Demonetisation of high denomination notes is likely to result in lower interest rates, says former Reserve Bank Governor D Subbarao. Subbarao, who was the RBI Governor from 2008 to 2013, has said banks will see their cost of funds declining even in the absence of any further policy easing by the RBI, encouraging them to reduce lending rates and pump credit into the economy.
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“As delegalised currency is deposited in banks and as new currency comes into circulation, some very positive dynamics will kick in. By far the most important outcome will be that as the shadow economy merges with the formal economy, it will spur economic activity into a virtuous cycle. This will be further buttressed by the ‘windfall’ deposits that banks will get which can be as high as 7.5 per cent of GDP,” said Subbarao who is now Distinguished Visiting Fellow at the Institute of South Asian Studies (ISAS), an autonomous research institute at the National University of Singapore.
“Real estate, which has been a safe haven for black money, will experience a squeeze. Although property values do not enter the CPI consumption basket, its benign impact will come through decline in rental values and transmission of that into the general price level. Government finances will improve as tax is levied and collected on the disclosed wealth which is reckoned as unaccounted. How big this will be is a matter of debate but there should be no doubt that the tax and enforcement agencies will scrutinize bank deposits with a hawk eye and come down ruthlessly on offenders,” Subbarao said in an article published on the ISAS website. During initial part of his tenure at the RBI, Subbarao reduced rates but raised it later to contain inflation.
In October 2012, when Subbarao, despite the government’s fiscal consolidation road map unveiled a day before, chose to keep the key policy repo rate unchanged in view of high inflation, the then finance minister P Chidambaram said, “If the government has to walk alone to face the challenge of growth, then we will walk alone.”
“A conservative estimate is that the government will be able to mobilise additional tax of the order of 0.5 per cent of GDP (Rs 65,000 crore). This will help fiscal consolidation, investment in infrastructure and in ‘crowding in’ private investment. The ‘cleansing of the system’ will be positive for both savings and investment. It will improve the ease of doing business, inspire investor confidence and raise productive capacity of the economy,” he said. Households, who have traditionally parked a bulk of their savings in physical assets like gold and dwellings, will now be positively biased towards financial savings which will have a significant multiplier impact on the economy, he said.
He said in the very short-term, delegalisation may hurt growth. The squeeze in cash will constrain consumption. “Arguably, delegalisation will also be disinflationary in as much as it cuts into non-discretionary consumption of items that go into the Consumer Price Index (CPI) basket. The faster and more effectively the Government and the RBI are able to handle the transition, the less will be the adverse impact. What is important, however, is the medium-to long-term macroeconomic implications, which are decidedly positive,” Subbarao said.
According to Subbarao, an issue that has engaged analyst attention and also baffled them somewhat is how the RBI will reflect the changes brought upon by the delegalisation in its balance sheet. “This is non-trivial, not only because of its implications for public finance but also for the autonomy of the RBI. All currency issued by the RBI carries a promise by the Governor to pay the bearer a sum equivalent to the value of the currency. This is a legal obligation,” he said.