India-Kerala oil swap

India is short crude oil, while Kerala is long the commodity. So it makes sense for the two entities (one of which is a subset of the other) to strike a long-term swap deal.

With oil prices being at a rather low level for the last couple of years (compared to the preceding decade or so), Kerala’s economy is in deep strife, as Mint reported. This is a consequence of a large amount of the Kerala economy being dependent on remittances from its expat workforce (35% of the state’s GDP, according to Mint), most of which is in the Gulf countries. With oil prices down, Gulf economies aren’t doing well, and being foreign workers, the expat Keralites, and consequently Kerala, is bearing the brunt of it.

With economic activity in the state reduced thanks to the withdrawal of legal tender of Rs. 500 and Rs. 1000 notes, the state is in deeper trouble, with doubts even cast on whether the state can pay salaries.

India on the whole, however, has benefited significantly from the fall in oil prices. With India a large net importer of crude oil, the drop in prices has resulted in significant easing of the pressure on the country’s current account deficit. The oil price drop has also helped in inflation dropping over the last couple of years, and since fuel is a transaction cost, has also helped in increasing economic activity.

After the oil prices dropped, experts advised the Union government to lock in the oil prices by signing long term forward agreements, in order to cushion the country’s economy against an oil price shock. The problem with striking this kind of a forward agreement is the need for a counterparty who faces the opposite risk. While investment banks can do such a deal, the margins can be high if a counterparty is not forthcoming.

With India benefiting from low oil prices and Kerala being hurt by them, the two entities should strike a long term oil swap. India can pay Kerala a fixed sum for the duration of the swap. Each month, Kerala will pay India an amount proportional to the extent by which the oil price (measured by indices such as Brent) exceeds a pre-agreed benchmark. In case oil remains below the benchmark, Kerala won’t need to pay India anything – the swap cash flows can be like an option.

This way, both parties will benefit. India will get hurt when prices increase but some of that will get compensated by the payments by Kerala. And while prices remain low, Kerala will get compensated for the loss in remittances by the payout by the government!

Wonder why no one’s thought of this so far!

The velocity of scarce money

Ever since the Union government took Rs. 500 and Rs. 1000 notes out of circulation last week, my consumption patterns have changed. Rather, I still consume the same things but I’ve changed my habits in terms of purchase. Not having the patience to stand in line at a bank or ATM, my inflow of Rs. 100 notes is close to 0. And I’ve been trying to keep my outflow close to that number as well.

So rather than shopping at the local vegetable market, I’ve been buying online on BigBasket, where I can pay using credit card. My grocer always took credit cards, so I continue to buy from him. I take Uber instead of auto rickshaws, and pay for my fuel purchases using credit cards. I’ve told my cook and maid I’ll pay them this month by bank transfer (they have PMJDY accounts).

The point I’m trying to make is that I’m trying to conserve my scarce hard currency, and have changed my purchase patterns to do so. And I’d expect everyone else to do the same, including people who are more into the so-called “cash economy”.

Plenty has been written about how the decision to withdraw notes can be seen as a monetary shock. Read Ajay Shah’s excellent take on it here, though Ajit Ranade argues that in the context of broad money it cannot be classified as a monetary shock. In a cash economy, the short term reduction in the availability of cash can result in sharply lowered economic activity.

In monetary terms, economic activity can be described as the product of the “quantity of money” (there is no one good definition of it) and the “velocity of money” (the rate at which money changes hands by way of enabling economic activity). Lower economic activity can be a result of either low money supply, or due to low velocity of money (see my old piece in Mint on how the 2008 financial crisis was characterised by low velocity of money).

While much has been written about the decrease in quantity of money thanks to money withdrawal, the velocity of money following the withdrawal is also a key variable to take into account. On the one hand, thanks to reasons I described above (scarcity of currency notes), velocity of physical currency is likely to go down. People are going to use it only when absolutely necessary, and not for discretionary purchases.

On the other, the velocity of money in the form of bank deposits is also likely to go down. While those that are experienced in using the banking system might be using the system more for transactions nowadays, a large amount of the currency being deposited is going into accounts of people who are not used to transacting using the banking system. And this money is likely to sit quietly and not contribute to economic activity (unless banks use it to lower lending rates and expand credit), implying a drop in the velocity of money from the banking system.

So both monetary counts taken together, a drop in economic activity in the near future is likely. Hopefully banks will cut lending rates (in the last couple of years, cut in policy rate has hardly been passed on to ordinary customers) in the near future (once they have the bandwidth to do so) to get us out of this drop.