RBI’s other MPC problem – Minting, Printing and Counterfeiting..

RBI has been in news for two things.  One for its mon pol framework and other for its decision to take back currency notes issued before 2005. Interestingly both the news have a common acronym –  MPC – which is central to the issue. For first news,  MPC stands for Monetary Policy Committee and for second it stands for Minting, Printing and Counterfeiting..

In an interesting article, Prof Vivek Moorthy of IIMB helps understands this second MPC problem of RBI. Needless to say lot less is written about this second MPC which is far more important than the first MPC which is just a reorganisation exercise :

At the outset, let us recognise that there is not one rupee crisis at present but actually two. Reflecting the excessively outward orientation of both India Inc and the financial media, the focus has been on the recent, sharp decline in the external value of the rupee.

Unfortunately, the far bigger crisis pertains to the rupee’s internal value, the decline in its domestic purchasing power. More specifically, there are insidious problems in the payments system, manifest not just in the flight to gold, but in the disappearance of coins, and the counterfeiting of notes. To coin an acronym, I will call this the MPC issue. To most of you this acronym would bring to mind the Monetary Policy Committee. I shall instead use it to refer to something else, generally ignored—minting, printing and counterfeiting. MPC entails huge costs that are seldom analysed.

Last year, a newspaper reported that “fed up by the constant shortage and increased black marketing of coins, wholesale traders in Mumbai have minted their own coins and are using them as currency. So far, 50,000 coins of R1 and R2 have been minted and are being distributed in the wholesale markets of Bhendi Bazaar and Masjid Bunder … For one rupee coins worth R100, one has to pay R114, and for two rupee coins worth R100, one has to pay R115…”

Here is some analysis and trends:

Before getting to the analysis of this matter, let us look at some basic trends in coin and note issuance (see table). What do the data show? First, there is a growing shift from coins (which was about 4% of currency in 1970) to notes. Second, the bulk of notes in circulation now are large notes.

Lower denomination currency generally tends to change hands more frequently than higher denomination currency. These lower denominations tend to be coins and not notes. This is because notes tear easily while coins last. From the central bank’s point of view, the cost of printing a given note is less than that of minting a given coin. Nevertheless, overall notes are more expensive to issue than coins since they have to be replaced. (This is the case even when there is no inflation.) RBI’s website section on currency states that notes in India have a life of less than one year.

Although coins are physically durable, nevertheless they fail to withstand inflation. They tend to disappear with inflation due to one of the two reasons. First, it becomes profitable to melt down the coin because the metallic value has risen above the face value. The higher the price level, the more the meltdown.

Simple calculations can reveal how the longevity of the coin is related to the inflation rate. Let us assume that the coins get melted when their metallic value exceeds their face value by a 30% threshold value. At this threshold, it becomes worthwhile to collect, melt down and recycle coins for various uses. In practice, this 30% premium will depend on the risks of and penalties for getting caught, the changing and varying costs of melting different coins with different metallic content etc.

Assume coins are issued at par, with face value equal to metallic value. Let us also assume that the steady CPI inflation rate is 10% and the price of the metal in the coin rises at the same rate. Then starting with the issue of the coin at par, in year 2, the price level is 121, and in year 3, it is 133.1. With the assumed 30% meltdown premium, at 10% inflation, it pays to melt down the coin before the end of 3 years. At 4% inflation, the coin lasts between 6 and 7 years, and with steady 1% inflation, it lasts for 27 years before it gets melted down.

One could argue over what the premium should be, but the broad idea is that coins lose value quickly in time of high inflation. He says low inflation is critical to resolving this MPC problem:

When contracts are adequately indexed to inflation, going from steady 4% to steady 1% inflation may not seem much of a gain, compared to the painful recession required to reduce inflation. Those tolerant of inflation would say that it is far better to accept, say, 7% steady inflation for India and pay the relatively small MPC cost of that inflation, compared to the huge output loss of a recession needed to bring inflation down. On this, I beg to differ. Granted, the minting and printing costs due to continuing inflation may be acceptable, but not the counterfeiting costs, or rather risks. With high inflation as the number of notes proliferates, so does the scope for counterfeiting.

The risks of counterfeiting currency, which is a significant part of terrorist and war strategy, are related to geography. Petty, internal commercial counterfeiting of notes happens now and then. However, when there are long and porous borders with hostile neighbours that smuggle in counterfeit notes, the benefits of aggressively pushing for low inflation are quite high. In the interests of national security, India needs a single-minded focus on bringing inflation down.

Ideally, with very low to zero inflation and steady technical progress, the payment system for an economy can somewhat efficiently polarise into two types of transactions: on one hand, durable coins for lower denominations and universal use, and on the other hand electronic transactions, mobile phone payment systems, etc, for higher denominations and where electricity is reliably available. We must keep in mind that electricity is generally not reliably available in India, and certainly not in remote and/or border areas. Cash is still king not just because it helps people evade taxes, but because of its convenience value. This is so in many countries across the world too.

There used to be significant attention to this problem earlier. Lately, we hardly see monetary economists focus on usage of currency, counterfeiting and so on. It is mostly about jazzy work on macro-finance that matters. Not basics..

Can the establishment of first MPC resolve the problem of second MPC?

With large section of media and markets expecting RBI to pause tomorrow, perhaps it will be an eternal wait..

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