In India we have instances of the government reneging on its liability to protect legal titles by confiscating private real assets—otherwise called nationalization. Recently we have witnessed the government reneging on one of its most visible liabilities—the national currency. The liability of a government when it issues a currency is to provide the services of a transactions medium to people. Governments actually charge a rent for the use of these services, which is inflation. Inflation decreases the purchasing power of money and in the absence of hyperinflation, people willingly pay this rental because of the convenience of holding a transaction medium that allows them to beneficially engage in economic activity. Governments confiscate currency when they renege on the monetary liability of liquidity provision services.
The modus operandi of confiscating currency is to suddenly remove legal tender status from an existing currency and to make it difficult for the public to convert its full holding of decommissioned notes into the new currency. Imposing a cost on the conversion process—through providing a short conversion period after which old bank notes cease to be legal tender, or restricting the amounts of old currency that can be exchanged or withdrawn from ATMs and bank accounts, or imposing costs on the conversion by requiring people to queue up or to provide proof of the origin of the funds—is an important component of confiscating currency. It is these aspects of the decommissioning of old notes that qualifies our current monetary history to be classified as one of confiscation of currency rather than the inappropriately used term demonetisation.
Demonetisation is more appropriately a term for the replacement of currency by deposits in commercial banks and the settlement of payments through deposits and digital modes of payment rather than cash. That is not what has happened in the current context. The currency in circulation today is approximately what it was on 8 November 2016. The recent Reserve Bank of India (RBI) publication titled Macroeconomic Impact Of Demonetisation—A Preliminary Assessment depicts currency in circulation by March 2017 to have returned to the levels at which it was in early November 2016.
Policymakers have scapegoated counterfeiters, terrorists and those who have black money as the main culprits they are seeking to rein in through the confiscation exercise. In the process, they have diverted public scrutiny away from those policy options that could be the means for achieving success against these “enemies of the people”. It is unclear how fighting against such enemies is best served through the blunt tool of currency confiscation that imposes the burden of the suspension of the ability to transact on those who are model citizens. At the very least, the RBI, which is tasked with the management of the currency, should have put out a white paper on what advice it gave to the government on the matter and why using a monetary tool was considered necessary to handle fiscal problems like corruption and the hoarding of black money.
By all accounts the attempt to hurt the “enemies of the people” was hurriedly pushed through without heed to planning the sequencing that best achieves that purpose when a monetary tool is being used. A thought-through policy would have first required by law that all cash above a specified amount be deposited at the bank rather than banning cash transactions above Rs3 lakh later at the time of the budget. The Bhim app and rationalization of merchant discount rates for digital transactions could then have been promoted. After a few months of such measures, the government could have announced a currency reform where new bank notes would replace existing ones. In this way, decommissioning notes would be an enforcement of a previous law. At the time of decommissioning, it could also have reduced the conversion period to as little as three days instead of 50 days, which would have prevented considerably the build-up of curb markets in the decommissioned bills through touts or the opening of new Jan Dhan accounts. The Soviet Union in 1991 and Nicaragua in 1988 experimented with short conversion periods with much success.
The RBI for long also took the rather blasé view that the decommissioned notes continue to be on its balance sheet even when they have not been exchanged, without considering that this amounted to it admitting that it could hold unaccounted stocks of wealth on its balance sheet. That would be akin to the RBI having black money on its balance sheet. Fortunately, better sense prevailed and the Specified Bank Notes (Cessation of Liabilities) Ordinance of 30 December 2016 clarified that notes not exchanged would no longer be a liability of the RBI.
Finally, the government and RBI have to announce to the public how they will manage a post-demonetisation world. If the government succeeds and the high-denomination currency in circulation is replaced by deposits in banks, then interest-bearing debt will have to be issued to buy back the currency that is being retired. Since high-denomination notes are about 10% of GDP (gross domestic product), the debt to GDP ratio will rise by 10%. The RBI’s operating surplus will also decline as its revenue from issuing currency will have shrunk. This means it will transfer less surplus to the government (equal to 0.5% of GDP in 2015-16). A larger debt and less transfers from the RBI will show up in higher fiscal deficits for the government. And if the operating surplus of the RBI declines, its independence will be shaky.
It would be nice if we the people are given some answers as to how policymakers will manage this brave new world after the “enemies of the people” have presumably been taken out.
Errol D’Souza is professor and dean (faculty), IIM Ahmedabad.