Currency swap and the reality distortion field

Narendra Modi’s surprise announcement of overnight cancellation of 86% of the currency is something of a reality distortion field


Photo: Reuters
Photo: Reuters

Walter Isaacson’s biography of Steve Jobs mentions the “reality distortion field” (RDF) about 34 times. It describes the charismatic power of the genius leader who could force his team to breach the bounds of thinkable thought. In mundane MBA lingo, it is translated as thinking out of the box. The term, coined at Apple, is borrowed from the 1970s Star Trek series in which aliens create their own new world through sheer mental force.

Prime Minister Narendra Modi’s surprise announcement of overnight cancellation of 86% of the currency of the world’s third largest economy (by purchasing power parity) is something of a reality distortion field. In a large developing country with excessive cash dependence, this was an unthinkable thought, let alone an actual decision. It is audacious, bold, and a risky gamble, many say. It even hurts some of the core constituency of his own political party. But by his extraordinary persuasion and oratorical skills, the Prime Minister has got the nation on board, and one survey says 82% of the public supports him.

“Corruption is a cancer” is a slogan we have been hearing for many years. When the rot is deep, you need harsh treatment with possible harmful side effects. Economists will forever debate the cost and benefits, and it looks like in the short term, the costs could be substantial. But seen from the RDF lens, the verdict that matters is the long-term verdict on this game-changer. For that, we will have to wait.

This is the season of the unthinkables. A person with zero political experience is elected to the highest office in the world’s most vibrant democracy—the US. The UK leaves the European Union after 43 years. India’s largest corporate group abruptly sacks its chairman. And then Modi presses the nuclear button on 86% of India’s own currency. Maybe not just unthinkable, it is the season for resets. Now that the unthinkable is possible, the black-money hoarders can forever be on nervous alert about possible future resets. It will also reset public cynicism about the impossibility of curing the cancer. It may rebuild the confidence of citizens in governance institutions, something thought unthinkable till recently.

While we wait for the impact of the RDF over the medium- to long-term, it is important to clarify two macroeconomic misconceptions. Firstly, no, this is not a negative monetary “shock”, at least in the conventional sense. Secondly, no, the fiscal side will not experience a windfall gain through the balance sheet of the Reserve Bank of India (RBI).

Was this (so-called) demonetization a monetary shock? (An aside: strictly speaking, demonetization means the removal of the high-value currency in circulation. Not reintroduction of new notes.) Consider the opposite situation. Milton Friedman suggested a famous thought experiment of a helicopter dropping cash all over the economy. This would obviously lead to inflation in the short run. Helicopter money is currently in fashion in these times of quantitative easing, when the EU and Japan are struggling to inject some inflation. So is India’s demonetization the obverse of helicopter money, due to the sudden suction of 86% of cash? Not so, because, in theory, all those notes will be replaced with new notes instantly. In practice, this is facing considerable teething difficulty. During that interregnum, it does work as negative helicopter drop, and hence is deflationary in the short run.

Consumption spending is down as new cash injection is slow due to the sheer challenge of logistics. More worryingly, as was articulated by Pronab Sen in this newspaper, the informal economy will bear some permanent costs. Those not linked with the banking system use high-value notes as a store of value. These are neither black-money hoarders nor tax evaders. These financially excluded households may also be socio-economically backward and low on financial literacy. They potentially face a huge negative shock. The other big constituency is the beneficiaries of the informal, cash-lending economy. They too face a negative impact on their working capital, with great danger of a wipeout of their businesses. So while technically cash replacement is not a negative monetary shock, it does have an impact on the informal economy.

Then, what about the impact on the RBI’s balance sheet? There has been some wrong analysis, which claims that since some old cash won’t be turned in, it would simply reduce the central bank’s liability. Estimates of this windfall gain vary from Rs2-4 trillion, equivalent to India’s entire fiscal deficit. The cheerleading and misguided analysts then gleefully conclude that the RBI can simply issue a large dividend to the government of India, equivalent to the reduction in liability. This is wrong on many counts. Notes are of varying vintage. Their write-down is over a long extended period. So the gains are gradual, and get recorded as special reserves. Secondly, the RBI has to keep issuing new currency to keep pace with at least the nominal gross domestic product growth rate. Thirdly, if the RBI tries to encash its gains by selling assets from its balance sheet, that might exacerbate the liquidity crisis. If anything, the RBI should be on standby to inject funds, if there’s large capital outflow due to any number of reasons. These could be the Donald Trump-induced risk aversion, the closing of the rupee-dollar interest rate arbitrage gap, the weakening rupee, and so on. So, no, fiscal deficit ain’t benefiting from the currency reset. If it were that easy, then we should reset every 10 years.

In summary, the macro impact is somewhat negative in the short run. But if the implementation glitches are sorted out quickly, then the RDF will hold sway. The unthinkable may happen again.

Ajit Ranade is chief economist at Aditya Birla Group.

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