Has there been a slowdown in money supply after inflation targeting?

Apprehensions have been expressed in public domain of a slowdown in money supply on the back of an inadequate reserve money expansion and this could play a role in growth slowdown

Global economy continues to hog the limelight with geopolitical uncertainty looming large with the recent escalation of hostilities. Fortunately, India’s financial sector is resilient with asset quality in a robust shape. Financial stability however assumes paramount importance in the current context with gyrations in asset classes across the spectrum likely becoming the norm. 
 

Against this background, repeated apprehensions have been expressed in public domain of a marked slowdown in money supply (M3) on the back of an inadequate reserve money (RM) expansion and this could play a role in growth slowdown of India coupled with global uncertainties. Since global uncertainties are exogenous the logical corollary squarely derived is that the RBI should augment base (reserve) money so that it can lead to higher broad money expansion. While this line of reasoning could obviously have some takers, this argument escapes the logic, understanding and appreciation of the riveting aspects of monetary economics. Let us explain why. 
 

First, there is no denying of the fact that RM growth has slowed down since the pandemic. From 18.8 per cent in pandemic year FY21, it decelerated to 5.6 per cent in FY24, and further to 3.9 per cent in September 2024, a decline of 15 percentage points, of which 74 per cent is because of a deceleration in currency in circulation (CiC). 
 

Such a large decline in CiC over the three-year period is attributed to a significant surge in retail digital payments/ 31 times CiC growth. In fact, 77 per cent of such retail digital payments was attributed by UPI transactions. Thus it is clear that the decline in CiC growth since the pandemic is amidst increasing adoption of digital mode of payments. In fact, if we look at the combined share of retail digital and currency to total transactions, the share of retail digital is now a whopping 89 per cent, while that of CiC is 11 per cent. 
 

Second, apart from the slow growth in CiC, the deceleration in RM is also because of the unusually high base of bankers’ balances held with the RBI in FY24 as return of Rs 2,000 denomination bank notes swelled the deposit base of the banking system necessitating higher bankers’ balances held with the RBI. In addition, the incremental CRR of 10 per cent imposed on the increase in NDTL of all scheduled banks between May 19 and July 28, 2023 further boosted bankers’ balances held with the RBI, though it has since been withdrawn. 
 

What is the impact of the increasing digital payments at the expense of currency and bankers’ deposit base? The currency to deposit ratio has subsequently declined from 17 to 15.1 during FY21 till September 2024. The reserve deposit ratio has declined from 5 in FY23 to 4.74 in September 2024.  Reflecting such a decline, the money multiplier registered an increase from 5.1 in FY23 to 5.6 in September 2024. In fact, the money multiplier tends to increase when the reserve ratio is cut/ and lower currency leakage indicating higher multiple expansion in broad money on account of bank deposits. 
 

Thus a lower expansion in RM can co-exist with a stable M3 growth with a jump in money multiplier making the relation of base money and money supply agnostic. In fact, M3 growth is consistent with the growth in nominal GDP in FY24 at 11.1 per cent against the nominal GDP growth of 9.6 per cent. 

Coming to the more intellectual discourse, under the flexible inflation targeting (FIT) framework, interest rate, and not monetary aggregates, is the key instrument of policy. We must emphasise that under a multiple indicator approach, that was in existence pre-FIT, the RBI used to give out targets of M3, deposits and credit growth at fiscal beginning. However, M3 in post FIT framework is determined endogenously in tune with structural changes in economy as well as evolution of the payment system landscape. Once the MPC sets the repo rate, the day-to-day liquidity management operations of the RBI aligns the weighted average call rate (WACR) to the policy repo rate. In this process, systemic liquidity becomes the more relevant metric than RM for achieving the specified short-term rate.
 

In fact, an analysis of the data since the global financial crisis indicates interesting facets of M3, RM and nominal GDP growth. In the pre-FIT regime beginning FY10 that ended in FY16, the average M3 growth at 13.5 per cent was lower than 14 per cent nominal GDP growth. In the post FIT regime, the average M3 growth at 10.2 per cent is higher than the nominal GDP growth at 9.7 per cent. Clearly the M3 growth has been endogenised in the model in accordance with changes and innovation in digital payment infrastructure. 

 

It is also important to appreciate that central banks in a FIT regime have much less control over base money and the money multiplier process (with the currency-deposit ratio being driven by behavioral aspects and the reserve-deposit ratio, that is, CRR not being an active policy instrument). Thus the argument of base money creation to bolster M3 is erroneous and misleading in the current context. 
 

We end with an interesting anecdote. The evolving financial ecosystem characterised by new business models and fast changing technology is resulting in increasing layers of disintermediation as money is returning to banks through round tripping. As an example, the TREPS market volume is now double the combined values of Repo and uncollateralised Call/Notice/Term. The interest earned through TREPS fares much better than similar yields incentivising mutual funds to lend through TREPS while banks benefit through ultra flexibility, pledging securities and borrowing for short duration, helping in ALM management.
 

This trend of growing layers of financial intermediation and rapid digitisation is likely to keep cost of funds and hence deposit rates higher for longer.  If banks are not able to pedal up their post-tax returns (for no fault of theirs) component to the Gen X, their Safety and Liquidity propositions might be defeating such very purpose. A level playing tax regime for bank deposits in accordance with other asset classes is thus a must now.

The author is Group Chief Economic Advisor, State Bank of India, and Member, 16th Finance Commission. Views are personal