Half dividend, full fallacy: RBI implies Modi & Urjit Patel got demonetisation wrong

Unhealthy results

Not only did the decision to demonetise 86% of the currency in circulation in November 2016 bring the growth of Indian economy down in the last financial year, its impact is set to linger on for many quarters to come. India's full year GVA (gross value added) growth declined from 7.9% in FY 2015-16 to 6.6% in FY 2016-17 - all thanks to demonetisation.

Even though most eminent economists in the country, as well as those abroad, including the likes of Kaushik Basu - currently World Bank's chief Economist - had criticised demonetisation, there were some experts who had invented theories of windfall gain to the RBI due to the extinguished liability on the extinguished part of the currency.

But forget windfall gains, the RBI till date has not been able to calculate the total number of currency notes that have been deposited during the two-month period of demonetisation.

The trauma does not end there. The RBI, for the first time in history, skipped releasing the balance sheet for the week ended 30 June. The central bank is supposed to close its accounting year in the last week of June each year.

The whole idea of windfall gain was based on assumptions that whatever money does not come back into the banking system will reduce RBI's liability. Since reduced liability, in normal accounting terms, can be taken as increased profits, the same logic was applied in calculating the gains from demonetisation.

However, the theory of windfall gain never took into account the cost of printing new notes, as well as the possibility of getting all the notes back into the system. If the RBI received all the notes back - which is quite a possibility - its liabilities increased in the form of interest outgo, while its printing costs went up along with other administrative costs.

A precarious situation

According to a Times of India report, on 25 November, the amount parked with the RBI under reverse repo crossed Rs 5.2 lakh crore, creating a situation where RBI would have run out of government bonds.

To avoid this, the RBI forced commercial banks to lock funds up to Rs 3.25 lakh crore in the form of cash reserves with the central bank, without any interest on deposits.

It was a precarious situation for banks as they were supposed to pay interest to their customers on deposits, while the RBI was not paying any interest to them on new deposits in the period of demonetisation. While the RBI came up with a Market Stabilisation Scheme to come out of this conundrum, managing various other costs associated with demonetisation was never going to be a zero sum game.

“In the Budget, it was assumed that around Rs 75,000 crore would come from the RBI, public sector banks and financial institutions compared with a little over Rs 76,000 cr in FY17,” Indian Express reported rating firm Care Ratings as saying.

The report further adds, “As public sector banks are unlikely to do better than last year and the RBI will be transferring a smaller amount, this will impact the fiscal deficit numbers. If other conditions remain unchanged, the fiscal deficit can increase from 3.2% to 3.4% this year."

In such a scenario, Finance Minister Arun Jaitley will either have to reduce capital expenditure in the remaining part of the year - which will drag down an already sluggish economy - or he will have to go for a higher fiscal deficit, breaching the budgetary projections.

It would be as though choosing between a rock and a hard place.

Questioning Urjit Patel's autonomy

RBI Governor Dr Urjit Patel had justified demonetisation as a policy action to "turn around" the economy. The government had also claimed that the decision was taken on the recommendation of the RBI.

But ff we take the RBI and the government at face value, the lower dividend not only indicts Modi's haphazard decision, but also Patel's understanding of using demonetisation to turn the economy around.

The manner in which the head of the government bypassed the prerogative of the head of the central bank - with just one TV speech on 8 November 2016 - to withdraw the legal tender of Rs 500 and Rs 1000 currency notes, surprised all foreing institutions as well.

International ratings agency Standard & Poor's director Kyran Curry did not mince words in expressing concern over the credibility of the RBI after the decision to scrap Indian currency notes was announced by the government.

Though the RBI did try to win accolades from independent observers by not reducing the policy rates - much against the expectations of the government - in four consecutive monetary policy reviews post demonetisation, such trifling measures have done little to bring back any credibility for giant institutions.

The damage has already been done. Now the only thing that remains is its actual accounting. Let's hope that the government and the RBI do that at the earliest by accepting their mistake.

But most likely, that is just wishful thinking.