Demonetisation - What if deposits in banks are greater than 15 Lac Crores?

On November 28th the Reserve Bank of India stated that

Banks have since reported that such exchange/deposits effected from November 10, 2016 upto November 27, 2016 amounted to ₹ 8,44,982 crore (exchange amounted to ₹ 33,948 crore and deposits amounted to ₹ 8,11,033 crore). They have also reported that the public have withdrawn, during this period, ₹ 2,16,617 crore from their accounts either over the counter or through ATMs.

The expectation was that thereafter the RBI will release similar data every Monday. On Dec. 5th, when RBI did not release the data for the week past, speculation was rife that most of the money may have actually returned to the RBI. And further that it amounts to a failure of the policy and that there is no black money at all. 

The amount forecasted / estimated by sources of journalists is Rs. 12.6 Trillion. has been deposited in banks till Dec 6. Total bank notes in circulation as of Nov. 8 was about Rs. 15 Trn. We still have about 3 weeks to go. 

The correct way to establish how much money has returned is to look at this 8.44 Tr figure. That is the focus. 

So weekly average is about Rs. 2.8 Trn as per RBI and as per Moneycontrol it is about  Rs. 3.15 Trn per week. Going by the same run-rate estimates we can get at least Rs. 19.64 Trn to Rs. 22.46 Tr. If you understand the "last-minute" psyche of Indians, I think last week will get at least twice the weekly deposits. Then you will get between Rs. 22.4 Tr to Rs. 25.2 Tr. 

Please note that these numbers are more than Rs. 5Tr  to Rs. 10 Tr more than what RBI has printed. 

So here are my thoughts on this:

1. It is OK if all the money comes back to the RBI and either gets changed or deposited in the banks. It means there won't be any disinflation because of loss of currency. 
2. If money is deposited in the bank that does not make it white money. It merely becomes visible black money as opposed to invisible black money. Knowledge of the quanta so revealed that itself is a benefit. Further, it is open for authorities to review and tax these proceeds accordingly. So it is ok if the deposits reach Rs. 15 Tr. 
3. The problem is what happens when the total deposits/exchanged amount exceeds Rs. 15 Trn. Once it reaches 15 Trn can RBI tell banks now don't accept any more notes? Or it accepts and asks Government to pay (reverse of dividend)? [Please refer to my previous blog-post on Black money and demonetisation before demonizing me.]
4. I would say, the fact that entire Rs. 15 Trn comes back itself means that the problem of Fake Indian Currency Notes (FICN) was more potent than was admitted previously. If our run-rate calculations turn out correctly, FICN could be between 33% and 66% of legitimate Indian Notes. That is not a joke. It is also a success of the Demonetisation drive.
5. I would say about 20-25% of the notes would have been definitely destroyed. But given the tax amnesty announced let us assume about 10-15% were destroyed. The black economy was estimated at 20-25%. Assuming some can be dissipated as white (through jan-dhan and other tricks) we can say at least 10% would be black. Still about 20% of the currency in circulation could be FICN. Compare this with estimates of about 2-5%. 

To top it all Modi did not ask for 50 days to clean up the black money he asked for 17 months. So there will be more action coming. This will be interesting, to say the least.

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Black Money & Demonetization

The Government of India announced that the Rs 500 and Rs. 1000 denominated currency notes will cease to be legal tender. The move was targeted towards tackling black money, corruption and terrorism. After initial euphoria, questions began to emerge. What are the costs of this demonetization? Will it be effective if people can still create new black money thereafter? Will it increase the GDP? Will it increase inflation? What about tax revenues? We look for answers.

Black money and demonetisation

To start off, black money is a wider societal ill and demonetisation is but one step in the war against black money.

Black money and black economy are also two different constructs. The terms shadow economy and underground economy are also used as synonyms for black economy. 

Black money is the currency of black economy. It refers to illegal money earned from illegal sources which has not been disclosed to the government. The advantage of black money is that it links into the legitimate economy, uses the advantages of the legitimate economy but does not pay the costs.

Research on tackling black money

The issue of black money has been well-explored. The National Institute of Public Finance and Policy has been active in research about black money. Their 1983 survey of estimates of Black Money[1] led to a report on Aspects of Black Money[2] in 1985. The Report of 2012 titled Measures to tackle Black Money in India and Abroad[3] and the 2012 White Paper on Black Money[4] by Ministry of Finance covers the various research studies and updates them. These studies however have not been able to determine a consistent estimation of the black economy. The estimates, including from other sources, vary from 15% to 45% of the total economy. The papers, however, give a broad spectrum of mechanisms to deal with black money.

Apart from the above Indian initiatives, there have been global initiatives to tackle “underground economy” or “shadow economy”. Primarily, the principles remain the same. Internationally, I find, they focus more on facilitating voluntary compliance than enforcement. Maintaining trust and confidence in tax system takes precedence[5]. They also recommend risk based monitoring mechanisms, coordination amongst revenue departments and education among other things[6].

Principles of tackling black money

The first principle is that remove the systemic pain that leads to creation of black money in the first place. Blame lies with the tax department. Black money is nothing but money generated in legitimate transactions which are hidden from government so as to avoid paying the transaction cost (usually tax) in the legitimate economy[7]. This is usually done by using physical cash. This cash thereafter must be processed to convert into consumption or investment. Black economy refers to various activities, transactions etc. that help process this physical cash, create returns on this cash, facilitate consumption using this cash etc. 

The second principle has two parts. First, not all cash transactions are necessarily black money transaction. They become black money transactions only if they are hidden from the legitimate economy. Thus, a shop-keeper who does not give receipt but declares the sale (it’s only hypothetical) does not create black money. Conversely, a shop-keeper who gives a receipt but discloses other receipt book to the tax authorities (happens all the time) creates black money transaction. Second, the black money must at some time or other be plugged into legitimate economy. Thus, it cannot be done using user-created currency that cannot be exchanged with local currency. So it depends on legal tender. It means somewhere down the chain there must exist a person for whom part of this black money is legal cash income which he can use for his own consumption in legitimate channels. Usually, this is the construction worker, or other poorest of the poor who will give certain services and his income will remain under the government radar. It can also be illegal traders in gold or diamonds etc. who can convert this into precious items that have quasi-legal tender status. 

The third insight is that black economy is continuously fed by parts of white economy that go underground. Quite a few people who do not want to promote black money contribute to it. They are either coerced – say developer forcing buyer to pay him in cash or government officer seeking bribes in cash. Therefore, preventing white money from becoming black the starting point. The recommendations of Report titled Measures to tackle Black Money in India and Abroad describe some strategies. The core principle is to increase the cost of converting legitimate money into cash (wherein government loses ability to track it) and reducing the cost of electronic transfer also promotes electronic transactions. 

Black money flows through a separate channel. Such channel has infrastructure to handle black money. The fact is black money seldom remains in cash. It moves into high value items like real estate, diamonds, gold, films etc. The people involved in these sectors have well-evolved mechanisms to absorb black money. One way is to create entire value chains that use only cash. It is easy in sectors where workers/suppliers are unorganised, contract workers – e.g. Construction, films production etc. Bringing systematic regulations that make it easy for the participants in the value chain to accept electronic payments will curb black money.

Black economy depends on black money financiers. These are money lenders earning like 2% per month on their investments for financing the activities in black money friendly sectors. Film financing, construction financing, financing retailers, dance bars, alcohol, etc. These financiers also need enforcement mechanism to ensure their money is safe. Naturally they ally with criminal elements. Al Capone, the famous Chicago mobster, was previously an enforcer but later a financier. 

Black money faces the same invest or consume choice as legitimate money. On the investment side, it seeks sectors that are friendly for black money. So those people who buy many apartments from developers and developer later sells these for profit, are contributing to investment side when their agreements are not registered and do not pay stamp duty. Jewellers and traders of precious stones also contribute helpfully in this area.

On the consumption side, black money seeks to buy three things legitimate goods that can be consumed openly (i.e. normal things in abnormal amounts – say many shoes, many suits etc.), illegitimate goods that can be consumed secretly (banned or imported exclusive foods – caviar or expensive wines, expensive furnishings, home decorations etc.) or stored secretly (high-end safes, etc.). Within these sectors there exists trails that lead to the people hoarding the money.

Black money is also used in legitimate investments. Foreign channels play critical role. Quite substantial investments in P-Notes is actually round-tripped black money. The key aspect of these instruments is create anonymity by being away from arms of the laws of the country from where income can be fed into the legitimate hands. In such cases, the source of income is illegal. Thus, many businesses in tax-havens such as Mauritius, Cayman Islands etc. exist to convert illegal money into legal money. Many of these investments come under the purview of money laundering.

Incentives for electronic transactions help prevent use of cash. Income tax deductions on credit cards or e-payments up to a certain limit can incentivise electronic transfers. South Korea used credit card income deduction experiment has been hailed as a success by OECD.

Strategies for tackling Black Money

The distillation of various approaches can be summarised as under:

1. Establish identity of persons (through PAN Card, Aadhar Card etc.) operating in the country – citizens and foreigners.
2. Enable low the cost direct bank transfers (Implementation of NEFT/IMPS/RTGS and other formats) including direct transfers of subsidies to the beneficiaries under the Aadhar scheme.
3. Enable electronic register of assets (Underway through electronic land records, digitisation of revenue records)
4. Reform tax system so that cost of compliance is lower than cost of tax evasion. (through initiatives such as Saral forms, e-filing, self-declaration etc.) Indirect tax system through simplification (GST).
5. Widen the net for disclosure by filing Income Tax return. (auto-processing returns for tax refunds)
6. Regulations that increase costs for black money creating activities. (Prevention of Corruption Act etc.)
7. Create attribution chain for funds entering and exiting the country (such as through P-Notes, FDI, Prevention of Money Laundering Act etc.)
8. Create e-trails of both incomes and expenditure.
9. Control on holding of cash and physical money including Indian and foreign money. (FEMA, recent demonetisation)

It is clear that black money clean up is underway on many fronts. Many of the pieces of puzzle have been put in place.

Semantics of the current demonetisation

Demonetisation is the mechanism by which the government states to withdraw the money which is current legal tender. The government being sovereign can take such decision. The effect of this announcement is that the currency notes in circulation will now cease to be valid tender and can only be exchanged at the banks. Demonetisation of higher denomination notes as an idea has been around[8].

There are two important issues with respect to the present demonetization. First, that the notes ceased to be legal tender from midnight of 8th November just 4 hours after announcement. So in effect the only places where they will be accepted will be banks. Second, even the banks have been given time until when they can accept the notes – 30th December. Third, the cash swap carries restriction. Thus, in effect the announcement forces these notes into the banks deposits within a short period of time.

As per RBI estimates[9], 15billion notes of 500 denomination (approx. Rs. 7853.75 billion) and 6 billion notes of 1000 denominations (approx. Rs. 6325.68 billion) exist. In addition, RBI estimates that fake 0.2 million notes of Rs. 500 and 0.15million notes of Rs. 1000 were discovered. The actual number of fake notes in circulation will be higher. These will be worthless from 09 November 2016 but you can get the credit for the money held as these notes in the form of bank deposit. Naturally, those who can disclose deposits equal to the amount they hold in cash will have no problem.

Hasn’t it been done before?

Indeed, it has. The first demonetization took place in 1946 and Rs 1000 and Rs 10,000 notes were demonetized. Later in 1978, Rs. 1000, Rs. 5000 and Rs. 10,000 were demonetized. This is the third time demonetization has taken place. 

The critical difference is in the quantum however. The first and second demonetisations effected really high value notes which formed a small part of notes in circulation. We can arrive at the estimates by comparing the denomination of the note with the annual per capital GDP. In 1960, India’s per-capita GDP was Rs. 400 (then currency), in 1978 per capita GDP was Rs. 1722/- whereas today it is Rs. 103,000/- (today’s currency). [10]Thus in 1960, a 1000 Rupee note was 2.5X and in 1978 it was 0.5X per capita GDP, considerably easy to withdraw. The second aspect is that today the 500/- and 1000/- currency notes represents ~85% of physical money in circulation. At that time, it was considerable less[11].

RBI earlier removed pre-2005 notes of all denominations from circulation as they have fewer security features compared with subsequent notes. The process of removing the older notes from circulation continued for nearly one year. The deadline was extended till December 2015 and those notes continued to remain legal tender till November 8. This was not exactly demonetisation but removing from circulation and has now subsumed into the present demonetisation.

Why attack the cash?

First, who holds black money in cash? Mostly corrupt people. Their pay-offs are in suitcases and hoarded in their houses. These are balances held till they find their target investments. A lot of black money itself is mainly held in gold and land. 

As explained earlier, cash, i.e. black money is the currency of black economy. The government cannot do much about black money that remain stagnant if it remains a legal tender. But remove the legality of it and the government is able to alter the cost-benefits equation of corruption. Demonetisation attacks the currency supply of the black economy. But removing the cash available to buy these gold and you affect the supply chains in black economy. When the flow gets interrupted the cost of corruption increases and payoff reduces dramatically. Such action attacks the chain that processes black money.

It is possible that as a result land prices and gold prices will fall. If land prices fall, middle class will be able to purchase land. If gold purchases are reduced, the forex pressure on INR will ease a bit. Thus, legitimate money which was being priced out of the economy gets an opportunity. Further, it prevents the black money processing chains from forcing white money into black.

Inflationary or Deflationary 

Firstly, part of the actual money in circulation is never recovered. Depending on various conditions, at least 20% of this paper money will never reach banks. This stock of money is lost. Many believe this to be deflationary. It isn’t. Since this money was never within the legal purview it was meaningless anyways. From government’s point of view, it was like the money we forgot in an old diary and the diary was lost. This money did contribute to the economy but to smaller extent.

Some say “but this money was being used to buy Audis and other luxury goods”. This is weak argument. Audi as a company does not receive unaccounted money (if they do that is criminal as well). The black money chain in such cases effectively starts with the dealers who game the system by discounting the vehicle or by making the vehicle pre-owned, prior owner being the dummy person. In either of these cases the black money is circulating to other illegal users. If such deals are curtailed it is good – not bad. In any case a black money purchaser who pays Rs. 2.5 million to buy Rs. 4 million Audi then can buy a Skoda legitimately. 

Will it work?

One argument is we tried it in 1978 and failed. Of course we failed. First the notes demonetized were too large for the size of the economy. Second, we can fairly estimate that the black economy may not have used the super high value notes as much too. The present action has better chance of success as it proceeds logically. First, people across India were given an Identity card (Aadhar), then bank accounts were opened for them (Jan-Dhan), and people across India can transfer money using SMS today. No strategy can succeed without proper systems in place. This time there are better mechanisms that people can switch to.

Another argument is that people can deposit the money now and withdraw cash five months later for black money transactions. Of course they can. But there are various laws in place that track the cash withdrawer. These guidelines were framed for Prevention of Money Laundering Act. As per RBI rules under that, every withdrawal needs a PAN card reference. Further, every branch manager is required to file detailed statement of weekly/monthly cash transactions. The cost-benefit for legitimate fellows becomes high. It is easier to monitor for the tax authorities. One person claims to have sent his 200 or so employees to convert old currency into new currency. Thus, per day at Rs. 4000/- per person he is converting Rs. 0.8million into cash. So has the system failed? The answer is no. It appears from the logical approach followed by the government that this is merely the beginning of effort against black money. I suspect these two mechanisms will be taken care of in subsequent actions. 

The more fundamental answer is that black money is not a pool but a chain. Break the chain or make the chain costly and you inconvenience the poor who did not have access to bank systems. But with Jan-Dhan accounts, poor have ready access to banking channels (though not credit). So if you are law-abiding citizen then you can sail through mostly unscathed no matter how poor you are.

Black money in real estate gold etc. 

Usually, black money is used to purchase the following items – gold, precious metals, precious stones, real estate, high end consumer goods, high-end liquor, drugs, and entertainment. The total quantity of Gold, precious metals, precious stones, liquor and certain high end consumer goods in the market that is disclosed and purchasable is unknown. Their price is reasonably known. The quantity of real estate, entertainment etc. is known but their prices are not known to the government. For high-end alcohol, drugs and other items, both quantity and price are unknown to the government. 

This sort of black-money driven consumption is out of purview of the legitimate formal economy. The effect of demonetization on such consumption will be positive. Either this spending will cease thus reducing illegal imports of gold, precious metals, stones, liquor, drugs, entertainment of certain types (dance bars for example) etc. Other parts will integrate into the formal system thus prices of real estate, entertainment will generate legitimate revenue for government.

In short, the demand for these items will not be affected that much in short term and definitely not in long term. There is no denying that the contours of demand will shift from shadow economy to formal economy.

No magical government windfall gain

One argument goes that if a certain portion of the cash does not get deposited then RBI will no longer have to be liable for those notes. That reduced liability will be transferred to Government. If you estimate that about 30% of the currency notes will not come back, Government could be receiving about 30% of Rs. 14 Trillion is more than Rs. 4 Trillion. Such gains will be a game changer. Such arguments are naïve as they come from misunderstanding of how central bank balance sheet works[12] and also how money is created. 

One must remember that Balance sheet is an accounting construct to understand the capital deployment. Destruction of soiled notes, removal of older notes and other activities also do not create any income for government. Such activities merely adjust the balance-sheet on the liability side only. Simply put, there will be no gain to the government if RBI’s liabilities are written off. 

The issue in present case is the quantum of readjustment. If RBI balance sheet shrinks by 30% one fine day, there will be panic. But this effect can also be muted by writing down in phased manner while keeping the liability alive on paper. If this was possible you could have seen demonetization every 5 years. The only effect is that it will improve the quality of RBI balance sheet but no further.

The second part of the argument is that such a windfall need not wait for demonetization. The windfall is nothing but quantitative easing. That has consequences and is a well debated concept. 

Do Terrorists carry money in trunks?

One of the stated aims of the demonetization was to tackle terrorism. It has met with lot of ridicule. People are asking if terrorist do carry money in suit cases while coming across the borders. Again these people are missing the point. 

In fact, money laundering is one of the most important financing mechanism for terrorists. It was after 9/11 that the US initiated substantial push towards enacting of anti-money laundering laws to prevent financing of terrorists. The anti-money laundering investigations fails when the money trail leads to cash. In India the terror-finance trail starts and ends with cash making it impossible to get early alerts of terrorist active in the country. Demonetisation will upset the financing chain for the terrorists.

As noted, black money is the currency of black economy. It is the black economy, including financiers that need extra-judicial enforcement mechanisms. The terror groups are at the apex of criminal elements that provide this enforcement mechanism. If film producers do not pay their financiers, they get call from D-company – in effect an enforcement call. The black economy is also as innovative as any other. The criminal elements then seeking alternative revenue streams indulge in various terror activities. The terror finance chain comprises gold, diamonds and counterfeit currency. The counterfeiters don’t keep the money in cash but quickly convert it into legitimate, legal bank accounts through SMEs and other small businesses. Using these fronts these terrorists use this money to buy information and access. The actual terror attack is only the “last-mile” effect. The ultimate “attackers” are usually pawns without any knowledge of systems.

Yet, the main effect of demonetisation and subsequent introduction of new notes will be to increase the costs of the counterfeiters. It will serve to shock this supply chain.

The unscrupulous SMEs

The biggest elements in the black money creation chain are the SMEs. SMEs are flexible entities like sponges when it comes to cash. The question of scale of SMEs in the black money chain is mind boggling. Over years I come to believe that at least 30% of SMEs exist solely for serving the black money chains and about 80% contribute to the black money chain (many don’t have a choice). 

Their modus operandi is thus. SMEs themselves exist so as to help tax management. I refrain from using tax evasion because many of these acts are in fact legal and encouraged by law. Next, using a complicit banker the SME’s get loans. Their auditors are complicit in the process too. Now, unscrupulous promoters siphon cash away from these entities and fund private gains/marriages etc. Banks lending to SMEs are left holding the bag. This has also caused substantial stress in the bank balance sheets. Many of these SMEs are quite lax about filing financial statements with the authorities.

Thanks to the demonetization, some of these SMEs will be used to convert the black money from promoters’ holdings into the SMEs holdings. Conversely, those having illegal cash can push it into the SME balance sheet and “make it legal”. Readers may have guessed that banks will benefit from this when their bad loans suddenly start turning good. The net effect, I suspect, will be positive. 

It is clear that the next element in the fight against black money should be SMEs. These entities are critical elements and cannot be missed for this fight to succeed.

Other black money creators

There are other critical elements in black money chain or black economy. These elements represent turning smaller amount of white money into black by aggregation and misrepresentation.

For example, take NGOs. Some of the NGOs existing only on paper. Their model is thus. These NGOs collect legitimate amounts from citizens and push it into causes like animal shelters, girl child, medical aid to needy etc. The main problem is that the costs of these NGOs is unreasonably high. They also commit fraud by misrepresenting number of animals and kind of facilities etc. creating a source of black money for the promoters who get salary and or benefits like cars and drivers from the NGOs.

Cooperative banks are another piece of the puzzle. These accept smaller deposits from individuals and loan to founders and directors. The process is illegal and escapes the law only because it is not regulated by the RBI but by Politicians who are themselves directors in such institutes.

Government aided/recognized schools, colleges and institutions which look innocuous and have no actual teachers, students or infrastructure but simply using approvals from complicit education officers create a chain wherein legitimate money turns into black money. Others institutes have proper systems but use management quota to pool students’ money into black money pools for the founders. Some use both mechanisms.

Such entities are inherently different from SMEs which exist to service the needs of a wealthy black money holder or create black money through banks. These elements will be hit substantially by the demonetization and their promoters will be forced to declare these amounts or destroy them. However, the issue is that they can continue to create black money sources since their model has not been dismantled.

Role of Religious and other public trusts

The model of trusts is a little different but they are as important elements in processing black money as SMEs and others listed above. The trusts are both receptacles and users of black money. They are not creators.

Some allow devotees to make small but numerous donations while spending substantial amounts on expenditures related to their promoters. Others are created out of anonymous black money donations with specific beneficiaries. Their nature makes them a hot-potato issue where they seem to be untouchable by any government, religious entities being protected by constitution. 

These trusts will die over time as their feeder mechanisms are constrained. Yet, the reason they are highlighted here is because within the next two months we will see a lot of trusts being formed with weird articles of constitution that violate the basic premise of laws on public trusts. 

So will demonetisation eliminate black money?

Not by itself. It is just one move of one piece in the chess board of black money. To check-mate the black money king, you have to win the board. There are various steps required as detailed above. Government can play all these moves and still fail if they play improperly. All we can say is that Government is playing well. But will it succeed? The efforts will bring massive amounts of cash into the banking system – a benefit in itself. Once the money is in the legitimate channels, it should be better utilized and revenue will be generated from its use. If that is success enough then yes. 

Then again the government has tackled GST which represents 2/3rd of its revenues. It has tried to increase the size of the pie on which taxes are imposed by forcing the transactions into formal economy. The next part is reform of Income Tax which will tackle the remain 1/3rd of the revenue. Then will come loophole plugging. There seems to be well thought out method to this madness. Rest time will tell.

Notes and links

[1] http://www.nipfp.org.in/publications/working-papers/1509/ 

[2] http://www.nipfp.org.in/book/927/ 

[3] http://dor.gov.in/sites/upload_files/revenue/files/Measures_Tackle_BlackMoney.pdf 

[4] http://finmin.nic.in/reports/whitepaper_backmoney2012.pdf 

[5] Comparing how some tax authorities tackle the hidden economy by UK National Audit Office Rand Europe 2009 

[6] Reducing opportunities for tax non-compliance in the underground economy – Information Note dated January 2012 

[7] The Shadow Economy Friedrich Schneider & Colin C. Williams, Institute of Economic Affairs, 2013 

[8] Proposed by various people such as Arthakranti and also by Peter Sands in essay titled Making It Harder for the Bad Guys: The Case for Eliminating High Denomination Notes, M-RCBG Associate Working Paper Series | No. 52 in February 2016 and later discussed by Lawrence Summers and others. 

[9] https://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=1181 

[10] World Bank data in currency of respective year. Earliest data available is 1960 so we have used 1960 data. Devaluation was in 1946 which was way before this year. 

[11] The numbers based on estimates by various agencies. 

[12] For basics refer to Centre for Central Banking Studies Handbook – No. 32 Understanding the central bank balance sheet by Garreth Rule.

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Why is QE — ZIRP/NIRP not working?

Most people wonder as to why Quantitative Easing (QE) along with low interest rate policy is not making their life easier. John Mauldin and Neil Jensen in their letters are wondering where the road to recovery is? Where is the inflation? Where are the corporate profits? Where is the growth? QE and low interest rate policy were the response of FED to the crisis of 2008. Some central banks have already gone Negative interest rate policy. But as yet, they are not working. Why? Because they are not supposed to work.

The crisis of 2008 was the result of few forces striking together — an over leveraged borrower, inflated prices of collateral and banking system with management’s hand in the cookie jar (lower provisioning and accounting gimmicks to announce record profits), resultant working capital -denied supplier and a proprietary money-desk betting on failure of the main street engineered by bank runs. When the crisis unfolded the prop-bets made a X amount of money, main-streets bets lost a 10X amount of money and banks ended up in trouble. FED’s response — lowering interest rates and priming the pump through QE was designed to recapitalize the banks and not rebalance the economy. When viewed through this lens the action of the FED makes more sense.

With low-yield funds from the FED, banks bet in the markets and earn capital gains to buffer their balance-sheets. With the balance-sheets bolstered with excess capital, the banks may, if they take fancy to it, then start lending to the main street thereby kickstarting the main-street which will hire more, jobs will come back, incomes will rise and debt will be repaid and world will be glorious once again.

This lens also tells us that FED is not going to raise interest rates any time soon. Not yet. The reason is that banking system is ever more skewed. The banks figured out way to make money for the management and shareholders without going through all that trouble. Just bet on the markets — inflate the asset prices (we are at upper end of the PE multiple band for stocks, Housing prices are recovering when quality of jobs is declining) make the bets, earn the money, keep provisioning low but DON’T announce record result as some costs have gone up. If you are wondering which costs are going up when inflation seems to have losts its mojo — don’t ask me. “The math dont add up mate!” Since provisioning is not adequate, if asset prices were to correct, banks will be in ever more trouble. The “Too big to fail” have become “If I fail you really get fucked” big. They need high asset prices and INCREASING asset prices to justify and unwind this shit.

Oh and if you want a way to fix the banking for real — fix the main street and banks will fix themselves.

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Dollar, the International Currency system and the Ghosts of Connally

US Dollar took over as the world currency thanks to Bretton Woods 1944 at the end of the World War II. With the world facing tremendous calamity, a sensible system was put in place, incorporating the learnings from the failures of Treaty of Versailies.

Begining its inception, the European states set out on a development spree that has since remained unmatched. Even the rise of China in peacetime does not match the speed and quality of development. But with development, there appeared cracks in the Bretton Woods system. Well, not exactly the Bretton Woods system - but the currency system. There appeared an fundamental incompatibility between the unique construction of US Dollar and the structure of Bretton Woods.

The Construct of US Dollar

US Dollar created in the aftermath of American struggle for independance was gold backed as was required to be able to trade in the global system. At the early stage, US Dollar was indeed made out of gold-silver mix (1:15) and each dollar was backed by 1.60gm of gold. The gold-silver ratio was reduced to 1:16 thereby devaluing the gold equivalence which now came to 1.5gm gold for each dollar. The new coins were made by gold-silver mix so exact devaluation can be debated. However, the weights of the coins continued to be reduced over the 19th century.

This bimetallism had to be gradually dropped since the silver coin weights were reduced and later substantial silver deposits were discovered leading to wild price fluctuations. Thus US Dollar came to exclusive gold standard. The formal gold standard act backed the Dollar with 1.67gms of Gold - a smaller devaluation by itself.

Note that at the time, Pound Sterling was the dominant currency and it was exclusively backed by gold. The Pound also fluctuated in its gold peg till early 19th century where the British put in place the gold standard. Their wide-spread empire and british respect for the value of the pound contract meant it quickly became global currency. US Dollar was emulating this precedent. 

In this process the pegs to the gold were altered by World War I and subsequently in 1931 Britain gave up the Gold Standard, leaving American Dollar as strong contender for world currency. All this was formalized in 1944 at Bretton Woods.

The Second part of Bretton Woods Agreement

At Bretton Woods it was also agreed that exchange rates between some dominant currencies would be pegged to the US Dollar and they were backed by Gold. With such a policy in place, European countries started on most ambitious reconstruction plan. This was supposed to be an opportunity for the American companies and it was. But it also created many European companies who became competitive vis-a-vis their american counterparts and started a cross-flow of trade and commerce. In the process, more US Dollars were created and soon there were too many and not enough gold to back it. 

This fact was noticed by the trading community who started bidding up the Gold prices prompting John Connally to push for abandoning the gold standard. He said later "My philosophy is that all foreigners are out to screw us and it’s our job to screw them first."

The Fiat-Dollar era  

The Fiat Dollar continued its run as the global currency thanks to burgeoning US population, US growth and demand from US markets. International trade soon became thoroughly Dollarized. The dollar-peg concept went from Europe to Japan. The latest in that phase came the dollar-peg by East Asian Tigers and mainly China. These countries vountarily gave up their freedom to conduct their monetary policy - depending on prudence of the US FED. This system then created today's unique problems.

Now with US being the defacto currency in the world, US lost its ability to devalue. Faced with this situation, US followed what John Connally famously said "The dollar is our currency and it is your problem". It printed and printed and printed. And so did everyone else - by default. In effect we do not see US Dollar being devalued - the point gold bugs keep making. Without the devaluation US is not getting the turbo-boost to kick start the growth leading many to call the other countries' monetary policy as "predatory". This problem is a corollary of the famous "Impossible Trinity" or "Mundell-Fleming Trilemma".

What should be the decent international currency system?

It is now clear that monetary policy independance can be given up volantrily and also taken away by coordinated action. The solution many propose is to go back to Gold standard - which may be a good intermediate arrangement - but not a good long term arrangement. A better idea is to go for a two-level currency system. SDR may be a good starting point - but SDR's may not give us the true global currency we need.

The global currency and relatively-fixed (stable) peg to global currency could be a good system. It will leave the monetary policy freedom with national central banks and yet keep the system stable most of the time.

Readings

1. Volcker's FT Alphaville interview
2. Economist on Mundell-Fleming Trilemma
3. Yanis Varoufakis - And the weak shall suffer what they must. (book)

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Should banks create money?

Bloomberg has a post about centralizing money supply - whole money, as they call it. It is not a very good idea. This is not the first time such suggestions have come up. As mentioned in the article, Irving Fisher first proposed a similar plan in the wake of the great depression. Since then many have proposed this idea but not many understand money creation.

Taxonomy of centralized money creation idea

The money creation ideas are varied:

1. Gold money: This is natural money creation. No one has any control over the money creation. Previously, gold, silver, diamonds, precious stones and other valuables (and sometimes sea shells too) were used. Many serendipitous discoveries of valuables created havoc with the money supply. Discovery of Potosi in South America and thereafter further discoveries of gold and silver had the effect of expanding Spanish money supply. 
1. Not under any control: Neither governments nor banks, no one has any control over the money creation process.
2. But Non-Arbitrary: It depends on the amount of gold you have. If you want more gold, you better import more gold by giving some valuable service to the other countries  who have gold. Over time as the total amount of gold available starts reducing you need to offer more and more to the countries that have gold.
3. Though subject to Nature: If by chance you discover a gold mine, you will be filthy rich, though if you discover too much then it may unleash inflation. Spain is believed to have faced such inflation on the discovery of silver mines in the South American colonies.
4. Deflationary and restrictive: As economic activity grows it becomes too high compared to the total amount of gold available to back it. Thus it tends to slow the economic growth pace. (Don't know if that is good or bad).
5. Favours status quo, old money and advantageous to miserly: Since total value of gold you have increases with time, people tend to postpone purchases and hold on to gold. Spending happens when absolutely necessary.
6. Exploitation and Theft prone: A doctor can charge atrocious fees from a rich person because of bargaining power equations. Gold can also be stolen. Stealing credit cards is less useful.
2. Gold-backed money: Introduced to circumvent the deflationary gold currency, countries peg the value of their currency to the gold they can back it with. When people talk of gold standard they are referring to this type of money creation. 
1. Partly Government controlled: Government issues currency and states the total amount of gold they back it with. So a gold-to-dollar exchange rate is established. The government can improve its reserves and thus improve money creation. 
2. Non-arbitrary: In its pure form it is non-arbitrary and similar to gold-money.
3. Not purely nature driven but subject to shocks: Since the government has control over the amount of money and amount of gold, the money creation is not as whimsical as simply discovering a gold mountain. Governments can reset the exchange rate to compensate for some changes. But arbitrary government intervention results in shocks and disruptions.
4. Mostly deflationary: Governments cannot measure economic activity easily (yes GDP calculations are guess-work and there is no Santa Claus just in case you were wondering). That leaves money creation open to political whims and fancies and invites tampering of measurement of the economic health. Mostly governments are slow to acknowledge the real growth in economy since it is always backward looking. It realises the growth till the growth results in deflationary pressures then increases money supply and causes a spike.
5. Perception of money losing value as government reset gold rate: As total amount of product and services of value in the economy rise more than amount of gold to back it up, the government is forced to alter the gold-dollar exchange rate downward leading to people feeling that each dollar is worth lesser in terms of gold though purchasing power may be higher.
3. Government-created money: This is non-gold standard money. Simply speaking the government issues money and backs it with a promise. This is what people wrongly believe is the current regime. 
1. Full government control: The government has effective control over the process. This is a mixed bag. It depends on the government. 
2. Some central bank control: The exact control depends on how money is created, is it by using government bonds then bought to a certain extent by central banks or some other way (simply printing).
3. Depends on confidence in Government: Prudent governments enjoy advantages but if you are Zimbabwe then you will end up in trouble.
4. Inflation/deflation depends on policy: If a government print too much then it stokes inflation and too little results in deflation. Prudently executed (Milton Friedman's about 3% money supply growth) works fine.
5. Value of money depends on inflation: If the government is able to deal with money creation effectively then a mild inflation - say 2% may result. There is not too much loss in value and it can be notices only over long time frames when quality of life changes are also noticeable.
4. Money created by banks: Mostly commercial banks create money by giving loans. These loans do not exist as money. This is the most misunderstood money creation mechanism. It is distributed money creation, without extreme control. Bankers and regulators forget that its success depends on devising proper incentives. 
1. Less government control:No country uses this method exclusively. Both Government-created and bank-created money is deployed. Thus there is always government control of some sort. Also since government is also a borrower (a big one at that), it has control.
2. Part central bank control: Central bank exercises additional kind of controls in this mechanism. First, it can partner with government in its money creation process by buying government bonds etc. Second, it controls the lending to the banks and thus influences at what levels of risk do banks create money. The key word is influences and not dictates. Thus this process is often likened to "pushing at a string" (which is difficult, you can pull at a string pushing does nothing unless there is pulling at other end by the banks).
3. Control to banks: In this scenario, Banks can ALSO determine whether to create money or not. That decision is based on whether the person demanding the money will be able to repay it or not. If he can, it means he is creating value with this money and thus able to repay it. 
4. Decision at the point of demand of debt: The decision to create money is forward looking. It is made at the point the person makes a demand for the debt. That borrower is expecting to create future value. If by banks assessment that value can be generated ONLY then money is created.
5. Depends on incentives: After reading this if you wonder why banks lend for consumption goods or lend to uncreditworthy borrowers - it is because of incentives. The power to create money is substantial power and with bad incentives, it can cause systemic harm as seen in 2008 crisis.
6. Central bank oversight: Central banks have oversight duty to watch what kind of money is created by the banks. The nature of lending is supposed to be value-focussed. Some consumer lending at the time economy is entering a pro-longed boom phase can be advantageous. But in an economy which cannot sustain a prolonged growth phase, these are risky loans and their proportion needs to be limited.

My suggestion

Out of the options, I prefer the last one - a combination of bank created and government created money. It is quite forward looking and takes place at the point of demand. It needs a lot of oversight and decentralisation. I have argued that IT systems have in fact centralized the loan decision making than allow the front-line managers to make them. This has resulted in an inaccurate assessment of borrowers and partly responsible for the 2008 crises. Amar Bhide also makes a case for intelligent decision making in his book "A call for judgement".

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Is assessment of risk a function of interest rate?

The interest rate that can be charged by the bank has  two limits.

The Lower bound equals what the central bank charges the bank. Any lower and the bank will make a loss on its lending portfolio.

The Upper bound is the ability of the risk taker to bear the burden of return. Thus, if a bank lends to a business that makes 10% return on capital employed - it cannot charge more than 10% else it will be unviable for the borrower to seek the debt at all.

The Actual interest rate charged is determined by a combination of the following factors:

1. An assessment of returns of the business based on the economy and her business 
2. Income of the borrower in total 
3. The value of the collateral pledged against the loan as a security should the borrower be unable to bear that return 
4. The demand for loans AND/OR
5. How well the other loans are doing (health of bank's loan portfolio) AND/OR
6. A combination of these along with global factors

Spread

Bankers think of returns as spread they make on top of the lower bound, i.e. rate set by the central bank. 

Risk V/s Spread

Now, in the mind of the banker risk is correlated with the spread. When the banker perceives higher risk she fattens the spread. This "risk" we talk about is risk resulting to the banker. It does not mean risk of the borrower alone. So if the bankers' portfolio is turning bad, the banker will still increase the spread - partly to compensate for the loss she suffers and partly because she assesses the general economic environment to be more risky. Thus, even if the central bank reduces the benchmark interest rate, the banker is reluctant to pass it on if she can avoid it. This creates tighter conditions putting more stress on the borrower. This is why Scot Sumner argues the monetary conditions were actually tight when we were almost at ZIRP.

In an economy that is weak, it acts as a stronger head wind for borrowers. It reduces their ability to borrow and to service their current borrowing. They want to pay down their debt and reduce their loans. Therefore, the economy contracts further. The banks seem happy at first, but soon realise that other borrowers who are not prudent are pushed to default. The implication of this on the bank depends on the mechanics of the process - the proportion of those who default v/s those who pay back, the chronology in which it happens etc.

In the next phase, the economy recovers, predominantly with equity capital. Equity can absorb the losses since it is built for higher risk. The surviving firms and individuals are left with core strength to  thrive in intense competition and are more prudent with capital allocation. The banks thereafter can lend to these survivors to help them scale up.

What does this mean?

This means, 

1. There is inherent value to competitiveness that signifies its ability to survive and repay the debt and repay the equity at decent returns. This ability reduces with increasing leverage by the borrowers. Thus when Anat Admati suggests investment banks have capped leverage ratios to 20 or 10 it makes sense.
2. Banks' business model seems to encourage the use of debt only to amplify equity returns. It is fine in a way but if that is the objective then banks should reduce/cut lending at lot earlier than they do. Naturally, in times of distress when the return ON capital matters lesser than the return OF capital, banks get into big trouble. It seems they get confused about what is their business model. 
3. Maybe, better than ZIRP, unleashing a new Government-backed Good Bank to pick up assets at distressed prices at lending rates with narrow and fixed spreads can work better. If the size of this bank is large enough in relation to the banking system, it may result in a lesser shock to the economy.

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Of Free drinks and negative interest rate policy...

If soft drinks (Coke/Pepsi/tea/coffee etc.) were freely available would you tend to have more of it? Often I end up having one extra coke. If its tea/coffee I end up having even more. I will have to work it off that day through exercise or it will cause some harm in the long term. 

Zero interest rate policy (ZIRP) is like that - if you already wanted Coke and it was easily available you end up having a little more Coke. Likewise, if you already wanted debt, and it was easily available at almost zero cost, then you will have a little more. But not a lot more - coz you have to work it off.

But what if you don't want them?

Say your doctor told you to not have soft drinks at all - no tea/coffee too. Now will you have that? NO? Even if I give you some money - say 2 cents - to have these soft drinks? Still NO? 

Well, me giving you some money is similar to Negative interest rate policy (NIRP). Or similar to one aspect of NIRP. You get a tiny advantage if you take on debt. Is it that difficult to understand why it doesn't work as central bankers hope?

But may be NIRP could work...

Now some will agree that ZIRP may not work, but, they say, NIRP could work. They point to the second aspect of NIRP which is that if you save you get taxed extra. Now if I have $100 in cash in a bank, next year I will have only $98 so next year I will be able to spend less than I can do today. Isn't that an incentive for spending now rather than next year? I say not always!

There are a few reasons:

1. If the trends are deflationary your $98 next year may be able to buy as much as $100 today - sometimes even more. If the efficient market hypothesis* were working prices would adjust to reflect the new purchasing power. NIRP would create some deflationary force as well. Yes, it is small but it is deflationary never the less. So unless the NIRP was creating an overwhelming inflationary force, it may push a precariously balanced economy into deflation. 
2. The NIRP tax does not affect those paying down an earlier debt. In fact, it encourages people to swap new debt for old debt. Debt repayment helps you avoid the tax. This is even more deflationary.
3. NIRP does not work if I anticipate unpredictable cash requirements - say because I want to keep some money to invest when prices correct, or I think my business loan may need to be repaid if my business does not do well in next quarter, or I expect health care costs etc. In fact, it works reverse - in such cases, I would be encouraged to save $102 or $104 just to keep a buffer.
4. NIRP may push those with huge cash balances to move cash abroad. Do you think Apple and Google will bring that extra cash into a country with NIRP? No way! They might move it to a destination where it will be easier to hold cash. So is this what you want to happen? NO! Who gets affected is the individual who keeps getting taxed extra.
5. I may not want debt or I may not want to spend at all. I have the clothes, I have the phones, computers, TV, house, car, swimming pool etc - all the goodies I can spend on when you nudged me to spend the last time. Now I have mostly everything I need. So why should I spend on something I am not excited about? Beats me!

* I don't think Efficient market hypothesis works on a "point-in-time" basis - though it works on an average basis.

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Happy Dassera - Why we Indians buy Gold during Dassera / Diwali period?

Indian fetish for gold is well known. The whole of the country goes to the goldsmith and buys their gold during Dassera/Diwali period leading to a huge buying spree. A lot of people ask me how the custom of buying gold during the Dassera (leaves of specific tree that are deemed to be gold) / Diwali period (actual buying of gold) came into being. Then they read wikipedia and various stories about Kuber (the God's treasurer) and other related stories. Here is the real(!) explanation.

Actually the story starts with Ramayana. Ravana, the demon king, had accumulated huge pile of gold and it was kept in Sri Lanka. Ravana being conqueror of three worlds had quite a stock pile at this place. The Ramayana has vivid description of gold-palaces and gold plated public places in Lanka. Nonetheless, he was all powerful so the stock pile was out of bounds for accumulation for the rest of the world.

The sequence of events unfolded such that Rama ended up defeating Ravana killing him on the day of Dassera. Naturally the assets of Ravana were accessible to the investors after that point. Therefore, the price of gold dropped drastically leading to a buying frenzy fuelled by suppressed demand.

The South which got wind of the end of Ravana started trading in gold contracts using tree leaves. The North got the information about demise of Ravana when Rama arrived in his plane (with of course quite a bit of gold) by Diwali. (No bloomberg in those times!)

Today, the situation is quite the reverse, gold prices actually go up during the festive times and therefore it makes no sense to buy gold on Dassera / Diwali period. Rather buy it a month or two before.

To me this story seems more plausible than all the mythical stories we have been fed. But then I am a rationalist.

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Yen Vs. RMB - China crippling Japanese companies?

Yves Smith asked "Has Chinese Currency Manipulation Succeeded in Breaking Japanese Manufacturers?" bringing out the effects of currency management. You can read the sorry strategic choices facing the Japanese regulators.

China is buying yen forcing appreciation that renders Japanese companies less competitive. China is also buying Japanese bonds. Now Japan must buy US Dollar to keep their exports competitive. Now, both countries are dependent on US/EU/developed world demand and hence they are fighting amongst themselves to capture the reducing developed world consumption share.

This is a problem you face when the market country undertakes QE. The supplier country has no choice but to undertake its own QE without which it suffers loss in competitiveness. The quantum of QE the supplier country must undertake is not merely equivalent to QE undertaken by market country but must also adjust for QE by other supplier countries and relative competitiveness between suppliers inter se. Thus, the supplier countries must do a lot more and therefore must face correspondingly lot more risks.

Thus, my advice to Japan would be to print till balance is restored. (This is not my optimal recommendation but I believe this will be best way to achieve their intent.

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Measuring real value

What is a measure of real value?

Now we cannot measure value but in terms of money. It means all our measurement of value is relative. It is like measuring time in terms of heart beats - 1 minute is 60 beats. Now if you start running (say printing more money) then will you have more minutes? Of course not! We will have to adjust the equation of how many beats make up a minute.

Modified Gold standard or constant money
Let us look at the modified gold standard - modified for simplicity. The total amount of gold in the world would remain constant. We would keep creating more value. So there will be natural deflation. The amount of deflation will tell us how much value we created. This is fine overall but total amount of gold is not fixed. It grows arbitrarily. So when Spanish empire discovered huge silver mine (also used like gold) they had a problem. So will we if some buried gold is suddenly discovered. Further, as I argued in my book, gold promotes hoarding while slight inflation promotes transactions (or velocity hence GDP). So gold may not be appropriate.

I believe real analysis will only come if we use absolute metric for value. Why can't there be a debate about possible metrics? It is remarkable that for all the human progress we are not able to create an absolute metric for value. 

Value of Gold relative to financial assets

Paul Kedrosky is a very insightful commentator and today he shared a linked from JP Morgan research titled Gold is Way Under-owned Compared to Other Times When the World Sucked. The post comprises mainly a chart shown below:

Now, shouldn't the real value created between 1982 and 2009 account for the difference?

Do we really believe we are creating real value? We believe stock markets are ways to invest into things that create value. Now what happens to the value we have created between 1982 and 2009. Gold is growing very slowly while we have (assuming) created a lot of real value. This real value will sit in as financial assets thereby reducing share of gold. Right?

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Gold backed currency is not viable

There is a big debate about going back to gold-based currency system. It has some obvious limitations. Ellen Hodgson details a simple argument against gold-backed currency in the Web of Debt - Chapter 37 - The Money Question: Goldbugs and Greenbackers Debate.

Constant volume asset-backed currency is deflationary
Broadly, any asset backed currency - asset availability will determine the amount of money in the system. So money supply will be limited to the extent we can find the asset - here - gold. Now,this is by no means a stable solution.

Store of value v/s transmitter of value
The real problem, I believe, is due to design of money. Money was designed as carrier of value not as a store of value. It was designed as a river not as a dam reservoir. The arguments for gold-backed currency stem from "store of value" side and arguments against it originate from "transmission of value" side. Inflation helps transmission but can potentially hinder "store of value" concept. Deflation helps "store of value" but can potentially hinder" transmission" concept.

In sum...
I believe these two functions are separate and must not be confused. We need a new design for money - one that can fit in both roles. Will someone open the financial innovation tool-box please? Anyone? Pandora?


Link
http://www.webofdebt.com/excerpts/chapter-37.php