Demonetisation unlikely to lead to windfall for govt: Experts
Many, including some in the government, are of the view that the withdrawal of high-value currency notes will lead to a windfall for the Centre through dividends earned from the Reserve Bank of India (RBI), but people familiar with the RBI balance sheet say that is unlikely.
What the withdrawal of the currency notes would ensure is complete elimination of fake high-value currency notes and some grip on the black money situation. For that, the government, RBI and banks will have to incur necessary cost, without expecting any other monetary gain.
Chief Economic Advisor Arvind Subramanian — who once suggested the RBI must use its foreign exchange reserves to recapitalise banks, and in turn was criticised by then central bank governor Raghuram Rajan — said on Wednesday the demonetisation is “not a wealth reduction in the economy, but a wealth transfer.”
“Instead of seeing it (the demonetisation) as a reduction of wealth, it must be seen as transfer of unaccounted wealth. It should be seen as a transfer of this unaccounted wealth from the private sector to the government and the public sector, which will boost economy,” Subramanian said in Delhi.
Subsequently, State Bank of India Group Chief Economist Soumya Kanti Ghosh wrote in his research report the demonetisation could be used as a fiscal tool. Ghosh estimated that the unaccounted cash not coming back in the system could be “significantly higher than ~2,500 billion, or ~2.5 lakh crore.” This number could even be a “gross underestimation” as he calculated that ~9 lakh crore could be the possible unaccounted cash in the system.
Currency issued is a liability for RBI — it is a promise that RBI owes a particular value to the holder of the legal tender. If this money is not returned to the banks (and therefore RBI), the central bank’s direct liability gets reduced by that much of amount. Therefore, the assets will have to be reduced, too. In short, RBI will have to shrink the balance sheet, reasoned the State Bank of India. The shrunk part can then be transferred to the government as dividend, goes the logic.
Alternatively, since RBI would not know how many old notes have to be exchanged, it will likely print extra money and a cash pay-out against the currencies can be done to the government. Or, “as RBI will issue notes only against the old notes, there has to be a decline of equivalent amount from RBI asset side/cash pay-outs,” said the research report. “Whichever way we look into it, we would expect the RBI to transfer this windfall to the government over a period leading to significant fiscal headroom for the government. … such amount may be at least ~2.5 lakh crore, but with a significant upward bias.”
RBI has been instructed by a committee headed by Y H Malegam that the former’s entire reserves should be transferred to the government as dividend for three years starting financial year 2014. Therefore, the entire nonaccounted money, which could be theoretically ploughed back as reserves can come to the government as dividend.
But that is not going to happen. Here’s why: The above logic is flawed, say other economists and central bank balance sheet experts.
First, the money held back cannot be wiped from the RBI balance sheet, but will reside as a ‘nominal’ reserve. Second, RBI gives dividend to the government through real reserves earned through real investment activities such as earning interest on US treasuries, or foreign exchange transactions. The dividend is never paid out of ‘nominal’ reserves, said a central bank watcher who didn’t want to be named
The money not returned to the banks are legal, but undeclared. They are still a liability to the RBI and it had already created assets against the value in the past.
“RBI cannot just go and declare that I hereby, am foregoing my liability,” said a senior economist who did not wish to be named.
“It would be akin to forfeiting public money and a central bank cannot do so,” said the economist, adding, to forfeit the money, the government has to issue an executive order that the undeclared wealth is now that of the government, which will have its own ramifications. “That doesn’t happen unless there is an emergency or a war-like situation.”
Instead, the liability of the RBI shifts from ‘Notes Issued’ head to ‘Other Liabilities and Provisions’ in the RBI balance sheet.
Economists explain a government cannot just take away public money, and the RBI cannot extinguish its liability, because the central bank has to honour the value any time a person with legal and taxed money lays claim on the value. And RBI can only give procedural excuse, but cannot deny honouring the value. Therefore, even if the government makes the paper valueless, the promise of the RBI governor cannot be eroded.
The promise will have to be fulfilled, albeit, through another set of papers or other legal tenders.