How is Money Created in India?
In 1969, Holmes was talking about the US. The situation is somewhat more complicated in India because there have been two liquidity requirements imposed on the banks by the RBI after the independence. These two requirements are called the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).
Prior to further progress, let me clarify what the RBI means by “cash”.
In the language of the RBI, “cash” does not mean just the rupee banknotes, and the rupee and smaller coins. Beyond these three are the “bank deposits” with the RBI which are just some numbers on some computers these days. So, rather than “cash” and consistent with the rest of the world, I will use the word “reserves” for these “bank deposits” with the RBI and save the word “cash” to mean what we ordinary people think “cash” is in our daily lives. The economists call the sum of cash and reserves, base money, whereas the sum of cash and deposits is broad money. It should be mentioned that while cash and deposits can buy things in the real world, reserves cannot. Reserves are common currency only among the banks and the RBI, and cannot go out of the banking system.
To sum up, the CRR is what the most of the rest of the world calls the “required reserve ratio”. As Holmes (1969) described for the US, the banks first create deposits by extending credit or buying government securities and then look for reserves to meet the CRR requirement also in India. The most recent banking data available at the RBI website—as of 17 February 2017 at the time of writing—shows that the reserve to deposit ratio was about 4%, which is consistent with the current CRR requirement.
And, had the CRR been the only liquidity requirement, the money creation process in India would have been no different than the money creation process in the US, for example. What sets India apart from most other countries is the SLR requirement. Because, the SLR requirement can be met not only by holding “reserves”, but also by holding gold and “government approved securities”.
When we look at the SLR historically, we see that the commercial banks in India have met their SLR requirement by holding “government approved securities” mostly. In addition, if we look at the above-mentioned RBI data we see also that way above 99% of the “government approved securities” were “government securities”. This comes as no surprise because these securities are very safe and pay high interest rates.
Further, as of the same date, the credit to deposit ratio was roughly about 70% while the government approved securities to deposit ratio was roughly about 30% and these two ratios nearly added up to 100% despite the expected measurement errors. Given that the current SLR requirement is 20.5%, this indicates also that the banks are holding way more government securities than they are required. This is understandable, because the banks need non-SRL government securities to repo (see, for example, Acharya and Öncü 2010 for a description) with the RBI to obtain reserves to meet their CRR requirement.
To sum up, while the CRR is a tool of the RBI to manage the liquidity in the banking system, the SRL is a tool to manage the liquidity in the economy, although nowadays the RBI uses the CRR to manage the liquidity in the economy also. To clarify these further, let me summarise the 17 February 2017 data from the above mentioned RBI website.
And, let me add to this that the total of all outstanding government securities is ₹47.2 trillion.
These data show that the commercial banks in India hold about 70% of all outstanding government securities and hence the SLR is not only a monetary policy tool, but also ensures the banks in India lend to the government. Furthermore, the availability of government securities puts an upper bound on the deposits the Indian banks can create.
If the banks buy all of the governments securities and use them to meet the 20.5% SLR requirement only, then the banks in India can increase the aggregate deposits to ₹230.4 trillion by extending additional credit. In this case, the credit extended to the rest of the economy other than the government would be ₹183.2 trillion. This is the maximum amount of credit that can be extended to the rest of the economy, if the government does not issue new securities and the SLR remains 20.5%. Further, in this scenario, the RBI has to increase the reserves to ₹9.2 trillion so that the banks can meet their 4% CRR requirement.
Of course, the above is just a hypothetical scenario I constructed to give the readers some idea about how these two ratios, reserves and government securities affect the availability of money and credit to the economy.
My Bad Bank Proposal
In light of the discussion so far, I now make my “bad bank” proposal to India and, for want of a better name, call it the Bad Bank.
- The Bad Bank would be promoted by the Government of India and capitalised with zero coupon perpetual bonds the government would issue;
- The Bad Bank would swap the zero coupon perpetual bonds with reserves the RBI would create. These reserves would be excess, because they would not back any of the deposits of the banking system;
- The Bad Bank would swap the excess reserves with the banks (public and private) for the bad loans.
Two things will happen to the banks (not just public, but also private):
- They are relieved of the bad loans;
- Since the excess reserves have zero risk weights, their capital ratios go up so that there is no need to recapitalise any of the banks.
Furthermore, although the base money was increased by the amount of the issued zero coupon perpetual bonds, since the existing deposits remained intact, the broad money neither increased (no immediate inflation) nor decreased (no immediate deflation). In addition, this operation would cost nothing either to the Government of India or to the Indian taxpayers, because the Government of India will pay neither coupon nor principal on the issued zero coupon perpetual bonds.
At this point, a decision has to be made regarding what to do the with the bad loans. One possible decision is to erase all of the bad loans against the Bad Bank’s equity and dissolve the Bad Bank. This is what I call a partial Jubilee. It is partial because in a full Jubilee, all of the debts in the country would be annulled and the country would start from a clean slate.
Of course, this is not the only possible decision. As in the case of the NAMC proposed by Acharya, the Bad Bank might bring in asset managers such as ARCs and private equity to manage and turn around the assets, individually or as a portfolio, and the like. Other possibilities can also be considered.
Let me conclude by noting that although what I proposed above solves the immediate stressed asset problem of the Indian banking system cheaply, it does not solve any other problems, be those economic, financial, political, social and the like. It only gives the country some breathing time so that she can attack and tackle all of her other problems.
Last Words
One last issue I would like to discuss is the excess reserves the RBI created. As readers familiar with the quantitative easing (QE) programmes implemented in the US would recall, many have expressed concern that the large quantity of excess reserves created through the QE programmes will lead to an increase in the inflation rate unless the Federal Reserve acts to remove them quickly once the economy begins to recover.
In an article titled “Why Are Banks Holding So Many Excess Reserves?” Keister and McAndrews (2009) addressed this issue and argued that if interest is paid on the reserves, this allows a central bank to maintain its influence over market interest rates independent of the quantity of reserves created by its liquidity facilities. This can also be considered in India. Furthermore, despite all these concerns in the beginning, no significant inflation took place in the US and, indeed, in 2015, the US was flirting with deflation.
And, of course, there is the luxury of the SLR that the RBI can use to manage the liquidity in the economy.
References
Acharya, Viral, V. and T. Sabri Öncü (2010): “The Dodd-Frank Wall Street Reform and Consumer Protection Act and a Little Known Corner of Wall Street: The Repo Market”, NYU Stern Regulating Wall Street Blog, 16 June,
Andrews, Evan (2016): “6 Longstanding Debts from History,” History Lists, 2 December, http://www.history.com/news/history-lists/6-longstanding-debts-from-history
Chandrasekhar, C P (2017): “Wicked Loans and Bad Banks,” Frontline, 1 March.
Fujiko, Toru and Keiko Ujikane (2016): “Bernanke Floated Japan Perpetual Debt Idea to Abe Aide Honda,” Bloomberg, 14 July
Holmes, Alan (1969): “Operational Constraints on the Stabilization of Money Supply Growth”, in: Controlling Monetary Aggregates, Boston: Federal Reserve Bank of Boston, 65-77.
Hudson, Michael (2013): “J Is for Jubilee, K for Kleptocrats,” The Insiders Economics Dictionary, 26 November.
IMF (2016): Fiscal Monitor: Debt—Use It Wisely, International Monetary Fund, Washington, October.
Jakab, Z and M Kumhof (2015): “Banks Are Not Intermediaries of Loanable Funds—and Why This Matters,” Bank of England Working Paper No 529, May.
Keister, Todd and James McAndrews (2009): “Why Are Banks Holding So Many Excess Reserves?” Federal Reserve Bank of New York Staff Reports, no. 380, July.
Mathew, George (2017): “Bad loan crisis continues: 56.4 per cent rise in NPAs of banks,” Indian Express, 20 February
Mathew, Alex and Ira Dugal (2017): “RBI’s Viral Acharya Proposes ‘Tough Love’ To Resolve Bad Loan Crisis,” Bloomberg-Quint, 22 February
Öncü, T. Sabri (2016): “It is the private debt, stupid!” Economic & Political Weekly, Vol.51 (46), pp 10-11
Sidhatha (2017): “Few Supporters in Govt for ‘Bad Bank’ Proposal,” Times of India, 27 February.
Unnikrishnan, Dinesh and Kishor Kadam (2016): “Explained in 5 charts: How Indian banks’ big NPA problem evolved over years”, Firstpost, February 10.
Werner, Richard A. (2016): ““A lost century in economics: Three theories of banking and the conclusive evidence,” International Review of Financial Analysis, Vol. 46, July, 361-79.
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