Indian Currency and Finance

by John Maynard Keynes

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.