The RBI’s bounty and its independence

Post demonetisation on 8 November, it has been furiously argued, including by some prominent economists, that in the event that some fraction of the demonetised notes are extinguished and never exchanged or deposited, the liabilities of the Reserve Bank of India (RBI) would reduce, and generate space for the central bank to print and transfer an equivalent monetary value to the government. That is, supposing Rs1 trillion does not make it back into the banking system, then RBI can print Rs1 trillion and transfer it to the government to be used for fiscal expenditure.

This fiscal bounty for the government can be used to finance government projects or can be simply transferred to people’s accounts for their spending (the so-called helicopter drop of cash). The government of India recently passed an ordinance to formally extinguish the liability of the central bank on the demonetised notes. Consequently, the RBI is legally within its rights to make this bonus-transfer and the presumption is that it will follow.

This entire line of reasoning, however, fails to recognize that this transfer by the RBI has direct consequences for its target interest rates and target inflation. Therefore, it is impossible to speak of this transfer without recognizing that it can compromise the central mandate of the RBI, which is to maintain stable inflation.

The argument for a benign transfer that does not interfere with RBI targets assumes the following: Nothing has changed post demonetisation, either with regard to economic activity or with regard to people’s preferences for holding cash or cash-like deposits. Consequently, there is no impact on the demand for money in the economy. In this case, the RBI can maintain the same level of its liabilities, that is currency in circulation plus bank reserves, as pre-demonetisation without compromising its main policy targets.

Also read: Demonetisation: How long will the effects of Modi’s shock therapy linger?

As should be immediately obvious, these assumptions are unlikely to hold. Regardless of how optimistic one is about the consequences of demonetisation, it will be hard to argue that economic activity will not slow down in the next several months. The latest estimates point to a contraction in the manufacturing sector (for the first time in 2016), with the purchasing managers index falling, and a sharp decline in new investment proposals. This is consistent with other evidence that points to a sharp drop in retail sales of consumer durables and non-durables.

This decline in economic activity will reduce the demand for money for transaction purposes. If the RBI decides to print money and maintain the same level of its liabilities (currency plus bank reserves), it will require a cut in interest rates that reduces the opportunity cost of holding money and raises the demand for it. In other words, this RBI transfer to the government will be the equivalent of a monetary stimulus. If the demonetisation shock is mainly a negative shock to demand, then a monetary stimulus can be a good idea. However, if demonetisation has negatively affected the supply in the economy with a breakdown of supply chains in the cash-dependent informal economy, this monetary stimulus will be inflationary.

Also read: GDP growth seen slowing to 7.1%, even without demonetisation factor

The other assumption that nothing has changed with regard to the preference for holding money flies against everything the government is trying to do to move towards a cashless economy, encourage people to save in interest earning accounts, and use digital payments for their transactions. This transformation will by design have an impact on the demand for money and once again affect the RBI’s interest-rate targets. Households may also decide to save increasingly in non-rupee instruments like gold or in foreign currency or in real estate. Once again, if the RBI maintains the same level of its liabilities, it will have to target a lower interest rate.

The bottom line is that the rush to transfer the bonus from reduced RBI liabilities to the government does not come for free. It has important consequences for monetary policy, and anything done in haste without a thorough evaluation of the consequences for the main mandate of the RBI, that is to maintain stable inflation, will be imprudent.

In recent weeks, the RBI’s credibility has come under attack as it has reversed its demonetization rules when they appeared in conflict with statements coming out of the finance ministry. The many rule changes, the lack of effective communication on when the cash crunch will end, and the surprising absence of any report on the consequences for the economy of the demonetization move has triggered criticism from several quarters, including from former senior RBI officials. It is, therefore, imperative that the RBI wades into this much touted bonus-transfer scheme with care.

The demonetization shock will transform the demand for money in the economy and the sensitivity of money holdings and economic activity to interest-rate changes. This directly influences monetary policy and the RBI’s ability to accomplish its mandate. To safeguard its reputation and independence, the RBI should publicly counter any pressure to make the bonus-transfer and highlight that this can conflict with the goals of monetary policy. Further, it should postpone any decision regarding these transfers until it is able to evaluate its implications for successfully accomplishing its own mandate, which is stable inflation.

Gita Gopinath is professor of international studies and economics at Harvard University and economic adviser to the chief minister of Kerala.