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Indian Financial System’s Trust Deficit: A Catch-22 Situation?

It’s already over one and half year since the demon of Demonetization struck Indian Economy at the mid-night of 8 November 2016, Tuesday. There was a spirited call from the Prime Minister of India to allow 50 days to cleanse the menace of black money and parallel economy from the nation. The Demonetization led to massive cash crunch for several months and untold sufferings to the people. Similar situation unfolded on another Tuesday on 17 April 2018 when different parts of India witnessed another bout of cash crunch in the banking system- dry run of ATMs and ‘No Cash’ display boards at ATMs in major cities and rural areas across many states- Bihar, Maharashtra, UP, MP, Karnataka, Gujarat, Andhra, Telengana, and even in Delhi-NCR region.

Many cities faced this unprecedented ‘Neo-Cash Crunch’– Bhopal, Delhi, Noida, Hyderabad, Patna and so on. It reminded people of the Demonetization days in November-December of 2016. Struggling crowds, standing since day and night, were exhausted and dying, just to get some cash from one’s own account, that to just for survival!

…Critical Trust Deficit in public may have developed due to series of financial and monetary shocks Indian financial system has faced over last one and half years due to various policies and problems like- Demonetization, GST reforms, Bank NPAs, Banking Frauds…

Since, two months earlier, the situation of drying up of cash was coming to the fore sporadically. Yet the RBI and entire banking system seemed unprepared and didn’t mind to take care of the situation. Reports came about Andhra and Telengana governments’ writing to RBI about shortage of cash since two months earlier. Myriad explanations are being given at the moment- logistic problems, shortage of printing of big notes, procurement seasons, marriage seasons and so on. However, the most disturbing one may be critical deficit of trust of the public at large on Indian Financial System, including on the robustness and trustworthiness of its Banking System. The Critical Trust Deficit in public may have developed due to series of financial and monetary shocks Indian financial system has faced over last one and half years due to various policies and problems like- Demonetization, GST reforms, Bank NPAs, Banking Frauds and so on.

The Unwanted Demo Effect

Government of India’s demonetization drive had removed 86% of currencies in circulation from the market- a whopping Rs 15.44 lakh-crore (INR 15.44 trillion) by scrapping high denomination bank notes of Rs 500 and Rs1000- for eliminating black money, curbing corruption, restricting counterfeiting of notes and controlling high denomination notes funded terror activities. People faced unprecedented hardships for several months to get bare minimum cash just for survival- in the process several collapsed and died.

The RBI in its Annual Report for FY2017 had disclosed on 30th August 2017 that Rs 15.28 lakh-crore, or 99% of the scrapped currency notes, were deposited back with the banking system till end June 2017. Only 1% of the demonetized cash i.e. about Rs 16,000 crore, could not come back- so effectively lost as unaccounted black money within the economy. Hence, the black money (unaccounted cash) could not get caught by the government significantly – if any small amount was there, got successfully converted into white bank deposits. A clear failure of demonetization policy!

Essentially how demonetization impacted on the monetary system was: abrupt shock of uncertainty and substantial cash crunch due to insufficient preparedness of the entire banking system to handle such a colossal crisis. On 11 August 2017, Economic Survey-II revealed a 20% reduction in cash in the economy. It took several months finally, even with newly introduced Rs.500 and 2000 notes, for the cash crunch to get eased.

Then came the growth impact of Demo Effect. The first Quarter 2017-18 GDP growth rate was pegged at 5.7% by Central Statistical Organisation (CSO). It was the lowest quarterly growth in previous 3 years, far below the 7.9% growth a year ago (Q1:2016-17). A gloomy picture indeed! The GDP growth slip had started immediately after the demonetization (6.1% in Q4: 2016-17). So, the economy had slipped off the trend growth for two successive quarters of FY17, due to cash crunch shock faced by millions of small businesses and shortages of finances in informal sector.

Hurried GST Reforms

Another miscalculation from the government was hurried implementation of GST reforms on Indian business starting July 2017. Implementing another massive economic reform just one quarter after the cash crunch shock was not even fully stabilized and the economy had slipped off the trend for two consecutive quarters, was a very risky step in any way. The government was not ready with the GST infrastructure and other processes. Likewise, businesses were unprepared to handle the new GST registration norms and invoice filing processes. There were lots of delays in uploading purchase and sell data into the GST network and even the IT network was not fully ready to handle sudden and massive digitalization of billions of tax filings leading to frequent collapse of the network.

Over and above this, small businesses took longer time to fully grasp the complexity of the tax filing norms. There was delay in getting back input tax credits, costs of tax and invoice filings had suddenly increased for firms- especially MSMEs, who preferred to contract out the process. Lots of confusion over tax rates and controversy over the tax slabs led to protests by traders in different parts of the country- leading to trade delays, transaction & logistics delays causing inventory pile ups and further slowdown of businesses. States were highly concerned about their revenue losses which were to be compensated by the centre over a 5-year period. Industrialized states like Tamil Nadu, Maharashtra and Gujarat, feared significant revenue loss from inter-state movement of their goods, as the new GST tax was to be collected in destination states. Undeniably, the GST reforms had contributed further uncertainties in the economy in the second and third quarter of FY18- for a considerable period of six months.

Cash Crunch Now

The recent cash crunch had put the banking system under siege. Initial reasons given by the government were three fold: Procurement Season of Farmers, Unusual Demand for Cash due to festival/marriage season, and Probable Cash Hoarding. But non-functional ATMs across the nation are also a big menace which has been regularly causing trouble to the people for getting cash. But can the Neo-Cash Crunch be attributed to people’s panic in the wake of ongoing banking crisis- colossal bad debts and bank frauds? Partly, yes. Bank NPAs and bank frauds have definitely put people on a heightened level of caution- increasing their fear of losing their hard earned money in case a bank fails. Finally, the FRDI Bill has added fuel to this fear.

Let’s examine these issues one by one. Procurement season of farmers’ harvest is going on in various states, which is also partly responsible for the higher demand for cash. Farmers’ produce are being procured by the government wherein as per norms 50% payment in cash is mandatory. So it’s plausible that in highly agrarian states like MP, UP and Bihar this could have led to sudden deficiency of cash in the ATMs if adequate replenishment could not get placed.

Unusual Spike in Cash Demand

The Banking Department of Finance Ministry has found that there is an unusual spike in   demand for cash since last one month leading to the first fortnight of new fiscal year. The Finance Ministry has instructed the Income Tax department to identify the reason of this sudden spike of cash leading to higher cash withdrawal from the ATMs without subsequent return of those cash to the banking system. For example in Telengana, in a single day, there was 130% higher cash withdrawal from banking system without all returning back as deposits. This was observed in at least five to six states. The reason of non-return of a substantial portion of the cash as deposits to the banking system is yet to be identified- which is the mystery. But one thing is sure- as acknowledged by the finance ministry- that there has occurred a demand for higher cash vis-à-vis other mode of transactions leading to cash shortage of estimated Rs.70,000 crore.

Many questions emerge- such as, why cash has come back suddenly in demand despite demonetization and subsequent digitalization of payments had substantially increased in the economy? Why big denomination notes like 2K are not coming back to the financial system? Are they being hoarded by public as more reliable store of value than the demand deposits in banks? If it is so, then is it a result of Critical Trust Deficit on the part of public at large on the Indian financial system? RBI as the custodian of monetary system, has to ensure that the public trust must not get shaken from the financial system due to the unforeseen and undesirable events leading to political and economic shocks on the fundamental institutions. And the process starts with restoring as well as maintaining shock-proof autonomy of one-self first.

The cash fluctuation in the economic systems is known to be a regular events- RBI and banking system work in tandem to maintain balance between the demand and supply position of cash aided by printing of more bank notes if required along with the routine replacement of soiled notes. So the demand-supply mismatch of cash is a temporary phenomenon, and seasonal. Procurement seasons, sowing seasons, marriages and festival seasons in India thus witness higher ‘transaction demand for liquidity’- a term coined by Keynes. But these fluctuations occurs every year and known to RBI and leading banks, and hence there should be adequate response to meet the situation. The marginal mismatch between the demand & supply of liquidity thus is essentially avoidable. When this situation is unpredictable and mismatch is substantial, then only a situation of liquidity crunch in the financial system emerges. This in fact was happening in India in last two months at least- gradually demand for liquidity was rising by 30% to 40% higher level and currency supply was lagging behind without much replenishment from printing of new currencies.

Lagging of currency supply was reported to be due to tactical strategy of not to increase the circulation of high denomination notes. This is also expected to be as part of a broader stategy of phasing out and withdrawal of high denomination currencies from circulation. As per reports since last one year, additional ₹2K notes are not being re-printed- disclosed by the Economic Secretary at the Ministry of Finance. The share of newly minted ₹2K notes in total value of currencies in the economy as on March-end 2017 was little above 50%, as per RBI Annual Report for 2016-17. In case of sudden spike of cash demand RBI is expected to overhaul share and supply of big denomination notes. Failure of mapping this situation and taking strategic decisions will in fact lead to unprecedented cash crunch. If 2K notes are not further printed, then it is as per expectation in the post-demonetization months that within two to three years the high denomination notes may be phased out from circulation.

Whatever be the reasons of the latest cash crunch, among the multiplicity of reasons, one issue is relatively clearer- that the Indian financial system is at cross roads. It is in ‘Catch-22’ situation! And it needs total overhaul to fix the system.

Restricting supply of high denomination notes is likely to cause pressure on the velocity of circulation of money. And in times of higher economic growth, monetary economic theory (famous Cambridge equation) suggests that the velocity of circulation of money must be able to adjust itself for enabling smooth trade flows. But here two things are happening simultaneously- supply of 2K notes are restricted and economy is already growing at more than 7% growth. Both factors will put heavy pressure on velocity of money- in absence of significant growth in non-cash & digital modes of transactions, which is in fact the case. Only way to tackle this situation is by printing more smaller denomination currencies against the bigger notes, so that monetary velocity can be balanced, or cash demand can be normalized. Unfortunately, smaller notes were also not getting printed more leading to twin deficits of bigger and smaller currencies like 2K and 200 notes.

Cash Hoardings

Added to the spike in demand for liquidity, was problem of cash shortages due to possible hoardings. Rs.14.48 crore of cash hoarding, in the form of big notes of Rs.2000 and Rs.500, was recovered on 26 April 2018- major amount from the election bound state of Karnataka (The Hindu, 26 Apr 2018). This indicates strong probability of their use in the upcoming election. The government had directed the Central Board of Direct Taxes (CBDT) and the Enforcement Directorate (ED) to trace the cash outflow from the banking system. As large amount of cash outflow in certain parts of the country was not followed by equivalent cash inflow as deposits into the banking system- it was well under doubt that cash currencies were being hoarded for illicit purposes.

Non-Functional ATMs

Primary findings from an July 2016 RBI survey of 4000 ATMs throughout the country revealed that around 30% ATMs of public sector banks (600) and 10% ATMs of private banks (100) surveyed were non functioning/ mal-functioning. The prominent reasons found were- technical problems, non-availability of network, power failure and non-availability of cash. RBI had warned the banks of penal action if the compliance levels were not met. As on May 2016, there were 1,02,779 on-site ATMs  as well as 1,11,492 off-site ATMs in India as per the RBI data.

ATMs have become loss-making service for banks as inadequate user fees are not enough to recover the costs, thus pushing banks for cut in free ATM transactions (since Nov 2014) and more technology/online apps usage to cut costs. The government was also pushing for online transactions post-demonetization through BHIM app, RuPay cards and supported other digital platforms like Paytm. In fact, shortage of cash post-demonetization had increased usage of digital transactions in the country, with lesser dependence on cash. Moreover, inter-bank ATM usages have not increased since then to avoid user charges. So, the entire process of demonetization, digitalization of payments system and restriction on free ATM transactions must have diminished the pressure on the ATM networks in last one year.

Panic from Bank NPAs & Bank Frauds

Indian people are facing critical trust deficit from ongoing banking crisis- colossal bad debts in public sector banks and bank frauds. The total amount of stressed assets in the banks have grown more than double from March 2011 level of 5.9% of loans to 11.9% in Dec 2017, i.e. to Rs 8.4 lakh-crore (INR 8.4 trillion). With poor recovery of about a quarter of the bad debts in India, people’s faith in the banking system is terribly shaken. Public sector banks’ efficiency does not rise significantly, thus they need capital infusion frequently. Indian government is already undertaking a recap program of Rs.2.1 lakh-crore (INR 2.1 trillion) over FY2018 and FY19. This obviously is at the cost of tax payers’ money– and again putting it into the risk of bad banking practices and inefficiencies. So it’s but natural to create panic of bank failure and loss of money among the people.

Added to this is the latest episodes of bank frauds- starting with the Rs.13,000 crore Punjab National Bank scam. Total amount of sum involved in the banking scams in the country at present is not less than Rs.30,000 crore as per various reports and CBI has registered cases against more than 50 people. Not to forget that India has already been grappling with Vijay Mallya’s Kingfisher Airlines’ loan defaults of Rs.9,000 crore to a consortium of 17 banks. Almost all major public sector banks and private banks like ICICI are exposed substantially into these bank frauds. India does not have a stringent law related to bad loan recovery, nor punishing the fugitives leaving the country after large scale financial offences. Last week only (on 21st April 2018), Indian government has finally promulgated The Fugitive Economic Offenders Ordinance, 2018 to empower authorities to attach and confiscate properties and assets of big loan defaulters and financial offenders absconding from the country. This law is applicable in case of economic offences involving Rs.100 crore or more. The ongoing bank fraud crisis undoubtedly, has put serious questions on people’s minds about safety and security of Indian banking system.

Fear of FRDI Bill

Another issue has equally created panic among people in recent times from Indian government’s proposed Financial Resolution and Deposit Insurance Bill (FRDI). This created a fear that banks will be empowered to use depositor’s money to rescue a bank if it fails. If a bank fails, the proposed Bill will provide a limited deposit insurance, not the entire sum deposited by a person. Presently, only maximum Rs 1 lakh of bank deposit is protected. Though RBI is trying to sort out this issue and government is assuring that depositors’ money will not be put into risk- but people seem not to be fully convinced. Then it’s no surprise, cash may be back in demand and people may have started hoarding big notes or needing cash to buy durable assets.

Summing up

Whatever be the reasons of the latest cash crunch, among the multiplicity of reasons, one issue is relatively clearer- that the Indian financial system is at cross roads. It is in ‘Catch-22’ situation! And it needs total overhaul to fix the system. The series of monetary shocks have put the RBI’s ability to foresee troubles into question, and equally created doubts about government’s intention to tackle the economic and banking sector reforms without much hiccups and pain to the people. Things should be put to steadiness, before the critical trust deficit becomes ‘too critical’!

The AuthorShri Manoj Kumar Sahoo is a Faculty of Economics, School of Liberal Studies, Pandit Deendayal Petroleum University, E-mail: sahoomanoj1@rediffmail.com

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