains to be made by
all in the form of a more transparent and cleaner economy in the long run.
Unfortunately, macroeconomic implications of any policy change are not as
simply explained.
Impact on interest rates
Bank repo rates, it is likely, will be cut in the runup to the Fifth Bi-monthly
Monetary Policy Review on December 7, 2016, on account of the huge funds
that have been mopped up by banks. An indicator of the southward movement
of interest rates can be seen by looking at the money market operations and
the behaviour of the daily weighted average call money rate (WACR).
The WACR is the operating target which the Reserve Bank of India seeks to
influence through its policy rate the repo rate. With the repo rate at 6.25 per
cent, the weighted average call money rate, which was 6.21 per cent on
November 8, 2016 the day demonetisation was announced, dipped to 4.44
per cent on November 14, and was 6.03 per cent on November 17, 2016. It is
clear that banks need to resort less to the inter-bank call money market funds
for their daily requirements of maintaining the cash reserve ratio.

Who benefits from such rate cuts and will such rate cuts really have a positive
impact on the economy? One, the rate cuts hardly impact the large percentage
of population (estimated at 58 per cent), who constitute the unbanked
On the contrary, the decline in liquidity on account of the restrictions in the
amount of notes in circulation, as also on the extent of withdrawals, will lead
to a rise in the interest rates in the unorganised sector and impact them
Will this drive larger numbers to be part of the formal banking system? Highly
unlikely, since the reasons for the financial non-inclusion may be more
deliberate, owing to factors such as lack of ability to provide collateral,
bureaucratic hassles and red-tapism, lack of adequate banking infrastructure
as also suspicion of the banking system at large among the poor unbanked and
under-banked segments.
Second, banks cannot use these transitory deposits turned into current and
savings (CASA) accounts (these are essentially short-term deposits), for giving
out long-term loans. It has been suggested that sectors such as highways and
shipping, where the demand for investments is huge, may be the natural
choice for such surplus funds.
However, given the long gestational lags in such sectors, can banks afford to
use CASA funds to finance the countrys infrastructure needs? These may
simply add to the banking systems strain by imposing higher mandatory
capital adequacy ratio requirements.
Third, as rates of interest in India decline, we can expect an outflow of funds
from India into more lucrative emerging markets, as also towards advanced
economies which have been experiencing a rising trend in their bond yields
since the beginning of the month. Thus, while the 10-year G-sec yield on
Indian government bonds declined by 30 basis points in the last month, yields
on other emerging market bonds have shot up by at least 30 basis points in the
same time, with Brazilian yields going up by 68 basis points.
Further, yields on German bunds have risen 22 basis points, on US 10-year
bonds have risen by 56 bps and on Turkeys bills have gone up 82.50 bps in
the same period. Such a bearish bond trend exhibited by India in the face of a

global bullish bond trend, will lead to capital outflows from India and
difficulties in financing our current account deficit (CAD).
Peoples expectations
It is important to analyse the outcomes of the demonetisation effort from the
point of view of what people expect to happen. The Rational Expectations
Theory an influential Nobel prize winning theory by Robert Lucas, based on
expectations of economic agents asserts that people try to forecast what will
actually occur, when forming their expectations. In doing so, there is a
constant effort to adjust forecasting rules so as to eliminate avoidable errors.
Past outcomes thus feed current expectations.
In such a scenario then, outcomes do not differ systematically (i.e., regularly
or predictably) from what people expected them to be.
From the rational expectations perspective, people may be caught unawares
sometime, and make certain forecasting errors. However, such errors cannot
occur persistently in one direction.

The current unsystematic and unanticipated move would have caught the
purveyors of black money and counterfeit money unawares. This may led to a
short-term impact on the amount of fake money in circulation, as also some
destruction of black money. However, as people begin to factor in these
developments into their expectations, the premiums and commissions
associated with corruption will only increase.
As such, the government may be better off adopting a credible policy stance
one that is understood by people and credible in its approach. Such a stance
would have have far greater chances of success.
There is no question of the reversal of the decision to demonetise. However,
the policy makers are better advised not to throw the economy out of gear
through persistent, unanticipated policy shocks.
Otherwise, the outcomes in the long run would be one akin to a more virulent
strain of bacteria resistant to all forms of antibiotics.

The writer teaches economics at the SP Jain Institute of Management &

Research, Mumbai. The views are personal
(This article was published on November 20, 2016)