Currency reform: a risky natural experiment

The popular quip being circulated in social media is on the money: India has seen an exponential increase in the number of economists ever since Prime Minister Narendra Modi announced his decision to withdraw banknotes of high value. There has been a gush of commentary on the impact this will have on the economy. Some of the best economists have jumped into the fray. Meanwhile, the hardship borne by ordinary citizens is undeniable.

Professional economists have a good reason to keep a close watch on the evolving situation. The currency reform is a great example of what economists call a natural experiment—albeit risky one. It is a sudden exogenous shock that completely alters the way participants in an economy take decisions. Such natural experiments usually offer rare insights into the economic process. They are analysed using statistical techniques that are not used in more normal times. Hence, how this decision plays out over a longer period of time needs to be watched carefully rather than jumping to quick conclusions.

Here are a few broad issues that deserve immediate attention.

First, the decision to withdraw old banknotes of high value has disrupted the monetary base in India. Currency in circulation accounted for 80% of the reserve money in India on 11 November. Some 86% of this currency in circulation was in notes of Rs500 and Rs1,000. So, the withdrawn notes are around 69% of the monetary base (and not the entire base as some have written). Never before has there been such a deliberate monetary shock to a smoothly functioning economy.

Second, what matters in a modern economy based on bank credit is not the monetary base but some measure of broad money, which includes both cash and bank deposits. It is important to remember that money is not the same as cash, though at least one investment bank seems to have made this rather elementary error in its research report on the impact of the withdrawal of old notes on the economy. A quick look at Indian monetary statistics shows that currency with the public accounted for only 7.3% of the broad money in the economy. So, the impact on broad money is far less severe than the impact on base money. What is happening right now is a shift in the composition of broad money—from cash to bank deposits.

Third, the stock of broad money in India is more than five times the stock of base money. In other words, the money multiplier is around 5.6. This standard analytical tool in monetary economics is determined by three variables—the monetary base, the cash reserve ratio and the ratio of cash to bank deposits (C/D) in an economy. The second is a policy variable which the central bank tinkers with while the third is a behavioural variable. The C/D ratio is normally stable—but the currency reform could change it dramatically. A drop in the C/D ratio (or when people begin to hold more of their money in bank deposits rather than cash) will push up the money multiplier, as long as banks lend out the money pouring in. In other words, the behavioural shift towards bank deposits could lead to an unexpected expansion in money supply, and perhaps provide a cushion against the reduction in the monetary base.

Fourth, the big problem is that a large part of the Indian economy is still outside the banking system. So, the cash shortage will hurt the informal sector that does most of its transactions in cash. The distinction between money and cash hardly matters here. The problems in the informal sector will pinch the formal sector as well. The drop in biscuit sales at the local paanwala will eventually hurt companies that supply these biscuits. If one looks at the structure of employment in India, cash-based activities such as construction, transport, small retail and restaurants account for a big chunk of employment outside farms.

Fifth, one of the intense debates within monetary economics is on the rather technical question of how money is created. Is it created by the central bank through the expansion of its balance sheet? Or is it created through the expansion of bank credit that the central bank then accommodates? Is money exogenous or endogenous? The ongoing natural experiment in which money is first being destroyed and then created could offer some interesting insights into this tricky issue.

The point is that the currency reform is a game-changer in the true sense of the word. It is quite clear that the immediate impact on the economy will be negative. However, the massive expansion of bank deposits will bloat the contribution of financial services to the increase in gross domestic product in the third quarter, a statistical illusion that could downplay the real impact on economic growth.

The real puzzle is what this means in the long run. Much depends on whether this exogenous shock alters citizen behaviour—in terms of whether less cash will be used in the future, whether the tax base will expand as more transactions are done through the formal financial system and if other policy measures restrict the creation of fresh black money.

There is a good reason why the attention of economists around the world is focused on India. This is a rare, and perhaps unprecedented, natural experiment whose deeper effects will be known well after the dust settles down.

Niranjan Rajadhyaksha is executive editor of Mint.

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