Indian Currency and Finance: Chapter VIII - The Indian Rate of Discount

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 VIII: The Indian Rate of Discount CHAPTER VIII. THE INDIAN RATE OF DISCOUNT 1. The Presidency Banks publish an official minimum rate of discount, in the same manner as the Bank of England. As an effective influence on the Money Market the Presidency Bank Rates do not stand, and do not pretend to stand, in a situation comparable in any respect with the Bank of England’s. They do not attempt to control the market and dictate what the rate ought to be. They, rather, follow the market and supply an index of the general position. It is, therefore, as the best available index to variations in the value of money in India that the Presidency Bank Rates are chiefly interesting; and it is in this capacity that I shall make use of them in this chapter. If we are to use these rates, however, as an index, a few warnings are first necessary. There is, of course, in India, just as there is in England, not one single rate for money, but several rates according the period of the loan required (or the maturity the bill negotiated) and the character of the security offered. The published Bank Rate in India represents, I believe, the rate charged day by day for a loan advanced on such security as Government Paper. The interest on a loan of this kind, that is to say, is calculated day by day at the published Bank Rate prevailing on each day. It may be said to correspond, therefore, to the London rate for some comparatively short period—say for fortnightly loans. Because the Bank Rate is at 7 per cent, it does not follow, therefore, that money can be used, or obtained, at this rate for two or three months. The rate ordinarily charged for fine bills of two or three months’ currency may be either higher or lower than the published minimum Bank Rate. Further, the rates published by the Presidency Banks may be from time to time more or less “effective.” The Banks may not always be able, that is to say, to do any considerable volume of business at their published minima. This would not be the case, I believe, in the busy season, so much as in the slack season, when the Banks do not let their published rates fall below 3 per cent, although money may be practically unusable and they would probably be glad enough to lend a large sum at 2 per cent. But these various qualifications do not prevent the Presidency Bank Rates from affording the best available index for measuring the relative ease or stringency of the Indian Money Market. I append a chart giving the movements of the Rate of Discount at the Presidency Bank of Bengal since 1893. 2. The rates, announced by the three Presidency Banks, are not always identical, but seldom, if ever, differ by more than 1 per cent. Such differences as there are chiefly reflect the differences in date at which occur the various crop movements with which each Presidency is mainly concerned. A wider difference of rate tends to be prevented, not only by the possibility of moving funds from one part of India to another, but also by the fact that the Secretary of State is willing to make his Bills and Transfers payable at any of the Presidency towns at the option of the purchaser. If there is relatively greater stringency at one of them, the bulk of the Council Bills and Transfers sold in London tend to be drawn on that one. The general appearance of the chart would not, therefore, have been appreciably different if I had chosen Bombay in place of Bengal. The official rates move by 1 per cent at a time. There have been occasions of movements by 2 per cent, but not recently. When the rate is rising or falling, however, at the beginning or end of the busy season, changes often follow one another in quick succession. 3. An examination of the chart shows that the Indian Money Market enjoys years of high and low average rates respectively, just as other markets do. But these annual variations, while perfectly noticeable, are relatively small in comparison with the seasonal changes, which are very great and very regular, and which afford the most clear ground of differentiation between the Indian Market and those with which we are familiar in Europe. Let us examine the annual fluctuations of the rate in recent years in more detail:— From this table and the chart it is safe to make the generalisation that the Indian Rate may be expected to reach 8 per cent in the winter or early spring, and to fall to 3 per cent in summer. Years differ from one another chiefly in the length of time for which the high and low rates prevail respectively. From 8 to 3 per cent is an enormous range for the normal seasonal fluctuation. What is the explanation of it? The Bank of England rate seldom exceeds 5 per cent, and in many years falls short of this, even in the winter. If there is so regular an expectation of obtaining 7 or 8 per cent in India on excellent security, why is it not worth some one’s while to transfer funds to India in the busy season on an ampler scale than is the case at present, and thus secure the advantage of so wide a discrepancy between the English and the Indian rates? 4. The facts are to be explained, I think, as follows. High rates of 7 or 8 per cent are not obtainable in India all the year round. In normal years they cannot be relied on to prevail for more than about three months. The banker who raises funds in London in order to lend them for short periods in India has to choose between leaving them in India all the year round, waiting after one busy season for the next, and bringing them back again to London after a comparatively short period. He must either accept, that is to say, the rate obtainable in India on the average of the whole year, or he must earn a high enough rate in the brief busy season to compensate him for bearing the expense of remittance both ways. In considering the difference between two European Bank Rates as the cause of a transfer of funds between the two centres, the cost of remittance, as measured by the difference between the telegraphic rate of exchange outwards at the beginning of the transaction and the telegraphic rate of exchange back at the end of it, is not, of course, to be neglected. But where the two centres are near together and there is no reason to anticipate the suspension of a free market in gold, this cost is, relatively, a minor consideration. The great distance, however, between London and India makes it in their case a very significant quantity, and a brief calculation shows that, measured in terms of Bank Rate, the cost of remittance works out higher, perhaps, than uninstructed common sense would anticipate. For, under present conditions, the cost of remittance both ways can hardly be less than 1/16d. per rupee, rising in most years as between certain dates as high as 5/32d., and reaching occasionally as much as 3/16d. It would not be prudent to act on the expectation of a less cost than 3/32d. Now 3/32d. on a rupee is about ·6 per cent. If this loss on exchange (i.e. on remittance) is to be recouped in three months (i.e. in a quarter of a year), an additional rate of nearly 2½ per cent per annum must be earned in India as compared with the rate in London. If a different degree of loss in exchange is anticipated, and if the length of time for which money can be used in India at a high rate is expected to be more or less than three months, the calculation must be adjusted accordingly. In any case the reason why the Indian and London Bank Rates can differ from one another for short periods by large amounts is adequately explained. If, for example, money can be employed in India at the high rate for one month only, even if the double cost of remittance for that period is so low as 1/16d., the difference between the London and Indian rates must amount to 5 per cent per annum to make a transfer of funds prima facie profitable. These illustrations show that what seems a very small fluctuation in exchange can account for a very wide difference in the rate of discount; and, apart from questions of unequal knowledge and unequal security, it is this possibility of fluctuation that makes distinct markets of the two centres. The underlying explanation is essentially the same as that of the circumstance to which I called attention in § 9 of Chapter II., namely, that a temporary premium of ¾ per cent on gold in those European countries where gold is not always freely obtainable, is as effective as a very great increase in the Bank Rate in preventing the remittance of funds abroad and even in attracting an inward flow of funds. 5. This discussion will have served to make clear a distinction highly important to the problem of the Indian Bank Rate. When we say that the Indian Bank Rate is apt to be high, we mean, not that the average effective rate over the whole year is high, but that the maximum rate in each year, effective for periods of shorter or longer duration, is generally high. A high average rate and a high maximum rate are likely to call for different explanations and, if a remedy is sought, for different kinds of remedies. The available evidence does not suggest that the average rate in India is at all unduly high for a country in India’s stage of economic and financial development. Some of the Exchange Banks, for example, do not find it worth their while to offer more than 3½ per cent on Indian deposits fixed for a year. It is the high maximum rate almost invariably reached which calls for enquiry. The phenomenon under discussion is in no way peculiar to India and does not arise out of those features of the Indian system which are characteristic of a Gold–Exchange Standard. We find the same thing in any country where the demand for funds for financing trade is to a high degree seasonal and variable in amount throughout the year, and where, at the same time, these funds have to be remitted from some far distant foreign centre—in the countries of South America, for example. In fact, by the establishment of a par of exchange between the rupee and sterling; the severity of seasonal stringency has been greatly moderated. The exceptionally high Bank Rates of 1897 and 1898 were partly occasioned by a natural timidity on the part of the Banks in importing funds at a rate of exchange which at that time was exceptionally high. The Banks had no guarantee that exchange would be maintained at or near the existing level, and if they imported funds they ran the risk of having to bring them home again at a heavy loss. Under present arrangements the maximum fluctuation in exchange between the busy season and the slack is known and limited. But while the stabilisation of the gold value of the rupee has done much for the Indian Money Market, and has rendered a 12 per cent Bank Rate most improbable except at a time of wide–spread crisis and panic, it does not prevent an 8 per cent or even a 9 per cent Bank Rate from being a comparatively common occurrence. Is it possible to conceive of any remedy or moderating influence for the somewhat severe seasonal stringency still experienced? 6. It is clear that a remedy can be sought in one or other of two ways only. Either the cost of remittance and the maximum range of fluctuation in exchange must be reduced, or a new source for the seasonal supply of funds must be found in India herself. I will discuss these alternatives in turn. It will help to make the points at issue plain if I begin by taking an extreme case. Let us suppose that exchange between London and Calcutta were fixed at 1s. 4d., in the sense that the Government were always prepared to provide telegraphic remittance in either direction at this rate. Under such circumstances, the London and Indian Money Markets would become practically one market, and the large differences which can now exist between rates current in the two centres for loans on similar security would become impossible. The effect of this on the volume of remittance would be very great. Every year immense sums would be remitted from London to India in the busy season and brought back again at the end of it, since the fact which now diminishes the profitableness of such transactions would have ceased to exist. The following illustration shows on how large a scale these seasonal movements to and fro would probably be. In July the cash reserves of the Bank of Bengal might stand, as things now are, at, let us suppose, about 1000 lakhs and its discount rate at 3 per cent. This reserve might be 400 or 500 lakhs at least in excess of what prudence required. But it would be useless to lower the Bank Rate; for the additional funds were probably not loanable in India for the month of July at any rate at all. Yet for the reasons already given it would not be worth while in existing circumstances for any one to borrow this sum and remit it to London, until such time as it may be again wanted in Calcutta;—it is better to let it lie idle and wait for busier times. But fix exchange at 1s. 4d. and all this would be changed. The Bank’s customers would immediately remit the 400 or 500 lakhs to London, knowing that they could be brought back without loss as soon as they were wanted. Every one in India having loanable funds to spare would act likewise. What would be the effect on the Secretary of State if he were to lay himself under such an obligation? In order to be in a position to act as universal money–changer, and to be able to provide large quantities of sterling in London in the slack season, and large quantities of rupee funds in India in the busy season, it would be necessary for him to keep very much larger reserves than he does at present in both countries. It might even be necessary for him to remit gold backwards and forwards himself, thus bearing the whole expense of which the Exchange Banks were being relieved. At present the possible fluctuation of exchange between what may fairly be termed the “gold points” on either side of 1s. 4d., acts in some measure as a protection to the currency and lessens the reserves which it is necessary for the authorities to maintain; a falling exchange acts as a drag on remittance from India and a rising exchange as a drag on remittance from London, thus bringing the private interests of individuals and the natural forces acting on the market into greater harmony with the interests of the market as a whole, and with the efforts of the Secretary of State to maintain the stability of the system. If telegraphic exchange were fixed at 1s. 4d., the Indian Bank Rate would closely follow London’s, but it would be at the expense of forcing the Secretary of State enormously to increase his reserves. 7. I have taken this extreme case in order to make emphatic the principles involved in all such proposals. But no one is likely to propose the above as a practical policy. More moderate proposals of the same kind, however, deserve consideration. Some critics, for example, have suggested that the Secretary of State should never sell Council Bills in London below 1s. 4d. This would lessen to a certain extent the probable range of fluctuation in exchange and might, therefore, diminish the risk of loss involved in remitting to India when exchange is high; but the Secretary of State’s withdrawal from the market would not necessarily prevent exchange from falling below 1s. 4d. Moreover, in normal times the policy actually followed already approximates closely to this proposal; in the last three years the occasions on which Council Bills have been sold below 1s. 4d. have been very rare. And in exceptional times it may be some protection to the sterling reserves if Council Bills can be sold at a lower rate if necessary. I conclude, therefore, that the advantage of such a policy would not be great, probably not great enough to outweigh the cost. Thus it is not easy to find a remedy for high Bank Rate by any method of diminishing the maximum range of fluctuation in exchange. Indeed so long as the currency arrangements are at all like those now in force, this maximum range may fairly be said to be determined by forces outside Government control, namely, by the forces governing the cost of remittance of gold. Though the burden of this cost may be shifted, it cannot be easily avoided altogether. 8. We must fall back, therefore, on the second alternative, the discovery of a new source for the seasonal supply of funds in India herself. A proposal, having this object in view, has already been put forward in more than one passage in the preceding pages. I believe that, in future, the Government of India may have in the busy season a considerable stock of rupee funds available in the Paper Currency Reserve and, occasionally, a surplus stock in the Indian Cash Balances. If a proper machinery is set up for lending these out in India, I anticipate some appreciable relief to the Bank Rate at the season of greatest stringency. Assuming that such a policy is practicable on other grounds, let us try to compare its precise effect as compared with the existing state of affairs. 9. Broadly speaking, surplus Government funds in India can at present be released only by the sale of Council Bills in London. When these bills are sold at a fairly high rate, the Government gain the premium over and above 1s. 4d. and are in a position to put out at interest funds in London. If the funds in India, instead of being released through the encashment of Council Bills, are lent out there direct, the interest obtained in India takes the place of the two sources of gain distinguished above. In the first case money is first borrowed from the London Money Market (by the Exchange Banks or otherwise) for the purchase of Council Bills, and is then lent back again to that Market by the Secretary of State. In the second case, instead of a double transaction in London there is a single transaction in India. It might be argued that the two methods come in the end to much the same thing; that there can be no relief to the Money Market unless the Government of India accept a lower rate of interest for sums lent out in India than is the equivalent of what they would make if they were to sell Council Bills at a premium and lend out the funds in England; and that the second method involves no net addition to the resources available in India. For the following reasons, however, I do not think that this way of looking at the matter would be correct. In the first place there would be an elimination of risk. If the average loss from exchange on funds sent out to India for the busy season works out at (say) 2 per cent per annum, the Banks, in order to recompense themselves for the risk of fluctuations beyond the average, would be able to make a difference of more than 2 per cent between the current Indian and English rates. In the case of funds borrowed in terms of rupees and repayable in terms of rupees, this element of risk is absent; and the elimination of it provides a source of net gain. If the effect of Government lending in India were to mitigate the seasonal stringency there, some lowering of the normal upper limit of fluctuation of exchange might result. In so far as this was the case, in normal years the consequences would be outwardly similar to those of the first alternative, discussed and rejected above, whilst the Government would not have bound themselves by any undertaking capable of turning out burdensome. Secondly, the rate of interest which the Secretary of State can earn on loans in London is appreciably lower, on account of the short period for which he lends and the nature of the security he requires, than the normal rate at which the Exchange Banks would raise their funds there, and a good deal lower than what would be obtained by direct lending in India. (It should be admitted, on the other hand, that the practice of lending funds in India would probably involve some sacrifice of perfect safety as compared with the present arrangements.) And, thirdly, it is not clear that it might not sometimes be feasible to lend out in India sums additional to those which would in fact be released under the present system, so that there would be some net addition to the resources available in India. 10. In addition, therefore, to the grounds for making loans in India from the Paper Currency Reserve which I have given in earlier chapters, I believe that it is in this direction that the best hope lies of a remedy for the high level which the Indian Bank Rate commonly reaches in the course of each busy season. I do not feel in a position to say anything very decided as to the manner in which such loans could be best made. But there is a presumption, I think, that, in the absence of a State Bank, they must be made, mainly if not entirely, through the Presidency Banks. And I believe that the Government would act advisedly if, as a general rule, 5 or 5½ per cent were the highest rate they ever chose to exact from the Banks. In financial matters of this kind there is a danger lest Governments prove too jealous of the profits of private persons. In a case where the co–operation of private persons is necessary, they must be allowed a reasonable share of the profits of the transaction. In their past relations with the Presidency Banks in the matter of temporary loans, the Government of India have sometimes seemed to attach more importance to preventing the Banks from making any profit out of the loans than to any other aspect of the transaction. I may repeat that the loans I contemplate are to be for the busy season only, and that they should not be made until the expectation of a normal or successful harvest is reasonably assured. 11. In the nature of a postscript to the above proposals, it may be instructive to consider them in the light of the actual circumstances of the season 1912–13. The peculiarity of this season from the point of view of the Indian Money Market was the combination of a high Bank Rate in India for a comparatively long period with a relatively low rate of exchange and only a moderate demand for Council Bills and gold. At the end of 1912 the situation could have been described as normal. The Bank Rate was at the somewhat high level usual at that time of year; exchange was high (the minimum rate for the allotment of Council Bills being 1s. 43/32d.); and the demand for Council Bills was on a large scale. But from January to March, although the Bank Rate remained at a high level and trade was active, the demand for Council Bills fell away, slowly at first and rapidly during March, exchange dropping pari passu until, during the latter half of March, the minimum rate at which Council Bills were allotted fell so low as 1s. 331/32d. The combination of so low a rate of exchange with an 8 per cent Bank Rate at Bombay was very abnormal. It is dangerous for a writer who is not in touch with the practical side of the Money Market to venture on an explanation of current events. But I will give my explanation for what it is worth. The poor demand for Council Bills in March 1913 is not to be explained by the competition of gold as a means of remittance; for the low level of exchange did not favour the importation of sovereigns (even from Egypt, except earlier in the season), and as a matter of fact the import of them was on a very much smaller scale than in the previous year. It must have been due, therefore, to an unwillingness on the part of the Exchange Banks and others to lay out money in London for the purchase of remittance to India. This unwillingness was due to a variety of causes. The lock–up of funds in silver and opium, and the freedom with which India was purchasing foreign goods, probably had something to do with it; and an important contributory influence was the dearness of money in London combined with a sufficient expectation of cheaper money soon, to provide an incentive to delay, wherever delay was possible. A precise diagnosis of the causes of the unwillingness on the part of the Banks to buy Council Bills is not necessary, however, to the lesson I seek to enforce. For whatever reason, Indian Bank Rates of 7 and 8 per cent, even in combination with a very low level of exchange, did not in fact tempt the Banks to buy Council Bills on any considerable scale. What was the effect on the Government Balances in India? The ordinary method, by which the rupees accumulating in the Reserve Treasuries from the proceeds of taxation are quickly released and given back to the Money Market, the encashment, namely, of large volumes of Council Bills, had failed. The position was aggravated by the large realised surplus, much of which was to be devoted to expenditure only in the next financial year, and which in the meantime was swelling the Government Balances in any case beyond their usual dimensions. So far, therefore, from assisting the market, the Government were busy increasing the stringency by taking off the market, week by week, rupees which for the moment they did not in the least want. Already at the end of 1912 (see table on p. 188) the sums lying idle in the Reserve Treasuries were unusually high. By the end of February 1913, the total Government Balances in India had risen to £17,400,000, and the end of March to £19,300,000, of which £8,000,000 lay in the Reserve Treasuries. What Money Market in the world could have seen such sums taken out of its use and control at one of the busiest moments of the year without suffering a loss of ease? The situation was not due, in my judgment, to any ignorance or incompetence on the part of the executive officers of Government, but to a system which provided them with no sort of appropriate machinery for dealing with the position. The “Independent Treasury System” and the traditional aloofness of Government from the Money Market were seen at their worst. Millions of rupees were lying idle in the Government Treasuries at the time of year when there was most work for them to do outside. The sort of arrangements I have outlined in earlier paragraphs might have done something, I feel sure, to ease the situation. One can point, therefore, to the first quarter of 1913 as a specific occasion on which Government could have lent sums in India with profit to itself, with advantage to the Money Market, and without incurring any risk of which it need have been afraid. 12. I have now completed my discussion of these questions. Two points I would end by emphasising. The first affects my general treatment of the subject matter. I have tried to bring out the fact that the Indian system is an exceedingly coherent one. Every part of the system fits into some other part. It is impossible to say everything at once, and an author must needs sacrifice from time to time the complexity and interdependence of fact in the interests of the clearness of his exposition. But the complexity and the coherence of the system require the constant attention of anyone who would criticise the parts. This is not a peculiarity of Indian Finance. It is the characteristic of all monetary problems. The difficulty of the subject is due to it. My second point affects the kinship of Indian arrangements to those lately developed in other parts of the world. Indian affairs are so exclusively studied by those whose knowledge and experience is preponderantly Indian or English, that the true perspective of India’s development is sometimes lost; and the value of foreign experiences neglected. I urge that, in her Gold–Exchange Standard, and in the mechanism by which this is supported, India, so far from being anomalous, is in the forefront of monetary progress. But in her banking arrangements, in the management of her note issue, and in the relations of her Government to the Money Market, her position is anomalous; and she has much to learn from what is done elsewhere. 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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