A week after the announcement of demonetisation (a misnomer, given that high–denomination currency notes have not really been withdrawn and merely replaced), the jury is still out on its effects.

The Government would want the common man to believe that the pain is limited only to the short run. In the medium to long run, with banks being flush with funds, interest rates will be lowered.

Further, it would like us believe that there are definitive gains to be made by all in the form of a more transparent and cleaner economy in the long run. Unfortunately, macroeconomic implications of any policy change are not as simply explained.

Impact on interest rates

Bank repo rates, it is likely, will be cut in the run–up to the Fifth Bi-monthly Monetary Policy Review on December 7, 2016, on account of the huge funds that have been mopped up by banks. An indicator of the southward movement of interest rates can be seen by looking at the money market operations and the behaviour of the daily weighted average call money rate (WACR).

The WACR is the operating target which the Reserve Bank of India seeks to influence through its policy rate —the repo rate. With the repo rate at 6.25 per cent, the weighted average call money rate, which was 6.21 per cent on November 8, 2016 — the day “demonetisation” was announced, dipped to 4.44 per cent on November 14, and was 6.03 per cent on November 17, 2016. It is clear that banks need to resort less to the inter-bank call money market funds for their daily requirements of maintaining the cash reserve ratio.

Who benefits from such rate cuts and will such rate cuts really have a positive impact on the economy? One, the rate cuts hardly impact the large percentage of population (estimated at 58 per cent), who constitute the unbanked segments.

On the contrary, the decline in liquidity on account of the restrictions in the amount of notes in circulation, as also on the extent of withdrawals, will lead to a rise in the interest rates in the unorganised sector and impact them negatively.

Will this drive larger numbers to be part of the formal banking system? Highly unlikely, since the reasons for the financial non-inclusion may be more deliberate, owing to factors such as lack of ability to provide collateral, bureaucratic hassles and red-tapism, lack of adequate banking infrastructure as also suspicion of the banking system at large among the poor unbanked and under-banked segments.

Second, banks cannot use these transitory deposits turned into current and savings (CASA) accounts (these are essentially short-term deposits), for giving out long-term loans. It has been suggested that sectors such as highways and shipping, where the demand for investments is huge, may be the natural choice for such surplus funds.

However, given the long gestational lags in such sectors, can banks afford to use CASA funds to finance the country’s infrastructure needs? These may simply add to the banking system’s strain by imposing higher mandatory capital adequacy ratio requirements.

Third, as rates of interest in India decline, we can expect an outflow of funds from India into more lucrative emerging markets, as also towards advanced economies which have been experiencing a rising trend in their bond yields since the beginning of the month. Thus, while the 10-year G-sec yield on Indian government bonds declined by 30 basis points in the last month, yields on other emerging market bonds have shot up by at least 30 basis points in the same time, with Brazilian yields going up by 68 basis points.

Further, yields on German bunds have risen 22 basis points, on US 10-year bonds have risen by 56 bps and on Turkey’s bills have gone up 82.50 bps in the same period. Such a bearish bond trend exhibited by India in the face of a global bullish bond trend, will lead to capital outflows from India and difficulties in financing our current account deficit (CAD).

People’s expectations

It is important to analyse the outcomes of the demonetisation effort from the point of view of what people ‘expect to happen’. The Rational Expectations Theory — an influential Nobel prize winning theory by Robert Lucas, based on expectations of economic agents — asserts that people try to forecast what will actually occur, when forming their expectations. In doing so, there is a constant effort to adjust forecasting rules so as to eliminate avoidable errors. Past outcomes thus feed current expectations.

In such a scenario then, outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be.

From the rational expectations perspective, people may be caught unawares sometime, and make certain forecasting errors. However, such errors cannot occur persistently in one direction.

The current ‘unsystematic’ and unanticipated move would have caught the purveyors of black money and counterfeit money unawares. This may led to a short-term impact on the amount of fake money in circulation, as also some destruction of black money. However, as people begin to factor in these developments into their expectations, the premiums and commissions associated with corruption will only increase.

As such, the government may be better off adopting a credible policy stance — one that is understood by people and credible in its approach. Such a stance would have have far greater chances of success.

There is no question of the reversal of the decision to demonetise. However, the policy makers are better advised not to throw the economy out of gear through persistent, unanticipated policy shocks.

Otherwise, the outcomes in the long run would be one akin to a more virulent strain of bacteria resistant to all forms of antibiotics.

The writer teaches economics at the SP Jain Institute of Management & Research, Mumbai. The views are personal