Will demonetisation lead to a windfall?

'A government can't just take away public money, and the RBI can't extinguish its liability.'
'The RBI has to honour the value any time a person with legal and taxed money lays claim on the value,' Anup Roy points out.

Many, including some in the government, are saying that the withdrawal of high value currency notes will lead to a windfall to the Centre through dividends earned from the Reserve Bank of India, but people familiar with the RBI balance sheet say that is unlikely the case.

What the withdrawal of the currency notes would ensure is complete elimination of fake high value currency notes and getting some grip on the black money situation.

For that, the government, Reserve Bank and banks will have to incur necessary cost, without expecting any other monetary gain.

Chief Economic Advisor Arvind Subramanian, who once suggested that the RBI must use its foreign exchange reserves to recapitalise banks, and in turn was criticised by then central bank governor Raghuram Rajan, said recently that 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 the economy,' Subramanian said in Delhi.

Subsequently, State Bank of India group Chief Economist Soumya Kanti Ghosh wrote in his research report that the demonetisation can be used as a fiscal tool.

Ghosh estimated that the unaccounted cash not coming back into the system could be 'significantly higher than Rs 2,500 billion, or Rs 2.5 lakh crore.'

This number could even be a 'gross underestimation' as Ghosh calculated that Rs 9 lakh crore could be the possible unaccounted cash in the system.

Currency issued is a liability for the RBI.

It is a promise that the RBI owes a particular value to the holder of the legal tender.

If this money is not returned to the banks (and therefore the 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, the RBI will have to shrink the balance sheet, reasoned SBI.

The shrunk part can then be transferred to the government as dividend, goes the logic.

Alternatively, since the RBI would not know how much of old notes have to be exchanged, the central bank will likely print extra money and a cash-payout against the currencies can be done to the government.

Or, 'as the RBI will issue notes only against the old notes, there has to be a decline of equivalent amount from the RBI asset side/cash pay-outs,' Ghosh's research report pointed out.

'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... such amount may be at least Rs 2.5 lakh crore, but with a significant upward bias.'

The Reserve Bank of India has been instructed by a committee headed by Y H Malegam that the entire reserves of the RBI should be transferred to the government as dividend for three years starting fiscal 2014.

Therefore, the entire non-accounted money, which could be theoretically ploughed back as a reserve 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 held back money cannot be wiped out from RBI balance sheet, but will reside as a 'nominal' reserve.

Second, the RBI gives dividend to the government through real reserves earned through real investment activities, like earning interest on US treasuries, or foreign exchange transactions.

The dividend is never paid out of 'nominal' reserves, said a central bank watcher who declined to be named.

The money not returned to the banks are legal, but undeclared. They are still a liability to the RBI and the central bank had already created assets against the value in the past.

"The 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 RBI's liability shifts from the 'Notes Issued' head to 'Other Liabilities and Provisions' in the RBI balance sheet.

Economists explain that 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 lay claim on the value. And the RBI can only give procedural excuse, but cannot deny honoring 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.

Photograph: PTI Photo