Indian Currency and Finance by John Maynard Keynes is part of HackerNoon’s Book Blog Post series. You can jump to any chapter in this book here . Chapter III: Paper currency CHAPTER III. PAPER CURRENCY 1. The chief characteristics of the Indian system of currency have been roughly sketched in the first chapter. I will now proceed to a description of the system of note issue. 2. In existing conditions the rupee, being a token coin, is virtually a note printed on silver. The custom and convenience of the people justify this, so far as concerns payment in small sums. But in itself it is extravagant. When rupees are issued, the Government, instead of being able to place to reserve the whole nominal value of the coin, is able to retain only the difference between the nominal value and the cost of the silver. For large payments, therefore, it is important to encourage the use of notes to the utmost extent possible,—from the point of view of economy, because by these means the Government may obtain a large part of the reserves necessary for the support of a Gold–Exchange Standard, and also because only thus will it be possible to introduce a proper degree of elasticity in the seasonal supply of currency. 3. By Acts of 1839–43 the Presidency Banks of Bengal, Bombay, and Madras were authorised to issue notes payable on demand; but the use of the notes was practically limited to the three Presidency towns. These Acts were repealed in 1861, when the present Government Paper Currency was first instituted. Since that time no banks have been allowed to issue notes in India. Proposals for a Government Paper Currency were instituted in 1859 by Mr. James Wilson on his going out to India as the first Financial Member. Mr. Wilson died before his scheme could be carried into effect, and the Act setting up the Paper Currency scheme, which became law in 1861, differed in some important respects from his original proposals. The system was eventually set up under the influence of the very rigid ideas as to the proper regulation of note issue prevailing, as a result of the controversies which had culminated in the British Bank Act of 1844, amongst English economists of that time. According to these ideas, the proper principles of note issue were two—first, that the function of note issue should be entirely dissociated from that of banking; and second, that “the amount of notes issued on Government securities should be maintained at a fixed sum, within the limit of the smallest amount which experience has proved to be necessary for the monetary transactions of the country, and that any further amount of notes should be issued on coin or bullion.” These principles were orthodox and all others “unsound.” “The sound principle for regulating the issue of a Paper Circulation,” wrote the Secretary of State, “is that which was enforced on the Bank of England by the Act of 1844.” In England, of course, bankers immediately set themselves to recover the economy and elasticity, which the Act of 1844 banished from the English system, by other means; and with the development of the cheque system to its present state of perfection they have magnificently succeeded. In foreign countries all kinds of new principles have been tried for the regulation of note issue, and some of them have been very successful. In India the creed of 1861 is still repeated; but by unforeseen chance the words have changed their meanings, and have permitted the old system to acquire through inadvertence a certain degree of usefulness. The coin, in which the greater part of the reserve had to be held, was, of course, the rupee. In 1861 this was a freely minted coin worth no more than its bullion value. When the rupee became an artificially valued token, rupees tacitly remained the legitimate form of the reserve (although after a time sovereigns were added as an optional alternative). Thus the authorities are free, if they like, to hold the whole of the Currency Reserve in rupee–tokens, and this reserve has become, therefore (as we shall see below), an important part of the mechanism by which the supply of silver rupees to the currency is duly regulated. While, however, the note issue has managed to evolve an important function for itself, I think the time has come when the usefulness of the Currency Reserve may be much increased by a deliberate consideration of the place it might fill in the organism of the Indian Money Market. I return to this later in the chapter. In the meantime I pass to a description of the Paper Currency as it now is—insisting, however, that when we come to consider how it may be improved, the circumstances of its origin be not forgotten. 4. For the first forty years of their existence the Government notes, though always of growing importance, took a very minor place in the currency system of the country. This was partly due to an arrangement, now in gradual course of abolition, by which for the purposes of paper currency India has been divided up in effect into several separate countries. These ‘circles,’ as they are called, now seven in number, correspond roughly to the principal provinces of India, the offices of issue being as follows:— The currency notes are in the form of promissory notes of the Government of India payable to the bearer on demand, and are of the denominations Rs. 5, 10, 50, 100, 500, 1000, and 10,000. Thus the lowest note is of the face value of 6s. 8d. They are issued without limit from any Paper Currency office in exchange for rupees or British gold coin, or (on the requisition of the Comptroller–General) for gold bullion. 5. Up to 1910 the following arrangements were in force. Every note was legal tender in its own circle. Payment of dues to the Government could be made in the currency notes of any circle; and railway companies could, if they accepted notes of any circle in payment of fares and freight, recover the value of them from the Government. But, until recently, no notes were legal tender outside their own circle, and were payable only at the offices of issue of the town from which they were originally issued. Beyond this the law imposed no obligation to pay. For the accommodation of the public, however, notes of other circles could be cashed at any Paper Currency office to such extent as the convenience of each office might permit. In ordinary circumstances every Government treasury, of which there are about 250, has cashed or exchanged notes if it could do so without inconvenience; and when this could not be done conveniently for large sums, small sums have generally been exchanged for travellers. 6. It is easy to understand the reasons for these restrictions. India is an enormously large country, over which the conditions of trade lead coins to ebb and flow within each year. At the beginning of the busy season when the autumn crops are harvested, rupees flow in great volume from the Presidency towns up country; in early spring they are carried to Burma for the rice crop; and so on—slowly finding their way back again to the Presidency towns during the summer. If the Government had made its notes encashable at a great variety of centres, it would have been taking on itself the expense and responsibility of carrying out these movements of coin at different seasons of the year. When a country is habituated to the use of notes for making payments, they can be very usefully employed for purposes of remittance also. But a note–issuing authority puts itself in a difficulty if it provides facilities for remittance before a general habit has grown up of using notes for other purposes. If, on the other hand, the notes had been made universal legal tender, but only encashable at Presidency towns, there would undoubtedly have been a premium on coin at certain times of the year. And this would have greatly hindered the growth of the notes’ popularity. The Government, therefore, did what it could to make the notes useful and popular for purposes other than those of remittance; and it facilitated remittance so far as the proceeds of taxation, accumulating in its treasuries, permitted it to do this without expense. But it shrank from taking upon itself further responsibility. Its practice may be compared with that of the branches of the Reichsbank. On the other hand, the objections to a policy, which divided the country up for the purposes of paper currency, are also plain. The limitation of the areas of legal tender and of the offices where the notes were encashable on demand greatly restricted the popularity of the notes. It might well have seemed worth while to popularise them, even at the expense of temporary loss. As soon as the public had become satisfied that the notes could be turned into coin readily and without question, their desire to cash them would probably have been greatly diminished. It is not certain that Government would have lost in the long–run if it had undertaken the responsibility and expense of regulating the flow of coin to the districts where it might be wanted at the different seasons of the year. 7. After the establishment of the Gold–Exchange Standard the importance of enlarging the functions of the note issue became apparent; and since 1900 the question of increasing the availability of the notes has been constantly to the front. In 1900 the Government issued a circular asking for opinions on certain proposals, including one for “universalising” the notes or making them legal tender in all circles. Some authorities thought that notes of small denominations (Rs. 5 and Rs. 10) might be safely universalised, without risk (on account of the trouble involved) of their being used for remittance on a large scale. It is on these lines that the use of the notes has been developed. In 1903 five–rupee notes were universalised except in Burma—that is to say, five–rupee notes of any circle were legal tender and encashable at any office of issue outside Burma; and in 1909 the Burmese limitation was removed. In 1910 a great step forward was taken, and the law on the subject was consolidated by a new Act. Notes of Rs. 10 and Rs. 50 were universalised; and power was taken to universalise notes of higher denominations by executive order. In pursuance of this authority notes of Rs. 100 were universalised in 1911. “At the same time the receipt of notes of the higher denominations in circles other than the circle of issue, in payment of Government dues and in payments to railways, post and telegraph offices, was stopped by executive orders”; and “with a view to minimise any tendency to make use of the new universal notes for remittance purposes, it was decided concurrently with the new Act to offer facilities to bankers and merchants to make trade remittances between the currency centres by means of telegraphic orders granted by Government at a reduced rate of premium.” In the following year the Comptroller of Paper Currency reported that no difficulty whatever was experienced as the result of universalising the Rs. 10 and Rs. 50 notes; and the inconveniences, the fear of which had retarded the development of the note system for many years, were not realised. 8. The effect of these successive changes has been to make the old system of circles virtually inoperative. With notes of Rs. 100 universal legal tender it is difficult to see what can prevent the public from using them for purposes of remittance if they should wish to do so. The “circles” can no longer serve any useful purpose, and it would help to make clear in the public mind the nature of the Indian note issue if they were to be abolished in name as well as in effect. 9. There must have been many occasions under the old system, on which ignorant persons suffered inconvenience through having notes of foreign circles passed off on them; and a long time may pass before distrust of the notes, as things not readily convertible, bred out of the memories of these occasions, entirely disappears. But, in combination with other circumstances, the universalising of the notes has had already a striking effect on the volume of their circulation, as is shown in the figures given below. It should be explained that by gross circulation (in the Government Statistics) is meant the value of all notes that have been issued and not yet paid off; that the net circulation is this sum less the value of notes held by Government in its own treasuries; and that the active circulation is the net reduced by the value of notes held by the Presidency banks at their head offices. For some purposes the active circulation is the most important. But it is the reserve of rupees held against the gross circulation which is the best indication of the surplus volume of coined silver available, if necessary, for the purposes of circulation. The following table gives for various years the average of the circulation on the last day of each month:— The following table gives in £ million the gross circulation of currency notes on March 31 of each year:— The following table gives the average monthly gross circulation in £ million (at 1s. 4d. the rupee throughout):— 10. The rules governing the reserves which must be held against currency notes are very simple. A certain fixed maximum, the amount of which is determined from time to time by law, may be held invested, chiefly in Government of India rupee securities. Up to 1890 the invested portion of the reserve amounted to 600 lakhs (Rs. 600,00,000). This was increased to 700 lakhs in 1891, to 800 lakhs in 1892, to 1000 lakhs in 1897; to 1200 lakhs, of which 200 lakhs might be in English Government securities, in 1905; and to 1400 lakhs (£9,333,000), of which 400 lakhs (£2,666,000) might be in English securities, in 1911. The interest thus accruing on the invested portion of the reserve, less the expenses of the Paper Currency Department, is credited to the general revenues of the Government under the head “Profits of Note Circulation.” This interest now amounts to £300,000 annually. Up to 1898 the whole of the rest was held in silver coin in India. Under the Gold Note Act of 1898 the Government of India obtained authority to hold any part of the metallic portion of the reserve in gold coin. An Act of 1900 gave authority to hold part of this gold in London; but this power was only intended to be used for purposes of temporary convenience, and, although some gold was held in London in 1899 and 1900, this was not part of a permanent policy. An Act of 1905, however, gave full power to the Government to hold the metallic portion of the reserve, or any part of it, at its free discretion, either in London or in India, or partly in both places, and also in gold coin or bullion, or in rupees or silver bullion, subject only to the exception that all coined rupees should be kept in India and not in London. The actual figures, showing where the gold reserve has been held at certain dates, are given below. Gold in Paper Currency Reserve (£ Million). 11. Gold was originally accumulated in the reserve in India through the automatic working of the rule by which rupees could be obtained in exchange for sovereigns. After exchange touched par in 1898, we see from the above table that gold began to flow in. When in 1900 the accumulations reached £5,000,000, attempts were made, in accordance with the recommendations of the Fowler Committee, to force it into circulation. After the comparative failure of this attempt, and the passing of the Act of 1905, as described above, the Paper Currency Chest in England was instituted, and by 1906 about two–thirds of the gold which had been accumulated up to that time was transferred to this fund. This stock is kept at the Bank of England, but is not included in the Bank of England’s own reserve. Gold which is thus transferred is said to be “ear–marked.” The fund is under the absolute control of the Secretary of State for India in Council, and transferences to it are, so far as the accounts of the Bank of England are concerned, reckoned as exports. Policy as to how much of the gold should be kept in London and how much in India has fluctuated from time to time. I shall discuss it in Chapter VI. 12. These are the chief relevant facts of law. Important considerations of policy do not lie so plainly on the surface. Since 1899 the circulation of notes has more than doubled, but the invested portion of the reserve has been increased by only 40 per cent. As the note issue has become more firmly established and more widely used, a growing and not a diminishing proportion of the reserves has been kept in liquid form. This is due to a deliberate change of policy, and to the use of the liquid part of the reserve for a new purpose. The bullion reserve is no longer held solely with the object of securing the ability to meet the obligation to cash notes in legal tender (rupees or gold) on demand. It is now utilised for holding gold by means of which the Secretary of State can support exchange in times of depression and maintain at par the gold value of the rupee. For the sake of this object the Government are content to forego the extra profit which might be gained by increasing the investments, and have steadily increased instead (as shown in the table on p. 49) the gold portion of the reserve. The Paper Currency Reserve is thus used to provide the gold which is the first line of defence of the currency system as a whole, and hence can hardly be distinguished from the resources of the Gold Standard Reserve proper. It is not profitable to discuss the reserve policy of the Paper Currency under existing conditions in isolation from the other reserves which the Government now hold. The whole problem of the reserves, regarded as a current practical question, is dealt with in Chapter VI. In this chapter I wish to look at the matter from a broad standpoint, with an eye to the proper policy in a future, possibly remote. 13. The present policy was designed in its main outlines at a time when notes formed an insignificant part of the country’s currency, and when the system of circles still greatly restricted their usefulness. The notes were at first, and were intended to be, little more than silver certificates. The rules governing the Reserve were framed (see § 3) at a time which, to the modern student of currency, is almost prehistoric, under the influence of the Bank of England’s system of note issue and of the British Bank Act,—an Act which had the effect of destroying the importance of notes as a form of currency in England, and which it has been found impossible, in spite of some attempts, to imitate in the note–using countries of Europe. As has been urged in Chapter II., England is in matters of currency the worst possible model for India; for in no country are the conditions so wholly different. A good deal of experience with regard to note issues has now been accumulated elsewhere which ought some day to prove useful to India if her English rulers can sufficiently free themselves from their English traditions and preconceptions. Let me first give a short account of the nature of the seasonal demand for money in India; and then discuss the salient respects in which her system of note issue differs from those of typical note–using countries. 14. In contrast to what happens in the case of most note systems, the gross circulation in India diminishes instead of increasing during the busy seasons of autumn and spring. This is due to the fact that the Government Treasuries, the Presidency Banks, and possibly other banks and large merchants, use the notes as a convenient method of avoiding the custody of large quantities of silver during the slack season when rupees are not wanted. That is to say, they deposit their surplus rupees during the summer in the Currency Reserve, holding their own reserves in the form of notes; and when the drain of rupees begins up country for moving the crops these notes have to be cashed. Thus in the dull season currency is largely in the hands of a class of persons and institutions which finds it most convenient to hold it in the form of notes, and in the busy season it is dissipated through the country and is, temporarily, in the hands of smaller men—cultivators who have sold their crops, small moneylenders and others, who habitually deal in small sums for which the rupee is the most convenient unit, or who do not yet understand the use of notes and still prefer, therefore, to be paid in actual coin. 15. Notes themselves, however, are used also, and to an increasing extent, for moving crops; and, although the gross circulation falls during the busy season for the reasons just given, the active circulation (i.e., excluding the holdings of the Government Treasuries and the Presidency Banks) does, as we should expect, increase at this time of year. When, therefore, we are considering what proportion of liquid reserves ought to be maintained, or what part the note issue plays in supplying the much needed element of elasticity in the busy season, it is of the active rather than of the gross circulation that we must take account. The figures are given below in lakhs of rupees:— We see, therefore, that, while the notes held by the Presidency Banks and the Treasury fall in the busy season by 700 to 1000 lakhs below their highest figure in the slack season, the active circulation increases in the busy season over its lowest figure in the slack season by about 400 lakhs (in the latest year for which we have figures, 1911–1912, by more than 600 lakhs). Of course this is not a very high proportion of the total increase in the volume of currency which is required in the busy season. But it is an amount well worth considering, and these figures put the note issue in a more favourable light as a source of currency in the busy season than is usually realised. The relative importance of notes and rupees in supplying the seasonal needs of trade is well shown in the following table:— Net Absorption (in Lakhs of Rupees) of Currency into Circulation (+) or Return of Currency from Circulation (–).(a) (a) In this table rupees (but not notes) in the Presidency Banks are treated as being in circulation. It would be a troublesome piece of work to exclude them, and would make, I think, very little difference to the result. The main variable element in the reserves of the Presidency Banks is the notes, and these are duly allowed for in the above table. The above table is exceedingly instructive. It shows that the notes supply an increasingly important proportion of the seasonal demand for additional currency. It shows also that the demand for notes from one year to another has been of a steadier character than the demand for rupees. In the period of depression from the winter of 1907 until the autumn of 1908 the active rupee circulation was much harder hit than the active note circulation; for in the six months January to June 1908 the rupee circulation fell by 1468 lakhs, while the active note circulation fell by 294 lakhs, and for the nine months January to September 1908 the former fell by 2186 lakhs, while the latter fell by only 96 lakhs. 16. Let me now turn to three salient characteristics, all closely connected with one another, and chiefly distinguishing the Indian system of paper currency from those of most note–using countries. In the first place, the function of note–issue is wholly dissociated in India from the function of banking. To discount bills is one of the functions of banks. Where there are Central Banks with the right of note issue, they are usually able, subject to various restrictions, to increase their note issue at certain seasons of the year in order to discount more bills. In the second place, as there is no Central Bank in India, there is no Government Banker. It is true that the Government keep some funds (rather more than £2,000,000, as a rule) at the three Presidency Banks. But the bulk of their floating resources is held either in London or in cash in their own Treasuries in India. Thus, as in the United States, the Government maintains an independent Treasury system. This means, just as it does in the United States, that, at certain seasons of the year when taxes are flowing in fastest, funds may sometimes be withdrawn from the money market. The difficulty and inconvenience to which this system has given rise in the United States are well known to those who are acquainted with the recent financial history of that country. The ill effects of it are to a certain extent counteracted, in the case of India, by a transference of these funds to London and a release of the accumulating currency in India through the sale of Council Bills. But this is not a perfect solution. The third and most important point arises out of the first two. The Indian currency is internally (i.e., apart from the import of funds from foreign countries) absolutely inelastic. There is no method whatever by which the volume of currency can be temporarily expanded by some credit device within the country to meet the regularly recurrent seasonal demands of trade. Cheque–using countries meet the difficulty by increasing the volume of credit created by the banks; most note–using countries meet it by the Central Bank’s discounting a greater volume of home bills than usual, and thus increasing its note circulation temporarily, without a corresponding increase in its metallic reserves. Except for a certain proportion of the business which is transacted by cheque (chiefly in the Presidency towns), there is nothing corresponding to this in India. Additional currency, whether notes or rupees, can be obtained in two ways only—by buying Council Bills in London or by bringing in sovereigns. Additional notes or rupees can be obtained in payment of Council Bills or in exchange for sovereigns, but not otherwise. The fact that a temporary increase in the media of exchange can only be obtained by bringing in funds from abroad partly explains the high rate of discount in India during the busy season. This question will be more fully dealt with in Chapter VIII. But the main point can be put briefly thus:—If funds are to be attracted from abroad for a short period (say three months), the rate of interest must be high enough to repay the cost of remittance both ways, which in the case of places so remote from one another as India and London is considerable. If there were some authority which could create credit money in India during the busy season, it would not be necessary for the rate of discount to rise so high. 17. The objections to the existing arrangements largely arise, therefore, out of the absence of a State Bank. This question is further discussed in Chapters VI. and VII. I feel little doubt that India ought to have a State Bank, associated in a greater or less degree with the Government. The Government is drifting year by year into doing more business of an essentially banking character; and as time goes on it will become increasingly objectionable to dissociate some of the functions of modern State Banking from others. But there is a considerable weight of opinion in favour of the view that the time for the establishment of a Central Indian Bank is not yet ripe. In the meantime is any partial remedy possible for the evils dealt with above? 18. I am inclined to think that such a remedy is possible. The manner in which the reserve against the note issue must be kept is needlessly restricted. Apart from that portion which is permanently invested, the whole must be kept in gold and silver. This is in imitation of the rules governing the Bank of England’s note–issue. But the note–issuing banks of Europe afford a better model. It might be proper to prescribe by law the holding of a certain proportion of the reserve (say one–third ) in gold or silver coin. A further amount might be held, as at present, permanently invested in Government of India securities. With regard to the rest the Government should, I think, permit itself much greater latitude. It should be free to lend it out on suitable security, either in India or London, for periods not exceeding three months. In London it should be lent out on the same conditions as the Cash Balances and the Gold–Exchange Standard (see Chapter VI.) are lent out at present. To lend in London would be technically convenient (for the reasons given on p. 172), but it would not cure the inelasticity of the Indian system. Part of the reserve should, therefore, be lent out in India. Suitable security for this purpose would be Government of India securities (which would have indirectly the effect of increasing the market for Rupee Paper) and Bills of Exchange of the highest class. It is not worth while to discuss here in detail the precise methods which it would be proper for the Government to adopt in lending out funds in India either from the Cash Balances or from the Paper Currency Reserve. Whether it were done through the Presidency Banks only, or whether an approved list of borrowers of Government funds were to be drawn up for India as is already the case for London, the effect on the Indian Money Market would be much the same. The needed element of elasticity would be obtained, and the present absolute dependence of India on London for an expansion of currency would be modified. I shall return to this proposal again in Chapters VI. and VIII. Its full force cannot be shown until we have discussed the question of the Secretary of State’s reserves as a whole, and have studied in detail the movements of the Indian bank rate. A good deal of opinion has been expressed in India lately in favour of loans being made there from the Government’s Cash Balances. In so far as this opinion demands some new machinery by which on suitable occasions the Government can lend out funds in India herself, the evil which it seeks to remedy is a real one. And the method proposed above is, I believe, the right way in which to approach the problem’s solution. 19. The discussion of this question will be concluded in Chapters VI., VII., and VIII. But it will be well to say a few words at once with a view to avoiding misunderstandings on two points. It has been necessary in the immediate past to use the Paper Currency Reserve as a part of the general reserves held for ensuring the absolute stability of the rupee. I do not advocate the lending out in India of any part of this reserve, or of the Cash Balances, at the expense of the stability of the Gold Standard, or until adequate measures can be taken in other ways to ensure this. But I think the time has practically arrived when the whole of the liquid portion of the Paper Currency Reserve is not required, in addition to the Gold Standard Reserve proper, for this purpose. A busy season will soon come when the Government might lend some part of its reserves in India without endangering in the least the stability of its system and to the great advantage of Indian trade. It ought, at least, to have the power to do this. 20. The remaining point is this. A provision of the above kind for introducing some degree of elasticity into the Indian currency system would not be very useful in a season such as that of the autumn and winter of 1905–6 or of the autumn of 1912–13, when there was a demand for rupees on so great a scale that it could only be met from the Mint. Additions to the currency of this kind can only be made by importing funds from abroad. But these are permanent not temporary additions. Every such addition makes a similar demand for new coinage in succeeding seasons less likely. They are abnormal, and recent history seems to show that these permanent additions to the Indian currency are not made by slow and steady accretions year by year, but in great bursts of activity at considerable intervals. In years of normal activity, therefore, there may be considerable stores of rupees lying idle in the reserves beyond what is required for the safety of the currency. Indian bankers and merchants can only get at these rupees, so as to obtain a net addition to the currency, by buying sovereigns or Council Bills in London. If the use for the additional currency is only temporary, the cost of transport or remittance is great enough to make it not worth their while to get this addition until the Indian rate of discount has been forced up to a high level. If the Government were free on such occasions to lend out some part of the rupees, against high–class security, at 5 or even 6 per cent, this would be profitable to the Government, and would prevent the discount rate from reaching a level which is caused, not by anxiety, but merely by the expense arising out of the distance between London and Calcutta. About HackerNoon Book Series: We bring you the most important technical, scientific, and insightful public domain books. This book is part of the public domain. Keynes, John Maynard, 2015. Indian Currency and Finance. Urbana, Illinois: Project Gutenberg. 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