What about cash that doesn’t return?

An animated debate has started on the treatment of scrapped currency notes that are unlikely to return to banks. Will it result in windfall gains for the RBI? If so, should the RBI transfer these gains to the Centre?

On January 16, 1978, demonetisation of ₹1,000, ₹5,000 and ₹10,000 notes was announced through an ordinance. The conversion of old notes was kept open till 1981. The value of banned currency notes was only ₹1.46 billion, about 1.7 per cent of the total value of currency in circulation (₹85 billion). Initially, about 68 per cent of invalid notes were withdrawn in 1978. By August 1981, about 86 per cent of such notes returned to the banking system. The value such notes that did not return to the RBI was hardly about ₹210 million. This liability does not exist in the RBI book. The amount was so small that transfer of such liability to the Government did not evoke any debate.

This time, holders of scrapped notes have been given a 50-day window to exchange/deposit such notes in banks and post offices till December 30. They can do so in the RBI offices as well even beyond the December 30 deadline.

The cut-off date for accepting old notes in the RBI has not been stipulated. This cannot be kept open-ended indefinitely to avoid potential misuse by holders of invalid currency notes. Sooner or later, the RBI, in consultation with the Government, has to indicate a cut-off date. Till then, old ₹500 and ₹1,000 notes shall continue to remain as currency liability as the RBI Governor has promised to pay the bearer the equivalent amount of legal tender.

Going by the 1978 experience, if one assumes that 15 per cent of the currently scrapped currency of ₹14.5 trillion shall not return to banks, it would be about ₹2.17 trillion. This is certainly a windfall gain for the RBI. On top of the usual transfer of excess income over expenditure to the government, if these extra gains to the RBI are transferred to the Government, it will be inflationary in nature. In an inflation-targeting regime, the RBI is likely to resist any such proposal. Nevertheless, possibility of the government asking for transfer of these gains in a phased manner over a period of time cannot be ruled out.

There is no scope for converting these notes into legal tender after the deadline is expired. It would not be prudent to treat such unwithdrawn notes as monetary liability after the deadline, despite Governor’s promise scripted on them. Assets are typically written off against liability (usually against capital/reserve). There is no uniform practice for extinguishing liabilities. The RBI may have to initiate a process, get the Board approval and then write-off liabilities with equivalent reduction in assets.

Following expiry of the deadline for conversion, the unwithdrawn amount remaining in the market would no more be monetary liability. Ideally, it can be treated as non-monetary liability to match total assets in the balance sheet. If it is not treated as non-monetary liability, then the reserve money shall be over-estimated and further complicate the compilation of monetary aggregates, money multiplier, etc.

The non-monetary liability can be capital, reserve, undistributed profit or specific provisions. The Central Board of Directors has to take a call and decide as to whether it would continue to sit in the RBI balance sheet as unrealised gain, like the reserve fund arising out of a one-time revaluation of gold in 1991 or can it be taken to the income and expenditure account. Even if it forms part of the income and expenditure account at some point of time, the Board can still decide to retain it as contingency reserve. Board has the prerogative to transfer the amount to the government, in which case net RBI credit to the government shall be reduced to that extent.

Now, the issue is whether it is prudent to transfer windfall gains to the government. The purpose of demonetisation is not to generate windfall gains to the RBI and then appropriate them for fiscal purposes. This is not consistent with international best practices. There could be perverse incentive on the part of the government to do so, by disrupting the economy periodically through demonetisation and thereby perpetrating hardships to the common man. The Government can anyway earn some revenues from the unaccounted income mobilised as deposit by banks in the normal course.

The accounting part is now well understood. On the day of transfer, it is buyback of old debt by the Government from the RBI. Any other use of this fund by the Government can impact fiscal discipline. Moreover, if currency in circulation goes up through large government expenditure, an opportunity shall be lost to reduce the currency-GDP ratio, which is as high as 12 per cent in India compared to about 4 per cent in other emerging economies. The Government should exploit this opportunity to popularise non-cash payments.

The windfall gain for the RBI need not be treated as windfall loss for the system. Pending improvement of banking habit of the people towards a less cash society, both the RBI and banks shall work as conduit for restoration of currency in circulation as per demand through day-to day liquidity management. Force feeding of currency into the system by transferring gains to the Government may be counterproductive.

The writer is former Principal Adviser and Head of the Monetary Policy Department, RBI