Probable impact of demonetisation on RBI balance sheet and monetary system…

As this blogger was wondering about the economics and logistics of the demonitisation (demon) and some trends too), was woken up by friends from markets. Their worry and sense of excitement was completely different. Keeping these basic problems aside, the interest was mainly in arbitraging from this demon exercise. The questions were what happens now to RBI balance sheet? Will rise in deposits lead to lower or higher money market and G-sec rates? Will it lead to lower or higher liquidity? Whatever it is, financial market players are always looking to arbitrage whatever the situation. Take it or leave it.

One decided to take it and atleast think through the circle of events. Given one’s earlier work on the topic one started from some basics.

Right at the start one must admit that this post is laced with loads of assumptions. In one stroke it is assuming people will find it easy to exchange or deposit cash, have bank accounts and so on. The reality is obviously different. The main purpose is to just understand the flows  in the abstract monetary system.

First of all, demon should mean RBI Balance sheet should decline as that is what leads to money being taken away from the system. But this is not the case here as we have swapping with new notes. So things get complicated. Moreover, the swapping may not be one on one as some might not disclose the entire cash given penalties and charges.

So say before demon RBI Bal sheet is like this:

Liabs                                                Assets
Currency              100                        G-sec                                100
Bank Reserves     100                       Foreign assets (forex)   100

So say 20% of currency does not came back to RBI. This leads to lower liabs.

Liabs                                                Assets
Currency                80                        G-sec                                100
Bank Reserves     100                       Foreign assets (forex)   100

The question is should RBI reserves or give govt profits? Then balance sheet is like this:

Liabs                                                Assets
Currency                80                        G-sec                                100
Bank Reserves     100                       Foreign assets (forex)   100
Profits to Govt       10
Reserves                 10

The higher one time profits will lead to lower fiscal deficit and this will lead to lower yields. This is one of the hypothesis.  However, this defeats the purpose of demon. As any reserves or profits will eventually come back to the system.

For demon to make sense, ideally RBI should cut the assets by 20%. . Come to think of it this is what demon should mean. Mon means rise in reserve money or RBI Bal sheet and demon means decline.

The next q is how does rbi cut assets. Two ways. By reducing GSec or forex.

Liabs                                                Assets
Currency                80                        G-sec                                90
Bank Reserves     100                       Foreign assets (forex)   90

If forex, then RBI sells fores and sucks liquidity. This means  liquidity should tighten and money market rates should go up. There will be downwards pressure on rupee as well.

If G-sec via OMO sales then yields should go up and liq again declines. Either way liquidity declines and in OMO sales we see yields also going up.

What eventually happens will depend on currency coming back and RBI deciding what to do of demon. Though if history is any guide, then the opposite happened. Last time demon happened in 1977-78, we saw both currency in circulation and RBI Balance sheet actually rising in 1978-79! So no case of tight liquidity etc but liquidity actually rising…

Another point is inflation back then. If inflation was high than nominally these values will rise. Mid 1970s inflation was very high due to oil shock and then started to decline a bit. After this demon ideally inflation should have declined but it rose significantly as there was no demon really as explained above. Inflation also rose as we see fiscal deficits also rising from 1978 onwards…

However, story does not end here. Another angle is rise in bank deposits. People are going to exchange currency in two ways. One is the direct exchange and another is deposits via the banking system. The above changes in currency in RBI liabs will happen via the banking system. The cycle is likely to be this:

  1. People come to a bank.
  2. Some choose to exchange. This gets reflected in RBI liabs straight away with some lag.
  3. Others choose to deposit first and then take out money when needed.
  4. So first the deposits with banks go up. This leads to rise in so called CASA balances of the bank. Thus, banks may not need to go for deposits etc for sometime.
  5. This rise in CASA will lead banks to park 4% of proceeds as CRR with RBI.

How does this show in RBI balance sheet eventually. Let us say 50% choose to deposit and 50% choose to exchange. So the Rs 80 aboe is divided into Rs 40 between currency and deposits.

The balance sheet of RBI in near future will be like this:

Liabs                                                Assets
Currency                40                        G-sec                               ??
Bank Reserves      111.6                   Foreign assets (forex)   ??
(100+0.04*40)
Total                      151.6

We see steeper decline in balance sheet here from 180 to 152. This is because as explained above it takes time for deposits to be converted to currency. So we have a case for a steeper cash crunch in the economy in near term. So on one hand rise in CASA deposits puts downward pressure on interest rates. On the other as it takes time to be converted back to deposits, it indicates cash crunch at RBI end. It will again depend on net net between central bank and banks. Banks might not be impacted as they have deposits but other players could face the crunch.

Another factor which has to be added is cost of printing these massive number of notes. This cost needs to be taken into account as well which also shrinks the balance sheet.

So lots of stories and linkages. What I have tried to do to best of my ability is to list these linkages. There could be some missing as well. The reality could be very different as seen in 1978. Moreover, what we have tried here is the accountancy angle. We could see no cash crunch at all due to several other known and unknown factors.

Things are different this time as Rs 500 and Rs 1000 notes with many people unlike 1977. How eventually people decide to exchange/deposit is what will matter.

I think I have only confused people more by this post. There are just no easy answers. Markets are dynamic in many ways and will move based on every bit of cue…

One Response to “Probable impact of demonetisation on RBI balance sheet and monetary system…”

  1. A. Vasudevan Says:

    Frankly I was confused. Best to go thru the RBI balance sheet as it appears in the Annual Report. And then react to the so-called demonetization of high value notes. And please stick to the words as they appear in the balance sheet.

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