Demonetisation without replacement
This is exactly the kind of policy which negates structural reform in the Indian economy and discourages investment
Of the two denominations demonetised on 8 November at midnight, Rs500 was the preferred storage denomination among labourers and itinerant people, and the modal transactional denomination in wholesale markets and mandis. The replacement trickle is said to have started supplying the new Rs500 note (although I have yet to see it), well after the Rs2,000 denomination made its appearance. Without enough Rs500 notes in circulation, the Rs2,000 note is rejected everywhere. It has simply not taken root as accepted tender.
To what extent was the demonetisation consistent with the statutory provisions in Chapter III of the Reserve Bank of India (RBI) Act 1934, which assigns to the RBI the sole right to issue currency notes under Section 22? The right to determine the denominations in which currency notes are to be issued, and the rights of non-issue or discontinuance of particular denominations, are assigned in Section 24 of that chapter to the government, subject to the recommendations of the central board of the RBI. The recommendatory authority of the central board is paramount, as stated in the Act. Discontinuance is not equivalent to cessation as legal tender, and usually carries a long phase-out period.
Cessation as legal tender is dealt with in Section 26, reproduced below. It also accords primacy to the central board of RBI.
“On recommendation of the Central Board the [Central Government] may, by notification in the Gazette of India, declare that, with effect from such date as may be specified in the notification, any series of bank notes of any denomination shall cease to be legal tender [save at such office or agency of the Bank and to such extent as may be specified in the notification].”
Note the wording, which speaks of the cessation of particular series of bank notes as legal tender. Neither the provision for discontinuance, nor that for cessation, visualizes the withdrawal of all series of an entire denomination without full replacement against other valid denominations. Every currency note carries a formal promise to redeem (pay) in full its face value, signed by the RBI governor. The authority of the RBI governor to give such a guarantee is backed by powers vested in him by the central board of the RBI. Indeed, it is because of this promise to uphold the value of the currency that central banks the world over worry so much about inflation, which erodes the domestic value of currency.
Redeem with what? In the old days it was precious metals which hold value over time, like gold or silver. Today, redemption means replacement with other notes of equal value and acceptability as legal tender. Does the promise mean eventual replacement, or immediate replacement, and if eventual, when? The public implicitly assumes immediate replacement, and it is that which underpins the acceptance of paper currency as legal tender.
The statutory responsibility for upholding the guarantee underpinning paper currency is vested with RBI’s central board. That responsibility would have been fulfilled only if replacement currency was stocked and fully available at any of the several surrender nodes for demonetized currency in this vast country. An emergency meeting of the RBI central board is reported to have been held on the evening of 8 November. Even if the board was trying to be a team player by going along with what the government wanted to do, why would they recommend turning Rs500 and Rs1,000 notes into pumpkins at midnight, without checking if replacement currency was in stock?
The supposition circulating the evening it happened was that security agencies had reported a massive surge of counterfeit currency all along the border, which the government felt powerless to push back without immediately declaring dead all high-denomination notes. We have so far no proof of any such compulsion. If there was none such, 30 December could have been targeted as the last date for validity of the old notes, and if a short interval between announcement and execution was thought essential, postponing the announcement itself to the evening of 30 December. That would at least have got over the hump of currency requirements for rabi sowing. All avenues for identification of the source of large-scale conversion of old notes, in either single or serial transactions, could have been put in place for the targeted date. Was this not what the Aadhaar server was meant to do, if indeed the server is working?
It was the absence of preparation with replacement currency, well-stocked banks and functional ATMs that turned this into an unmitigated disaster, rather than the suddenness of the change. A forward effective date known only to the RBI governor and the government could in principle have been kept secret. Even the board did not need to be informed in advance, while currency stocks were being prepared. After the announcement, currency printing went into overdrive in a manner that clearly shows the RBI was a follower, not in the know, of what happened.
The central board of the RBI is not operating at full strength. There are four vacancies yet to be filled, out of 10 seats for external directors. Given the supreme importance of the central board in the functioning of the monetary system, this weakens the ability of the board to reflect the considered judgement of various sections of the informed population. An immediate possibility is for the three external members of the monetary policy committee to be automatically appointed to the board. They have already received security and income-tax clearances, so there are no procedural barriers to appointing them. All three are academics, and so could be expected to exercise dispassionate professionalism at meetings.
What if the central board had refused to go along until replacement currency was fully in place? Section 30 of the RBI Act does give the Union government the power to supersede the board. But in such an exigency, the government has to place before Parliament an explanation of the circumstances under which the supersession was done, within three months.
All the expected gains of this action—the additional income tax revenue from stocks of currency deposited in banks as current income, the spike in property tax payments from people using that window to get rid of their stocks, the reduction of monetary liabilities of the central bank which could enable pay down of the stock of government debt—would have accrued even with a 50-day preparation period for demonetisation. The advantages of going without preparation of replacement stocks are altogether unclear.
But the costs on the other hand are abundantly clear. The vast majority of the Indian population, whose survival is mediated by the validity of currency, suffered from the cessation with the speed of lightning. Although hospitals and pharmacies were formally exempted from the demonetisation, they often chose not to cooperate. Half-finished construction works dot the landscape, as labour contractors were left without stocks of Rs100 notes with which to pay wages. Migrant labourers in urban areas returned to their rural points of origin, if they could manage enough legal currency for the bus fare. In rural areas, many stood in line all day for several days at the only bank or post office they had access to. People reportedly died waiting in line for usable currency. Bank employees died from the stress of coping with irate customers.
The costs are not merely short-term. Much of the untaxed wealth in this country is not held as cash or jewellery. It is turned into income-earning financial assets through loans to small businesses. Some of the largest commercial construction companies borrow from holders of big stocks of cash on the thriving informal market. If not converted into a financial asset, cash is typically spent on housing and house renovation, weddings or tourism. Construction, weddings and (domestic) tourism are the most employment generating activities in India. The impact of demonetisation will therefore be not merely to reduce growth but to pull down the employment elasticity of growth, until activity in these sectors picks up again.
This is exactly the kind of jerky policy which negates structural reform in the Indian economy, and discourages investment. Investment calls for a stable macroeconomic environment, where the dominant currency denomination is not withdrawn at 3 hours’ notice. Yes, of course, such an action will deaden the cash hoards of criminal and other elements. But it will also deaden the economy. It has awakened troubling memories of pre-reform India and the kind of brittle policy alterations which characterized that period. We already have exceptions made every day, on the repair and patch as you go model. Agricultural seed sellers were authorized to accept demonetized currency, when it became clear that rabi sowing was being affected. The definition of non-performing assets was altered for loans up to Rs1 crore, when banks began looking at sure-fire defaults by small-scale units.
The biggest mistake was in the timing, just as the goods and services (GST) council needed co-operation between Centre and states on the contours of the GST. The flow of tax evasion, not the stocks accumulated from past tax evasion, is what matters. And GST is the most major assault we have attempted on that flow.
Meanwhile, the entrepreneurial Indian population has devised its own methods of coping with the situation. Some traders are reported to have gone back to accepting the old currency, with the formation of chains linking them to authorized acceptance points. And street food providers are eyeing those long queues in front of banks.
Indira Rajaraman is an economist.