Are top banks getting their economics wrong?

India’s premier banks are increasingly churning out economic concepts that are difficult to fathom. The latest example is the SBI’s June 19, 2023 research paper titled “Withdrawal of ₹2,000 note: How it could result in a bank deposit boost, repayment of loans boost, consumption boost, RBI CBDC boost and a possible GDP boost”. This follows the RBI’s decision of May 19, 2023 to withdraw ₹2,000 notes (worth ₹3.62 lakh crore) constituting 10.8% of cash-in-circulation in March 2023.

The SBI Research calls this a “precision strike” – a variation of “master stroke” and “surgical strike” with which every government action (including the twin shocks of demonetisation and GST) used to be qualified with – and concludes: “We expect Q1 FY24 GDP growth at ~ 8.1% with an upward bias due to the impact of ₹2,000 note withdrawal event…this reinforces our projection that FY24 GDP could be higher than 6.5%, basis the RBI estimate”.

What logic or evidence SBI gives in support?

It says the withdrawal of the notes would (a) boost bank deposits (b) boost repayment of loans (c) boost consumption demand and PFCE (d) boost the RBI’s CBDC (Central Bank Digital Currency) and (e) boost GDP growth – the title of the paper and the text claim.

It then calculates these gains in money terms: The withdrawal of the notes (i) is likely to increase banks deposits by ₹1.5 lakh crore (after partial withdrawal by depositors) (ii) lead to 30% of deposits or ₹92,000 crore might go for loan payment (in cash credit and overdraft) (iii) consumption demand may be “frontloaded” by ₹55,000 crore which, in turn, would boost PFCE by ₹1.83 lakh crore through “multiplier effect” and thereby, boosting the GDP growth to 8.1% in Q1 of FY24 – from 6.5% estimated by the RBI.

What is striking here is the proposition that the deposits of ₹2,000 notes would lead to “frontloaded” consumption demand. Why would that happen? The SBI explanations: “With the bank note remaining a legal tender, unlike demonetisation, consumption could see a boost.”

This begs the question: Why didn’t the deposits of demonetised notes of ₹1,000 and ₹500 boost consumption demand in 2016 and later?

After all, the depositors got equal monetary value in return, in lower denominations of ₹100, ₹50, ₹20 and ₹10 (later in ₹2,000 and ₹500 notes) – all of which continue to be legal tenders – and presumably, also used for consumption (given the cash rationing at the time). Since money supply is a function of the value and transactions, if the demonetisation of ₹1,000 and ₹500 notes wouldn’t have mattered because those were replenished with notes of equal value – just as it would happen for the 2,000 notes.

Further, going by SBI Research’s economic logic, if the withdrawal of ₹2,000 notes, constituting 10.8% of cash, can boost the GDP by 1.6 percentage points (8.1% minus 6.5%) then the withdrawal of ₹1,000 and ₹500 notes, which accounted for 86.9% of cash-in-circulation in November 2016, would surely have boosted the GDP growth by a greater magnitude. Here, all other factors of GDP growth are kept constant (unchanged) – following the SBI logic.

What happened was just the reverse.

The GDP growth fell to 6.8% in FY18, from 8.3% in FY17, and then progressively fell to 3.9% in the pre-pandemic FY20 (revised upward from 3.4% in recently). That the demonetisation began the derailment of economy by wiping out millions of jobs and small businesses (thereby damaging informal economy contributing nearly 50% to the GDP) is no longer disputed.

Bank deposits did go up as people rushed to exchange the demonetised notes in 2016 but a few other things also happened which points to SBI’s poor economic logic.

One is write-offs of loan defaults (NPAs). The SCBs had written off ₹1.08 lakh crore in FY17 (demonetisation fiscal), which progressively increased to ₹1.63 lakh crore in FY18, ₹2.37 lakh crore in FY19 and ₹2.38 lakh crore in FY20 (before the pandemic). The SBI itself wrote off ₹20,339 crore in FY17, which sharply increased to ₹1.5 lakh crore in the three next fiscals (FY18-FY20) – averaging ₹50,000 crore.

These write-offs then required re-monetisation of banks.

Two, the SBI re-introduced “penalty” on the poor for not maintaining minimum monthly balance in 2017 after five years, collecting ₹1,771 crore during April-November 2017 – which was more than SBI’s July-September quarter net profit (₹1,581.55 crore) and nearly half of its net profit of April-September 2017 (₹3,586 crore). In all, SCBs collected ₹10,000 crore in such penalty in three fiscals of FY17-FY19.

Three, the SBI also imposed costs on banking transactions beyond four transactions, either through bank branches or ATM, at ₹15 plus GST for each such transaction.

Why did the banks impose such costs on people? Obviously because banks needed to mobilise more resources to make their balance sheets look healthier.

But this is not the first instance of SBI Research getting its economics wrong.

It had advocated for demonetisation in March 2016 – months ahead of the actual event. It said the RBI would get a “windfall” gain of ₹3-4 lakh crore from demonetisation. Both turned out to be false. Almost the entire money came back to the system; the “windfall gain” was zero. The failure to get “windfall gain” led to a wild goose chase by the IT department. Then, the Centre demanded higher shares of RBI’s reserve money, which eventually materialised with transfer of ₹1.76 lakh crore in August 2019. Less than a month later, in September 2019, the Centre announced the corporate tax cut of ₹1.45 lakh crore. The same month, state governments were told they wouldn’t get the GST Compensation because of lack of resources.

In essence, public paid for demonetisation – not just with penalty for not maintaining minimum balance, higher NPA write-offs, subsequent bank recapitalisation and ₹15 plus GST for more than four banking transactions in a month, but also due to overnight loss of millions of jobs and small business (cash was rationed and millions stood outside banks for months to get their own cash).

RBI’s confusion over ₹2,000 note withdrawal

The RBI notification asking people to deposit ₹2,000 notes by September 30, 2023, is also bizarre.

Its circular of May 19, 2023 gave four reasons for this: (a) it was issued to re-monetise after demonetisation (oxymoronic) (b) printing of these notes stopped in FY19 (c) its life-span was 4-5 years and (d) stock of banknotes in other denominations was adequate. To compound the confusion, it said that the withdrawn notes “will continue to be legal tender”.

Indians and Indian economy were paralysed for months following the overnight, unprepared demonetisation – despite warnings from former RBI Governor Raghuram Rajan, followed by a note from the RBI (as he wrote in 2017 book “I do what I do”). If it remains a legal tender why should it be withdrawn?

The big questions are: Legal or not, is the currency note issued by the RBI a safe and reliable tender? If yes, does it come with a pre-determined sell-by-date or is it completely arbitrary?

The poor may not have much of a choice but the rich billionaires do and they may opt for foreign currencies to keep their money safe. People’s trust in Indian legal tender has been broken twice in the past seven years (demonetisation of 2016 and now).

Was the RBI’s decision political?

Doubts arise because the demonetisation came just ahead of the Uttar Pradesh elections (February 2017) and it starved the opposition of cash; the number of candidates contesting this election fell by 30%. Four states with high stakes, Madhya Pradesh, Rajasthan, Chhattisgarh and Telangana, face elections later this year.

For the record, the RBI circular came five days after the BJP lost the Karnataka elections (counting on May 13, 2023).

RBI’s actions have been questionable of late. Here are two more examples.

Free pass to banking fraud and missing notes

On June 8, 2023, 10 days after RBI Governor Shaktikanta Das red flagged governance failures in SCBs and listed five “innovative ways” in which stressed assets (NPAs) were concealed and evergreened, the RBI gave a carte blanche to all banks and financial institutions to go for “compromise settlements” with accounts marked as “fraud and willful defaulter” (“Framework for Compromise Settlements and Technical Write-offs”).

It didn’t stop there.

It said banks and other financial institutions were free to give fresh loans to those very debtors after 12 months – which was banned earlier. The RBI didn’t explain why.

Those supporting the RBI may argue that this gives PSBs a level-playing field since private banks do it or that there should be separation of banks’ commercial activities (fresh loans to willful defaulters and fraudsters) from the criminal proceedings (which the RBI’s new framework leaves untouched).

But which fraudster and willful defaulter would like to pay back loans after tasting blood – compromise settlement means pay back next to nothing, no repayment (recovery) of the rest, fresh loans after 12 months and too slow judicial proceedings to act as deterrent (ask Vijay Mallya, Mehul Choksi, Nirav Modi and others who have fled the country and declared fugitives). Besides, most loan defaults involve PSBs – which are public depositories and mainstay of Indian banking/finance systems.

The magnitude of public money at stake with willful defaulters is ₹346,479 crore as on December 2022 – as the Transunion CIBIL, a credit information company registered with the RBI, has revealed. There are 16,044 willful defaulters – borrowers who have the ability to pay but don’t pay – with SCBs. This was a straight 41% jump from ₹245,767 crore in December 2020.

So, banks and financial institutions would now have to take heavy haircuts on ₹3.46 lakh crore again – after SCBs wrote off ₹12.3 lakh crore as NPAs in the past eight fiscals of FY15-FY22.

Fortune India explained why such “compromise settlements” is invitation to more banking frauds and willful defaults – which are on the rise in recent years and many such business tycoons have fled the country with bank loans. Many like the Sandesara brothers, fighting banking frauds (involving $1.7 billion) in India, are running flourishing oil business in Nigeria (fled India in 2019) and are also suspected to be doing business with public sector oil PSUs.

The second example is about missing ₹500 notes.

A national daily recently reported that the whereabouts of 1,760.65 million of ₹500 notes (both old and new ones designed post-demonetisation), valued at ₹88,032 crore, is not known. The report is based on the RTI replies from the three government mints – Bengaluru, Nasik and Dewas – and the RBI reports showing the notes it received during FY16 and FY17.

This mismatch may not actually amount to theft but what has caused disquiet is the RBI’s late-night response to it on June 17, 2023, which said: “These reports are based on erroneous interpretation of information collected under the Right to Information Act, 2005 from the printing presses. It may be noted that all banknotes supplied from printing presses to RBI are properly accounted for. It is further informed that there are robust systems in place for reconciliation of banknotes printed at the presses and supplied to RBI which include protocols to monitor production, storage and distribution of banknotes.”

This statement doesn’t explain (a) why or how the mismatch happened and (b) why is the report which relies on official records was “erroneous”.

A mere statement from the RBI assuring that “robust systems” exist isn’t enough. It is the credibility which is on the line for long, particularly because RBI’s robust systems (i) haven’t deterred PSBs to invent “innovative ways” to evergreening loans, as the RBI Governor recently found out (ii) it is giving a free pass or “revdi” to fraudsters and willful defaulters and (iii) its explanation for withdrawal of ₹2,000 notes lacks conviction.