Opinion

The law on cash that will not come back: Will the government get a big bonanza from the RBI?

What happens to the assets on the RBI balance sheet which back the demonetised notes that are not exchanged?

There are three important questions of law associated with demonetisation. This article seeks to shed some light on the third question, namely: What happens to the assets on the RBI balance sheet which back the notes that are not exchanged?

The demonetisation of Rs 500 and Rs 1,000 notes has led to speculation about the amount of currency that will not be deposited or exchanged at all, because of fear of scrutiny by tax authorities. Some suggest that from and out of the notes in circulation, close to 20% may not be exchanged or deposited at all with the Reserve Bank of India (see here, here and here). (Others believe this will not happen).

The numerical values involved are very large – 20% works out to Rs three trillion disappearing from circulation.

The law governing the withdrawal of legal tender in India allows the Central government to declare that currency notes of a certain denomination will not be legal tender, except at the specified offices of RBI until such date as may be specified by the Central government in a gazetted notification.

In his speech, the prime minister specified March 31, 2017 as the date up to which RBI will accept the demonetised currency. However, to our knowledge, this date has not appeared in a gazetted notification (See here). Let’s assume that RBI will cease to be liable to accept the un-returned demonetised notes after a certain date, which for the time being, appears to be March 31, 2017.

The central bank of any country must, for every note that it issues, back itself with corresponding assets. The liability incurred on notes issued and the assets backing such liability, are reflected in the balance sheet of the central bank. Typically, these assets are government securities, bullion and foreign securities. Now, in a one-time event like demonetisation, the liabilities of the central bank may significantly plummet, as the central bank will no longer require to honour the commitment to pay on the notes that are not returned to it. This would lead to a mismatch in the balance sheet of the central bank.

In the past, we have seen such gains being made in other countries that have substituted currency. For instance, the Bank of Israel recorded a gain of about $62 million for the notes that had passed the legal date for exchange and were no longer in use. There is considerable public discourse on what will happen to the windfall made by the RBI, if the above mentioned estimates were to translate into reality.

In this article, we argue that unlike several other countries with precise laws governing their central banks, there is legal uncertainty on what happens to the surplus reserves or income accruing to the RBI, whether as a result of a one-time demonetisation event or due to its regular operations.

There is a need to re-visit the legal framework governing surplus distribution by the RBI.

Lack of clarity

Ordinarily, when a mismatch occurs on the balance sheet of a corporation due to a sudden change in the liabilities, the resulting surplus assets are either (a) distributed as dividend to the shareholders; or (b) credited to reserves. This takes place under the rubric of a “dividend distribution policy”, which is generally voted upon by the board. The circumstances in which shareholders should or should not expect dividend, and the manner in which the retained earnings will be utilised, are generally codified in the dividend distribution policy. The policy is disclosed to the shareholders, so as to enhance predictability, and governs their relationship with the corporation.

Likewise, where a central bank has surplus reserves or profits in any given financial year (whether due to a one-time event like demonetisation or otherwise in the course of its regular operations), the shareholders of the central bank (in a majority of the cases, the government) must have clarity on the distribution policy. This must be clearly spelt out to the Central government in the law governing its relationship with the RBI or in an agreement between them that is available in public domain. This is critical to ensure both (a) the independence of the RBI as it pre-empts any possibility of political pressure for distribution of surplus profits or reserves; and (b) accountability of both the RBI and the Central government with regard to the distribution of surplus profits to the Consolidated Fund of India.

Currently, this clarity is missing. As a result, the distribution of surplus assets by the RBI to the Central government has fluctuated year-on-year, except for the last three financial years, as shown in the graph below:

Transfer to government of India, by the RBI (Percent to profits)
Transfer to government of India, by the RBI (Percent to profits)

The graph shows that the proportion of profits transferred to the Central government has fluctuated across the years. However, for the last three financial years, the distribution has remained constant at 99.9% due to the recommendations of the Report of the Technical Committee to review the level and adequacy of internal reserves and surplus distribution policy. See here (hereafter, the Malegam Committee Report, which is discussed in greater detail later in this article).

What does the law say?

In India, the relationship between the RBI and its sole shareholder, ie. the Central government, is governed by the Reserve Bank of India Act, 1934. As currently drafted, the provision governing allocation of surplus profits lacks details on the reserves that the RBI must maintain and the proportion of surplus that RBI must distribute to the Central Government. The RBI Act contains one provision on allocation of surplus profits. Section 47 of the RBI Act says:

After making provision for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation funds and for all other matters for which provision is to be made by or under this Act or which are usually provided for by bankers, the balance of the profits shall be paid to the Central Government.

The provision implies two things (a) surplus is only the amount which is left after the RBI has made adequate provision for all other matters for which provision is to be made (i) under the RBI Act or (ii) for matters which are usually provided for by bankers and (b) the entire residual surplus shall be paid to the Central government. There is no clarity in the RBI Act on:

  1. The proportion of profits which may be allocated to reserve funds or the purpose of the reserve funds;
  2. the cap, if any, on reserves;
  3. the proportion of profits which must be distributed to the Central Government;
  4. the timing of distribution of profits;
  5. the manner in which these decisions must be made.

The current legal framework is, therefore, inadequate as it offers no transparency with regard to these matters.

Reuters
Reuters

Global practices

What do central banks around the world do with their profits and surplus assets?

Laws governing several central banks around the world have a numerical value, which offers clarity on the distribution policy. Several legal frameworks governing central banks across the world, precisely state the proportion of surplus assets that must be credited to the reserves, the proportion that must be distributed to the exchequer, the timing of distribution, etc. Some examples are listed below:

  1. Specifying the percentage of profit which must be distributed: Some laws governing central banks mandate the specific percentage of net profits which must be distributed by the central bank. For instance, the Bank of England Act, 1946 requires the Bank of England to pay to the Exchequer, on every 5th April and 5th October, a sum equal to 25% of the net profits for its previous financial year, or such other sum as it may agree to with the Treasury.
  2. Specifying the proportion of profit which may be credited to the reserves: For instance, the Bank of Korea Act, 1997 has adopted an alternative approach by specifying the proportion of profits that Bank of Korea may retain. It allows the Bank of Korea to accumulate 30% of the profits, after providing for depreciating assets, every year. It allows the balance profits, remaining after such accumulation, to be credited to special purpose reserves, with the explicit approval of the government. It mandates that the balance, if any, remaining after creation of such reserves must be paid out to the government of Korea.
  3. Specifying the kinds of reserves that the central bank may accumulate: The Bank of Thailand Act, 1942 specifically sets out the percentage of reserves that the Bank of Thailand must accumulate. It requires the Bank of Thailand to constitute the following reserves, namely, (a) ordinary reserves intended to cover possible loss; (b) reserves derived from the revaluation of assets and liabilities; and (c) other reserves for particular purposes as may be established by the Bank’s Board upon the approval of the Minister. The net annual profits of the Bank, after deduction of accumulated loss, if any, shall be provided in the following order for: (1) ordinary reserve amounting to 25 per cent; (2) other reserves for particular purposes, as specified by the Bank’s Board, upon the approval of the Minister. Any remaining net profits shall be paid in as state revenues.
  4. Capping the accumulation of reserves: The United States follows a de-centralised system of central banking where there is no single federal reserve bank but 12 Federal reserve banks. The Federal Reserve Act, 1913, which governs the Federal Reserve System, mandates the Federal reserve banks to first pay out dividend to the stock holders (which are essentially member banks) in proportion to their holding in the Federal reserve bank. It then allows the surplus to be accumulated as a surplus fund of the Federal Bank, but specifically caps the surplus. It mandates that the surplus, if any, remaining with the Federal reserve bank, after providing for expenses, payment of dividend and allocation to surplus, shall be distributed to the Treasury.

The takeaway from the list of laws illustrated above is that there is a quantitative indicator that imparts clarity to the treatment of surplus assets by the central bank. The indicator may be indicative of what needs to be distributed, what needs to be credited to reserves or the cap on reserves. The RBI Act lacks this clarity, thereby leading to speculation.

Reserves maintained by RBI

RBI maintains the following major funds:

  1. Currency and gold re-valuation account
  2. Investment Re-valuation account
  3. Exchange Equalisation Account
  4. Asset Development Reserve and
  5. Contingency Reserve

Out of these, the first three are funds to which unrealised gains and losses on existing assets of the RBI, are credited and debited. The Asset Development Reserve was created out of profits to meet the RBI’s internal capital expenditure and invest in subsidiaries and associated institutions. The Contingency Reserve consists of the amounts added on a year-to-year basis for meeting all other unexpected and unforeseen contingencies (Malegam Committee Report (2013)).

Therefore, technically, in the absence of any specific provision in the law, which restricts the internal capital expenditure that the RBI may make or the contingencies that the RBI can provide for, it is perfectly legitimate for the RBI to credit the windfall to its Contingency Reserve or Asset Development Reserve.

In the absence of legal clarity, the Malegam Committee was set up by the RBI to review the level and adequacy of internal reserves and surplus distribution policy of the RBI. It suggested that

  1. Since the balances in the Contingency Reserve and Asset Development Reserve were in excess of the buffers needed, there was no need to make any more transfers to these funds;
  2. the entire surplus should be transferred to the Central government.

Hence, for the three years immediately following the report of the Malegam Committee, i.e. 2013-14, 2014-15 and 2015-16, the entire surplus was transferred to the government. This brought some consistency in the distribution of surplus. But, no steps have been taken to reform the law to ensure such consistency in future.

Conclusion

The present legal framework is unclear on the adequacy of reserves of the RBI. While this has led to widespread speculation on what will happen to any windfall that may be realised from the demonetisation event, the issue of distribution of surplus by the RBI is not a one time problem. This problem will continue to crop up every time the RBI has surplus profits.

To ensure transparency in the distribution of surplus from the central bank to the Consolidated Fund of India and to ensure the independence of the central bank in making such decisions, revisiting the legal framework governing reserves and the surplus distribution policy, is imperative.

This legal framework should offer precise guidance on i) the purpose for which the RBI can maintain reserves, ii) a cap on such reserves, and iii) the dividend distribution framework.

The last couple of years have witnessed some headway in reforming the decision making processes at the RBI. In 2016, the RBI Act was amended to provide clarity on the manner in which it may exercise its monetary policy functions.

The current government must focus its effort on such deep institutional reforms. It is a good time to resume this process by focusing on the decision making process for allocation of surplus assets by the central bank.

Radhika Pandey is a researcher at the National Institute for Public Finance and Policy. Bhargavi Zaveri is a researcher at the Indira Gandhi Institute for Development Research.

This was first published on Ajay Shah’s blog under the title “Legal questions about demonetisation: What happens to the assets that back extinguished rupee notes” on November 18, 2016.

We welcome your comments at letters@scroll.in.
Sponsored Content  BY 

Harvard Business School’s HBX brings the future of business education to India with online programs

HBX is not only offering courses online, but also connecting students to the power of its network.

The classic design of the physical Harvard Business School (HBS) classroom was once a big innovation – precisely designed teaching amphitheaters laid out for every student to participate from his or her seat with a “pit” in the center of the room from which professors orchestrate discussions analyzing business cases like a symphony lead. When it came to designing the online experience of HBX—the school’s digital learning initiative—HBS faculty worked tirelessly to blend these tenets of the HBS classroom pedagogy with the power of new technology. With real-world problem solving, active learning, and social learning as its foundation, HBX offers immersive and challenging self-paced learning experiences through its interactive online learning platform.

Reimagining digital education, breaking the virtual learning mold

Typically, online courses follow a one-way broadcast mode – lectures are video recorded and reading material is shared – and students learn alone and are individually tested. Moving away from the passive learning model, HBX has developed an online platform that leverages the HBS ‘case-based pedagogy’ and audio-visual and interaction tools to make learning engaging.

HBX courses are rarely taught through theory. Instead, students learn through real-world problem-solving. Students start by grappling with a business problem – with real world data and the complexity in which a business leader would have to make a decision – and learn the theory inductively. Thus even as mathematical theories are applied to business situations, students come away with a greater sense of clarity and perspective, whether it is reading a financial report, understanding why a brand’s approach to a random sample population study may or may not work, or how pricing works.

HBX Platform | Courses offered in the HBX CORe program
HBX Platform | Courses offered in the HBX CORe program

“Learning about concepts through real-life cases was my favorite part of the program. The cases really helped transform abstract concepts into observable situations one could learn from. Furthermore, it really helped me understand how to identify situations in which I could use the tools that HBX equipped me with,” says Anindita Ravikumar, a past HBX participant. India’s premier B-school IIM-Ahmedabad has borrowed the very same pedagogy from Harvard. Learning in this manner is far more engaging, relatable, and memorable.

Most lessons start with a short 2-3 minute video of a manager talking about the business problem at hand. Students are then asked to respond on how they would handle the issue. Questions can be in the form of either a poll or reflections. Everyone’s answers are then visible to the ‘classroom’. In the words of Professor Bharat Anand, Faculty Chair, HBX, “This turns out to be a really important distinction. The answers are being updated in real-time. You can see the distribution of answers, but you can also see what any other individual has answered, which means that you’re not anonymous.” Students have real profiles and get to know their ‘classmates’ and learn from each other.

HBX Interface | Students can view profiles of other students in their cohort
HBX Interface | Students can view profiles of other students in their cohort

Professor Anand also says, “We have what we call the three-minute rule. Roughly every three minutes, you are doing something different on the platform. Everyone is on the edge of their seats. Anyone could be called on to participate at any time. It’s a very lean forward mode of learning”. Students get ‘cold-called’ – a concept borrowed from the classroom – where every now and then individuals will be unexpectedly prompted to answer a question on the platform and their response will be shared with other members of the cohort. It keeps students engaged and encourages preparedness. While HBX courses are self-paced, participants are encouraged to get through a certain amount of content each week, which helps keep the cohort together and enables the social elements of the learning experience.

More than digital learning

The HBS campus experience is valued by alumni not just for the academic experience but also for the diverse network of peers they meet. HBX programs similarly encourage student interactions and opportunities for in-person networking. All HBXers who successfully complete their programs and are awarded a credential or certificate from HBX and Harvard Business School are invited to the annual on-campus HBX ConneXt event to meet peers from around the world, hear from faculty and business executives, and also experience the HBS campus near Cambridge.

HBXers at ConneXt, with Prof. Bharat Anand
HBXers at ConneXt, with Prof. Bharat Anand

Programs offered today

HBX offers a range of programs that appeal to different audiences.

To help college students and recent graduates prepare for the business world, HBX CORe (Credential of Readiness) integrates business essentials such as analytics, economics, and financial accounting. HBX CORe is also great for those interested in an MBA looking to strengthen their application and brush up their skills to be prepared for day one. For working professionals, HBX CORe and additional courses like Disruptive Strategy, Leading with Finance, and Negotiation Mastery, can help deepen understanding of essential business concepts in order to add value to their organizations and advance their careers.

Course durations range from 6 to 17 weeks depending on the program. All interested candidates must submit a free, 10-15 minute application that is reviewed by the HBX admissions team by the deadlines noted on the HBX website.

For more information, please review the HBX website.

This article was produced by the Scroll marketing team on behalf of HBX and not by the Scroll editorial team.