Home / Opinion / The monetary policy committee’s realistic currency swap assessment

The messy reintroduction of banknotes into the Indian economy over the past few weeks has attracted the largest share of public attention because of the ample drama involved. It is now perhaps time to refocus on an equally important question: What is the likely effect of the withdrawal of specified banknotes on economic growth in the coming quarters?

The caution shown by the six members of the monetary policy committee (MPC) that sets interest rates is in sharp contrast to the general hand-waving by several instant economic experts, on the one hand, as well as the dramatic forecasts by some financial firms on the other. Their basic point is that it is too early to tell. The monetary policy committee members also seem to believe that the effects of the currency swap on economic growth will be transient. The edited minutes of their latest meeting were released on Wednesday.

Such caution is realistic given the uncertainty right now, and thus welcome, though the Reserve Bank of India will at some point have to stick its neck out by providing some specific numbers about how the currency swap will have an impact on the economy. India does not have a system of dot plots provided by members of the monetary policy committee, but the private sector will need guidance on the growth expectations of those deciding monetary policy.

There are two ways in which the monetary shock will (rather than could) hurt economic activity. One, the disruption in supply chains that are heavily dependent on cash transactions, i.e. the informal sector. Two, the negative wealth effect that could hit the economy in case real-estate prices tumble.

What is not clear is the extent of the impact. The first bits of data that are now available do not support the extreme view that the Indian economy has collapsed because of the decision by the Narendra Modi government to withdraw banknotes of high value from circulation. The trends are mixed. There is the resilience shown in activities such as rabi sowing, imports, cement sales and airline bookings on the one hand, and there is the weakness indicated by the decline in truck rentals, car sales and prices of perishables on the other.

Much of what is available right now is data for November, which may seem better than expected because of orders booked earlier as well as hasty purchases made as part of the nationwide rush to get rid of old currency notes, sometimes at discounted rates. The real picture will be available only in the coming months, and even then it seems doubtful that a total economic collapse is likely. However, there will be continued pain in the informal sectors where cash rules.

Forecasts about any economy hit by an exogenous shock are bound to be fragile. It is worth remembering that the darkest forecasts about the impact of Brexit on the British economy—an economic winter—have as yet not been proven to be true. As economist Deepak Lal has pointed out in the Brexit context, popular forecasting models that are based on projections of existing trends are incapable of dealing with structural changes for which there is no previous data. The same scepticism is relevant in “demonetized" India as well.

What now? A lot depends on how soon the currency in circulation is replenished. Many analysts predict that it could take several months for things to revert to normal. The cash crunch could actually ease much before that. Here’s why.

People hold cash for three primary reasons: for daily transactions, for emergencies, and as a store of value. What really matters right now is the money that is needed for daily transactions, to lubricate economic activity. Monetary policy committee member Chetan Ghate has quite rightly mentioned the “fast restoration of the transaction demand for money" in his statement.

Our informal estimate is that around 70% of the demand for cash in India is for transactions, so the Indian central bank needs to pump in Rs10 trillion or so to get the usual ease of buying and selling back on track, even if one does not consider the spike in digital payments. That should be achieved in the next few weeks, though more Rs500 notes need to be in circulation to break the current mentality of hoarding notes because of rationing.

In short, the currency shortage should ease very soon. But the impact of the currency policy will linger longer. A drop in economic growth is very likely. A total economic collapse is very unlikely.

Is the effect of the currency swap likely to hit economic growth in a major way? Tell us at

Subscribe to Mint Newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.

Never miss a story! Stay connected and informed with Mint. Download our App Now!!

Edit Profile
My ReadsRedeem a Gift CardLogout