Former Chief Economic Advisor Arvind Subramanian has said demonetisation “was a massive, draconian, monetary shock” but did not result in a significant fall in nominal GDP growth, in contrast to the massive fall in currency in circulation.
In his book Of Counsel: The Challenges of the Modi-Jaitley Economy, Subramanian, who was CEA from October 2014 to July 2018 before he returned to the US citing family commitments, said: “Demonetization was a massive, draconian, monetary shock: in one fell swoop 86 per cent of the currency in circulation was withdrawn… Real GDP growth was clearly affected by demonetization. Growth had been slowing even before, but after demonetization, the slide accelerated. In the six quarters before demonetization, growth averaged 8 per cent and in the seven quarters after, it averaged about 6.8 per cent,” he said in the book — published by Penguin Random House India, it will be released next month.
What is striking, however, is how small the demonetisation effect was compared to the magnitude of the shock, as during this period, currency in circulation collapsed and recovered subsequently, but through all of this, the economy was “chugging along almost unmindful of the currency in circulation” as there was no sharp dip in nominal GDP, he said.
Subramanian also called for the government and the RBI to enter into a “grand bargain”, wherein the Centre provides additional supervisory powers to the RBI in return for the central bank deploying its surplus capital to augment the resources for recapitalising public sector banks. The RBI holds excess capital of Rs 4.5-7 lakh crore, a part of which should strictly be used to recapitalise banks instead of financing the government deficit, he said.
The government will possibly need to provide anywhere between Rs 3-5 lakh crore — in addition to the amounts already spent — to restore the fundamentally viable PSBs to health, he said. The additional equity infusion is essential to address the lingering challenge of twin balance sheet stress, wherein both banks and the companies face stress due to massive unpaid loans.
As part of the grand bargain, the government should allow majority private-sector participation in PSBs and grant the RBI greater supervisory powers over public sector banks by amending the Bank Nationalisation Act, and allowing it to implement the Prompt Corrective Action (PCA) framework for less strong banks.
Indicating that the Insolvency and Bankruptcy Code alone may not be enough to tackle the challenge of stressed assets in the banking system, Subramanian argued for setting up a centralised Public Sector Asset Rehabilitation Agency (PARA) that can take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt.
Praising the RBI for maintaining the integrity of the PCA process, he said the record of the RBI as supervisor — along with that of the government as owner of public sector banks — has not been pretty. Referring to the recent loan scandal at Punjab National Bank and loan defaults by ILFS, he said the RBI did not prevent such problems nor could it detect them in real time.
While the RBI has acted tough since then by questioning bank accounting practices and removing executives at public sector banks, “the central bank has not fundamentally overhauled its supervisory organization, or its procedures, in part because it hasn’t been held accountable for its failures”. The Banks Board Bureau set up by the government to improve governance at public sector banks has also had “very little impact” so far.
He said the merger of PSBs can at best be a Band-Aid but does not address the main problem. “Merging bad banks with tolerably good banks does not improve the health of the overall banking system in any way. Consolidation is at best a Band-Aid for the system, and at worst a distraction for management from their key priority of dealing with their bad assets. Meanwhile, there is still no serious consideration of privatizing some of the major public sector banks.”
He said the GST was a major structural reform and hoped that if land and real estate are included in the GST regime, a key sources of black money creation can be tracked.