The Reserve Bank of India’s Annual Report released on Wednesday was much awaited by those who wanted to get a full sense of the impact of last year’s demonetisation exercise. What does the report tell us?

According to the government, the objectives of demonetisation were: to eliminate fake currency; inflict losses on those holding black money and, in the process, create a windfall in terms of an enhanced dividend for the government from the RBI; additional tax collection, and the disruption of terror and criminal activities.

The Annual Report shows that during the year 2016-’17, Rs 41.5 crores worth of fake currency notes in the form of old Rs 500 and Rs 1,000 notes were detected in the banking system. This is well above the Rs 27.4 crores of fake currency detected in these denominations in 2015-’16. The estimate of the total fake currency in the system was Rs 400 crores. It is safe to say that fake currency in Rs 500 and Rs 1,000 denominations was eliminated as those notes can no longer be used anywhere. However, counterfeits of new Rs 500 and Rs 2,000 notes are already being intercepted, which suggests that the elimination of fake currency is not a lasting benefit and perhaps alternative approaches are required to address this problem.

It is difficult to explain how the decision may have affected terror and criminal activities. Those commenting that demonetisation has had a negative impact on these activities are mainly relying on anecdotal reports. It is possible that cash-based terror and criminal activities may have been disrupted for some time, as did cash-based legitimate activity, but from the data on terror-related casualties, it is not clear that there has been a significant disruption.

Black money

On black money, the initial narrative by the government and its supporters was that a large amount of demonetised currency will not find its way back into the system. That is why a number of steps were taken to make it difficult to deposit old notes, and the exchange of old notes for new was stopped after just a few days of the demonetisation announcement on November 8.

The RBI Annual Report says:

“Subject to future corrections based on verification process when completed, the estimated value of SBNs received as on June 30, 2017 is 15.28 trillion.”

As the estimated value of demonetised notes was Rs 15.44 lakh crore, only about Rs 16,000 crore worth of demonetised notes did not come back. Even this may be an overestimate, as the notes to be received from District Central Cooperative Banks and Nepalese citizens and Financial Institutions are yet to be added to the total value of notes returned. So, this purported benefit did not materialise in any significant way. It cannot be said that significant losses have been inflicted upon those holding black money. From the stated objectives of demonetisation, the only variable that remains to be observed is the claim that it would lead to an increase in tax collection. On this front, it is too early to say anything with confidence.

Impact on monetary policy

While the benefits of the exercise are debatable, a relatively less deliberated issue is the impact on the conduct of monetary policy. The RBI formally became an inflation targeting central bank in 2016 but the liquidity surge in the banking system that came about in the aftermath of demonetisation complicated the conduct of monetary policy. In addition to the conventional reverse repo auctions (an exercise to remove excess cash from the banking system), the RBI introduced an array of instruments to absorb demonetisation induced liquidity from banks. Chief among them was the hike in incremental Cash Reserve Ratio – the percentage of cash deposits that banks must keep with the RBI– at 100% on deposits accrued between September 16 and November 11, and the increase in ceiling on the issuance of securities under Market Stabilisation Bonds.

While the increase in incremental Cash Reserve Ratio dented banks’ earnings as banks do not earn interest on the cash reserve parked with the RBI, the issuance of Market Stabilisation Bonds marked a departure from their traditional role. These bonds are generally issued to mop up the excess supply of rupees arising from the RBI’s intervention to purchase dollars. While the increase in these bonds represent an increase in quasi-fiscal cost (the interest payments are made by the government and this shows up as fiscal costs instead of appearing as reduced RBI profits) to the government, the repeated auctioning of such bonds (as the RBI report acknowledges) tends to push up the yields which may be contrary to the stance of monetary policy, which may be accommodative or at best neutral in the present low growth and investment regime.

The mopping up of liquidity eroded the RBI’s earnings. Additionally, its expenditure on printing of currency doubled from last year. Overall, while its income for the year decreased by 23.56%, its expenditure increased by 107.8% resulting in a sharp decline in the RBI’s surplus.

Demonetisation served as a negative shock to the economy. Growth in the quarter following demonetisation slowed to 6.1%, and to 5.7% in the next quarter (April-June). A number of small-scale businesses were adversely affected. The unorganised sector especially bore the brunt of the sudden shock. The lessons are clear: tax reforms and effective monitoring of suspicious transactions are a better alternative for addressing the issues that the policy-makers sought to fix through demonetisation.

Radhika Pandey and Suyash Rai are researchers at the National Institute of Public Finance and Policy. The views expressed are personal.