On November 8, and subsequently, the government announced its intention to try and wilfully default on its obligations. This may seem surprising when stated in such a fashion, but this is the implication of some part of the government’s post-facto justification of demonetisation, and one that has gathered steam in the last week. The argument has been made rather clearly when government functionaries and others argue for extinguishing the Reserve Bank of India’s liabilities in the form of unreturned notes. Default has been replaced by a seemingly more technocratic demonetisation.
Notes and reserves are the liability of the Reserve Bank of India. The Central bank is a fully owned entity of the Indian state. On the consolidated government balance sheet, which combines the Reserve Bank and the Central government, therefore, there are two key liabilities: government bonds (some of which are held as assets by the Reserve Bank but the majority of which is held by the public at large) and money (reserves and notes that are held by the public). Money is best seen as zero yield perpetuity just as government bonds are positive yield liabilities with finite length. When a note is issued, a permanent liability is created without a date or time of redemption. While the government can declare its notes are no longer legal tender, it does not claim that it is not a liability of the Reserve Bank without further legal recourse.
In an accounting sense, if the current stock of demonetised notes is returned to banks as deposits, which, therefore, increases reserves, this will show up as a swap of liabilities of notes for reserves in the Reserve Bank’s balance sheet. In its claims that black money will not return, the government is hoping that a certain amount of the notes are not returned to the Reserve Bank (via bank deposits) for exchange. But from the point of view of the Central bank’s balance sheet, the permanent liability does not stop being a liability of the Reserve Bank even if it is no longer useable or used as a means of settlement between private agents. When the government declared that Rs 500 and Rs 1,000 notes were no longer legal tender, it did not declare that these notes were no longer the liability of the Central bank. The distinction is crucial.
If one is to take that written guarantee of the Reserve Bank governor – “I promise to pay the bearer the sum of x rupees” – seriously (and one must take it seriously in order for notes to be used as legal tender and function as money), the only way to extinguish this liability is to directly repudiate it. Note that the Reserve Bank itself has not contravened this promise in the case of pre-2005 notes that it seeks, nevertheless, to withdraw from circulation. In several cases of demonetisation worldwide, demonetised notes can be returned indefinitely to the Central bank in question since all that is being changed is the form of the liability itself, and not the actual quantity of the liability.
Anyone who states a hope that these claims will not be forthcoming and that they will be extinguished is stating a hope that the Reserve Bank is going to be able to dishonour one of its key liabilities. On the consolidated balance sheet of the government, this is equivalent to hoping that claims on outstanding bonds are not forthcoming so that the government can write them off. In an accounting sense, this is the same as hoping to promote a legal default.
At the time of writing this, there is massive confusion about the government’s motives. Going by some news reports, the Centre may be hastily trying to create provisions post-facto whereby it will be able to allow repudiation. Indeed, a coming windfall for the state has been touted for weeks. But in other articles, it has been claimed that the government expects all demonetised notes to come back into the system. These two cannot be simultaneously held positions. If the government truly holds the latter view, it is baffling why it insisted on such a short window for returning the scrapped notes, since a longer and more reasonable time frame would have meant a less disruptive and more efficient demonetisation process. On Wednesday, Reserve Bank Governor Urjit Patel clarified that there would be no windfall through an extinguishing of liabilities, but carefully added “as of now”, leaving the door open to doing so later through an ordinance.
This is not surprising since the legality of the demonetisation manoeuvre itself is very much in question, since unlike the 1978 demonetisation, a statute of Parliament did not precede this one. Moreover, it is not clear whether the Reserve Bank can or will seek to permanently discontinue the exchange of old notes. Nor is it clear, should it decide to do so, whether this can be treated as a windfall of the state in any way. Finally, a large fraction of the notes that were in circulation have been returned to the system, undermining the case that a large fraction of the cash stocks were black money. Still, it is clear that some portion – current estimates suggest Rs 200,000 crores – may not return to the system.
This much, however, is clear. If the Reserve Bank does decide to extinguish old notes as its liability, it will be doing two things. First, it will be defaulting on its own promise. Reserve Bank Governor Urjit Patel’s signature will be worth a little less than it is now, which is itself a statement with very large long-term consequences on basic trust and monetary soundness. Second, it will be administering, without parliamentary approval, one of the largest capital levies in independent India.
And it bears thinking on whom this levy will be imposed. Certainly, some part of it will be with those with ill-gotten gains who have not been savvy enough to find ways around the system. But a large number of vulnerable and perfectly honest people who are unbanked, or who were unable to exchange notes by the November 25 deadline, or who are not able to access the Reserve Bank window, or who simply cannot exchange their notes in time for whatever reason, will be wilfully expropriated.
Arjun Jayadev is an Associate Professor of Economics at the Azim Premji University in Bangalore and at the University of Massachusetts, Boston.