Neelkanth Mishra | Sep 16, 2024, 11:40:00 PM IST
This appeared in the Economic Times on 17 September 2024 (link).
The economy has slowed over the past few months. Sales growth has decelerated for both consumption items like cars, and for proxies of investment like cement. This was visible in the June quarter GDP report, and things haven’t improved in the first two months of this quarter.
Two of the major drivers are well understood: election-related slowdown in government spending, which should be temporary, and weakening of exports given wobbly global demand and China’s overcapacity, which can last. But there’s a third factor as well: the economy’s running short of money.
That song from Cabaret, ‘Money makes the world go round’, was on the mark. As much as it’s a store of value, money is also the medium of exchange for all economic transactions (barter is rare today). If adequate money is not supplied, economy starts to slow.
While there are many measures of money supply, for most practical purposes, it’s the sum of currency in circulation (‘hard cash’) and bank deposits, with the latter accounting for more than four-fifths of money in existence. This is why the debate on the persistent shortage of deposits is not an arcane problem for bankers, but a macroeconomic policy challenge.
Monetary theory is an important part of economics. But despite decades of thought and research, the process of money creation is not as well understood as one would like. There is consensus on who creates money – central banks, by buying government bonds or foreign currency assets, and commercial banks, by giving loans or buying bonds. But when it comes to the exact mechanism through which this occurs, views diverge.
On one side are economists who believe that the quantity of money can’t be controlled, and that the financial system automatically creates money the economy needs (‘Money supply is endogenous’). Money supply can be influenced by calibrating the cost of money (read: interest rate).
Others believe that the central bank controls ‘base money’, and then commercial banks use that to create the money necessary for the economy to function.
Perhaps reflecting this unresolved debate, textbooks state that the quantity and cost of money can’t both be controlled accurately at the same time, an economic version of Heisenberg’s ‘uncertainty principle’ in physics. But even if the exact mechanism of money creation may be unclear, we can analyse the problem via RBI data that splits the current money stock into RBI-created and bank-created money.
Since 2000, RBI’s share of the stock of money (measured at the M3 level) has fluctuated between 16% and 23%. However, its share of incremental money supply over the last 12-24 months has been just 14%. Initially, this was deliberate, as RBI tried to drain surplus liquidity it was forced to inject in 2021 when it bought dollars to prevent the rupee from appreciation. However, over the past year, its share of money stock slipped to a low 17% in January this year, and is up only marginally since.
To be sure, in trying to keep liquidity in marginal deficit till recently, RBI was only following instructions of its liquidity management framework. However, RBI-induced money creation has lagged. This is either because rise in government cash balances drove an unintended tightening of effective liquidity for much longer than normal (more cash with government means less banking system deposits), or because some (still unknown) part of the economy created headwinds.
Add to this the ‘destruction’ of money when banks’ equity base grows. Last year, the banking system reported a record high ₹5 tn of profits, taking a record amount out of the deposit system. As a result, for more than 30 months now, banking system credit has grown faster than deposits, pushing loan-to-deposit ratio (LDR) to record highs.
When banks were asked to reduce LDR, they had to slow down credit, thus restricting bank-led money creation too, slowing overall money supply growth to single digits. This sharp curtailment of the credit impulse is hurting economic growth.
These are early days yet. But it appears that RBI is now trying to address this problem, with a noticeable change in its liquidity stance. Since late June, overnight liquidity has been in surplus. The major driver of a 2-yr high in durable liquidity was the dividend paid to GoI in the second half of May. But recent foreign currency market interventions also point to deliberate liquidity injection.
The resultant decline in effective overnight rates below the repo rate has so far not transmitted to lower borrowing costs in the interbank funding markets for longer durations (say, for 3 or 12 months), as the market doesn’t trust that this surplus will last.
If markets continue to ignore this change in stance, RBI may have to resort to stronger measures. It can make an explicit comment – look the other way when bank LDRs rise (this is how higher banking equity can transition to more deposits), or cut cash-reserve ratio (CRR), which is 50 bps higher than in the pre-Covid period.
The inevitable rise in government spending, given that the 4-month fiscal deficit was only 17% of the full-year target (the lowest this century), should help revive economic momentum. But with exports unlikely to improve meaningfully, reversing unintended tightening of money supply is important.