Indian Currency and Finance

by John Maynard Keynes

22. So much for the proper magnitude of the Reserve, regarded as a Currency Reserve. The question of its use as a Banking Reserve raises two problems—a problem of policy and a problem of statistics. Ought the Government to allow its Reserve to be used as a Banking Reserve? If so, how large ought this Reserve to be? Let us consider policy first.

23. There are three kinds of crises by which the Indian Money Market might be assailed—a purely internal crisis, in which the banks have difficulty in meeting a run on them by their Indian depositors; a purely external crisis, in which India owes, and is called on to pay, large sums in the London Market, but is free from serious banking trouble at home; and a general crisis, in which the features of an internal and an external crisis are combined.

A purely internal crisis of the first kind might require assistance from the resources of Government, but would involve no claims on their sterling resources specifically, as distinguished from their rupee resources. The trouble would probably begin with a boom of the usual type, heavy commitments on the part of the banks, large importations of foreign goods, and (in the future) a good deal of internal company promoting. If, early in the autumn, a serious failure of the monsoon became apparent, a widespread suspension on the part of the numerous bubble banks, which have been springing up lately all over India,[70] would be a probable consequence. Indian depositors generally might take alarm and hoard money in their own houses on a large scale. Exchange Banks have such large deposits in India and so little cash there[71] that they would probably require to import funds from London as fast as possible. The Indian Joint Stock Banks, however, are now so important that the part played by the Exchange Banks might not be adequate to save the situation. The Government would then be called on to make advances to the Presidency Banks. This has happened from time to time in the past, the last occasion being in April 1898, when the Bank of Bombay, whose bank rate was then at 13 per cent, asked the Government for an advance of 25 lakhs.[72]

This raises the first question of policy—whether the Government should help the bankers’ reserves on an occasion of internal crisis by making rupee advances to them. But it is hardly relevant to the question of the Government’s sterling resources; and, unless the Government Savings Banks were to be in trouble at the same time, it is not likely that there would be any difficulty in helping the bankers, if it were thought right to do so.

A crisis of the second kind, due to general depression or bad harvests, in which India has to meet a heavy adverse balance in London, provided that, as in 1907, it is not accompanied by internal banking difficulties of the kind just described, causes, it is true, a drain on the Government’s sterling resources through the necessity of providing remittance on London, but only in proportion to the volume of notes and rupees which are brought to the Government for encashment or in payment of sterling drafts.

At first, therefore, in such a case, there is no question of the Government’s using its reserves otherwise than as currency reserves; and the banks will have plenty of notes and rupees with which to buy the Government’s sterling drafts. Only if the depression is very prolonged, and one bad harvest follows another, is the need likely to arise for sterling advances from Government, otherwise than against a corresponding face value of notes and rupees.

It is not very improbable, however, that in the future there might be a general crisis of the third kind—a heavy adverse balance against India, and an internal banking crisis at the same time. It is in these circumstances that the most difficult question of policy arises. The Indian Money Market would need to remit funds to London, but, on account of the internal banking crisis and an outbreak of hoarding amongst depositors, would not have even rupee resources with which to do it. Consequently the Government’s offer to sell sterling drafts in Calcutta, or to release gold from the Currency Reserve would not meet the case. If general distrust of banking was widely spread, and notes, gold, and rupees were being hoarded in the old–fashioned way on a large scale, the banks would not be able to put their hands on sufficient cash resources of any kind to enable them to pay for the Government’s drafts on a scale adequate to their necessities. The position would be that the Indian Money Market was on the verge of general insolvency with the Presidency Bank Rates at (say) 12 per cent, and that the Indian Government had (say) £40,000,000 sterling resources in hand with demands on only a modest scale for the encashment of notes and rupees. The Government would be vehemently urged to save the situation by making sterling advances, not simply in exchange for notes or rupees, but on some other non–monetary security.

24. We now have the possibilities before us. If in any of these sets of circumstances the Government were faced with demands for advances either in rupees or sterling, what line would it be proper to take?

On the one hand the policy of advances may introduce into the Indian Money Market a serious element of weakness,—an element, perhaps, inseparable from a system where there is no central banking authority and where the currency authority stands, normally, outside the money market. It is not the business of the Government to hold any of the reserves which the bankers ought to hold. But if the Government does, in fact, for another purpose hold large reserves in its hands, and if it is believed that it will in case of extreme necessity come to the market’s rescue, the bankers may tend to keep somewhat lower reserves than they ought, and than they otherwise would. We have over again the situation which has long existed, to its detriment, in the United States. There, as in India, the Government, with immense currency reserves of gold, is normally aloof from the money market. There also they have no central banking authority. The expectation that the Government will bring some of its gold to the rescue in extreme circumstances, has always been said to exert an enervating influence on the banks themselves in the matter of the precautions they take for times of crisis. The ultimate solution probably lies in the establishment of a Central Bank for India which shall be the Government Bank and shall hold the banking and currency reserves at the same time.[73]