Thursday March 30, 2023

Demonetizing for growth

December 11, 2022

Currency in circulation makes up almost 20 per cent of Pakistan’s GDP, increasing from eight per cent, only about a decade back. Explosive growth of money supply has led to too much cash in the economy chasing too few goods.

As supply of goods remained constrained – since that cash never worked to increase aggregate supply – it exerted pressure on the exchange rate resulting in depreciation of the Pak rupee over the years. A natural consequence of too much cash chasing too few goods is inflation, and we have been riding one wave of inflation after another without addressing the root. The root cause is the prevalence of too much cash in the system, and that needs to be sucked out.

It is a structural problem that is now out of control. The inability to address it may eventually lead to hyperinflation, while policymakers in Mississauga, London, and Islamabad will keep harping on about how conventional monetary economics does not work for us, as if we are situated on another planet. It works really well, and bouts of inflation as a consequence of growth in money supply are a testament to the same.

Demonetization is a radical way to solve this problem, which comes with its own set of problems. Demonetization is often touted as a fix-all panacea for the bogeyman of corruption, but it does more than that. A strategy that demonetizes the largest currency note in circulation – Rs5000 – will massively reduce currency in circulation, as most of the same is denominated in currency notes of Rs5000.

This is how it can be played out. The central bank announces demonetization of the Rs5000 currency notes, and gives a hard deadline of six months for everyone to deposit the same in their respective bank accounts. But Pakistan has one of the lowest financial inclusion levels in the world, which would then require the central bank to enable every citizen of the country to have a bank account linked to their CNIC, just like we have in the case of National Tax Number. Each citizen can walk into any bank branch, or just use their mobile phone to open a bank account, and deposit their stash of Rs5000 currency notes in the same. Sounds simple, but it isn’t.

This will send shockwaves across the informal economy, from the usual real-estate rent seekers, to traders, and wholesalers – the usual coterie that tries to stay out of the tax net. There will be massive political opposition, but we can either fix structural issues, or pander to rent seekers. We have been doing the latter for the last seven decades, maybe we can actually try to fix structural problems for a change.

With every citizen having a bank account, it will be possible to deposit the demonetized currency notes in an orderly manner. Extra effort may be required in areas where prevalence of banks is low, and for the same purpose dedicated camps can be established to facilitate the same. Similar infrastructure is rolled out during elections, or natural disasters.

The technology infrastructure that enables efficiency and prompt payments already exists in the form of RAAST, which can allow payments to be done through the formal financial system. Similarly, all biometric data already exists with NADRA that can be used for opening up accounts. Effectively, the technology stack to accomplish demonetization exists at this time, and someone just needs to execute here.

As the demonetized currency notes are deposited in the banking system, the overall size of the formal financial system will start growing, which will reduce the equilibrium interest rate in the near term, pushing banks to actually start taking risk, and lending to the private sector. Demonetization will increase the available supply of capital that can be redirected towards productive capital and eventually push up aggregate supply.

However, this does not give a free passage to the government which continues to run fiscal deficits. As more capital comes into the system, there needs to be rationalization of the tax policy such that the capital remains in the system, and is not harassed out. Currently, the tax policy is structured such that it is more convenient and economically efficient to stay out of the formal financial system – and this needs to change through a more encompassing fiscal policy.

Demonetization will have a high social and political cost, and there will be unintended consequences. When India demonetized a few years back, there was massive social unrest, and its quarterly GDP took a one-time hit, but since then it continues to grow at high single-digit levels while payments have largely shifted to the digital medium. A consequence of this is muted inflation, and mid single-digit interest rates that spur economic growth.

The cost of inaction, and not bringing money supply under control is much higher than any social or political cost. The technology exists to mitigate any potential risks, and to make the process easier for the citizens of the country. If price stability is a critical mandate for the central bank, then it must work towards this, rather than extending the year by which a hypothetical inflation target can be met without making much effort to address structural inefficiencies.

The country is at the stage of a monetary and economic cycle where any delays in addressing structural weaknesses are only going to make things worse, eventually leading to hyperinflation fueled by a mix of excessive debt burden, a fiscal squeeze, and a depreciating aggregate supply.

Demonetization is a radical step that may actually garner popular public support, but may not be supported by various rent-seeking interest groups. We can either make economic policy that serves the interests of the citizens of the country, or we can continue to benefit a few thousand vocal rent seekers. The choice should be very clear.

The writer is an independent macroeconomist.