The costs and benefits of demonetisation
The Reserve Bank of India (RBI) is transferring Rs30,659 crore of its surplus to the government for financial year 2016-17 (July-June), less than half of the Rs65,876 crore it had transferred in the previous year, and substantially lower than what the government had estimated in its budget document (Rs58,000 crore).
At least four factors have contributed to the decline in the Indian central bank’s surplus for the year and behind two of them, demonetisation has played a critical role.
While the jury is still out on the long-term benefits versus short-term pains inflicted by demonetisation, the sharp drop in the central bank’s dividend payout to the government is a direct fallout of the exercise. It will have an impact on the government’s fiscal deficit—the target for which during 2017-18 is pegged at 3.2% of India’s gross domestic product (GDP).
In the 50 days between 10 November and 30 December 2016, Rs15.4 trillion worth of currency notes of denominations of Rs1,000 and Rs500—some 86.9% of the value of total notes in circulation—were withdrawn to attack black money hoarders, fake currency and terror funding in the country.
There has been speculation that the Indian government could use the currency that would not be returned to solve its fiscal problems. The argument has been that if a portion of the currency withdrawn or demonetised would not return to the banking system, to that extent, the RBI’s liabilities would go down and the central bank could transfer an equivalent amount of assets to the government as a special dividend.
At the initial stage, the quantum of unreturned currency was speculated to be around Rs3 trillion. While no official figures are available as yet of how much money has returned to the system, ironically, instead of helping the government tackle its fiscal deficit, the impact of demonetisation on RBI’s balance sheet will queer the pitch this year. (To be sure, RBI governor Urjit Patel has ruled out any possibility of transferring the unreturned money, if any, to the government in the form of a special dividend.)
This is the lowest dividend paid since 2011-12, when RBI had transferred Rs16,010 crore to the government. It had paid Rs33,010 crore in 2012-13, Rs52,679 crore in 2013-14 and Rs65,896 crore in 2014-15.
What are the four contributing factors to the depletion of RBI’s income and rise in expenditure?
First: The firming up yields on foreign securities is one of the reasons. Unlike the Sri Lankan central bank—which classifies its foreign currency assets including derivatives, says how much of these assets it is holding till they mature, and how much it can trade, and explains the credit risk by giving its exposure to different geographies such as the US, Japan, the UK, Europe, etc.,—RBI does not give any details of its foreign assets. It keeps deposits with other central banks, foreign branches of Indian banks, the Bank for International Settlements, special drawing rights acquired from the Government of India, and foreign treasury bills and dated securities.
I presume that the bulk of its foreign investments are in US papers. The 10-year US paper yield rose from 1.44% in July 2016 to 2.3% in June 2017; similarly, the one-year US Treasury Bill yield rose from 0.44% to 1.23% and that of 3-month US T Bill yield rose from 0.2857% to 1.01% during this period.
The prices and yield of treasury bills and securities move in opposite directions. This means that when the yields rise, prices go down. So, RBI’s foreign investment portfolio is hit as it needs to be marked to market (MTM), an accounting practice whereby an asset is valued at the current market price and not the price at which it was bought. Going by the RBI annual report, foreign securities, other than treasury bills, commercial papers and certain “held to maturity” securities are marked to market on the last business day of the month. Treasury bills and commercial papers are carried at cost, adjusted by amortization of discount, daily.
Second: The appreciation of the local currency has also contributed to the erosion of value in RBI’s foreign assets. In fact, it’s a double whammy for the central bank. Since its balance sheet is in rupees, its foreign currency assets have first taken the MTM impact and, at the second stage, lost value while converted into rupee. A dollar fetched Rs67.32 in July 2016; but in June 2017, it fetched less—Rs64.58. This means, there has been a 4.25% value erosion while converting its foreign currency assets into Indian rupees. Since June, the rupee has appreciated further. This piece of data illustrates the impact best: RBI’s foreign exchange reserve of $363 billion was equivalent of Rs24.3 trillion in July 2016; in August 2017, it rose to $393.5 billion but in rupee terms, the rise is marginal—Rs25 trillion.
Third: The printing of new currency notes of Rs500 and Rs2,000 to replace old notes of Rs500 and Rs1,000, distributing them (Indian Air Force helicopters were used to send new currency notes to banks and automated teller machines in Jharkhand, Bihar and parts of North-East), hiring shredding and briquetting machines on lease to scrap old notes and currency verification machines to weed out fake notes have been a costly affair. India imports most of the paper used for printing currency notes, primarily from Italy and Switzerland. Of course, the cost has been shared by RBI and the government as the notes are printed at four presses—two each run by the government-owned Security Printing and Minting Corp. of India Ltd (at Dewas in Madhya Pradesh, and Nashik in Maharashtra), and Bharatiya Reserve Bank Note Mudran Pvt. Ltd, an RBI unit (at Mysuru in Karnataka, and Salboni in West Bengal).
There is no clarity on the exact cost of printing the currency notes. Answering a question in Rajya Sabha, the upper House of Parliament, a minister has said the cost for printing one new Rs500 note is between Rs2.87 and Rs3.09 and that of one Rs2,000 note is between Rs3.54 and Rs3.77. According to former RBI deputy governor R. Gandhi, who was overseeing the entire currency operations of the central bank till he retired in April, the number of notes that were withdrawn could be 23-24 billion of Rs500 and six billion of Rs1,000. We don’t know exactly how many notes of Rs500 and Rs2,000 have been printed to replace the old lot. Nonetheless, this is a direct impact of demonetisation.
Fourth, and the last contributing factor to the depletion of RBI’s dividend is the cost that it had incurred to stamp out excess liquidity from the system, an offshoot of demonetisation. Money in the banking system, or liquidity, had been tight in April-May 2016, eased in June-July, but in November-December, there was a deluge of money as people rushed to bank branches to deposit old notes. Initially, RBI imposed an incremental cash reserve ratio, or CRR, on banks to soak up all deposits collected between 16 September and 11 November; but it had to use other instruments later—such as reverse repo window and selling securities under the so-called market stabilization scheme, or MSS—to drain liquidity.
There is no cost for CRR as banks are not paid any interest on the money kept with RBI and the cost of MSS is being borne by the government but RBI pays for the money banks keep with it through the reverse repo window. Banks were paid 5.75% and 6% for their surplus kept with RBI for various tenures between overnight and 90 days.
If banks want money from RBI, the central bank gives overnight money at the repo rate against government securities as a collateral. The amount a commercial bank can borrow from the central bank is capped at a quarter percentage point of its net demand and time liability, or NDTL, a loose proxy for deposits. For term repo—when a bank takes money from RBI for seven days and 14 days—the amount is capped at 0.75% of a bank’s NDTL. If banks have excess liquidity (which they continue to have), they park the money at RBI’s reverse repo window. Apart from overnight money, where the rate is fixed, banks can offer money for seven days and more. Unlike the repo, there is no cap on the amount of money that can be parked at the reverse repo window. This means banks can lend as much as they want to but the central bank must have securities to offer as a collateral to absorb the money. The average daily absorption of money through the reverse repo window (net of infusion as some banks need to borrow money from RBI to take care of their temporary asset-liability mismatches) was Rs1.6 trillion in December, Rs2.2 trillion in January, around Rs3.5 trillion in February, Rs4.5 trillion in March, Rs3.8 trillion in April, Rs3.4 trillion in May and Rs3.1 trillion in June. The MSS, too, soaked up Rs3.8 trillion in December, Rs5 trillion in January and Rs2.9 trillion in February, but this cost is borne by the government.
So, lower dividend is the cost of demonetisation which the government will have to bear. While many have been talking about job losses and how it has affected the small and medium enterprises and economic growth, this is possibly the first quantifiable impact of demonetisation. We will get the know the exact quantum when RBI releases its annual report later this month.
Are there any benefits of demonetisation? Do they overweigh the costs? I don’t have a definite answer, but there are several visible benefits in the short-term we are seeing; we would need to wait to get the full picture.
## Direct tax collections rose 19% in April-July of FY18 as more individuals have come into the tax net. In absolute terms, direct taxes, made up of personal and corporate taxes, have been Rs1.9 trillion, and the number of individual tax returns filed jumped 25.3%.
## Tonnes of black money may not have been unearthed but the government has been closely following the leads given by the banks and chasing people whose official income does not justify the amount of money they had deposited in November-December 2016 to get rid of the old Rs500 and Rs1,000 currency notes.
## Indeed, the digitalization of money transactions has gone up substantially in the past few months, following demonetisation. It will not be possible to have a cashless economy, as envisaged by the government, in the foreseeable future but, certainly, we are slowly moving into a less-cash regime. As the digital transactions rise, tax compliance is bound to rise with every transaction leaving behind an audit trail.
## Finally, demonetisation has improved transmission in the banking system and led to the greater financialization of savings.
A recent RBI research paper says between 28 October 2016 and 6 January 2017, notes in circulation declined by about Rs8.8 trillion, and this is reflected in a 4 percentage points increase in the share of low-cost current account and saving account deposits, or CASA. It also led to a 48% increase in deposits in Pradhan Mantri Jan-Dhan Yojana accounts, with the addition of 18 million accounts post-demonetisation. The banking system’s aggregate deposits grew by 14.5% year-on-year between 11 November and 30 December 2016 against 10.3% during the corresponding period of 2015. Most banks witnessed withdrawal of money by depositors subsequently, but despite that, till March-end, the excess deposit growth is around 3.5 percentage points, or around Rs3.5 trillion. The rise in CASA has brought down the cost of money for banks and they have brought down their loan rates (some banks, even the savings account rate) – something which successive RBI rate cuts could not do.
Another RBI paper says that the drop in interest rates on bank deposits after demonetisation and the decline in gold prices, coupled with a dull real estate market—regulations such as the Real Estate (Regulation and Development) Act, 2016 and the Benami Transactions (Prohibition) Amendment Act, 2016 have contributed to that—have been drawing savers and investors to the equity market, directly and through the mutual fund route.
The assets under management by mutual funds rose to Rs20 trillion in July, with the flow of money into equity schemes doubling.
The premia collected by life insurance companies also more than doubled in November 2016. About 85% of the total collection of Life Insurance Corp. of India—which saw its premia collection rise 142% in November 2016—were under the ‘single premium’ policies, paid in lump sum.
If the shift from physical to financial savings lasts for good, then the cost of capital will come down and the much-criticized demonetisation will be a boon for the Indian economy.
The questions are: Will it last? Will the government be able to block the reverse flow? Will investors permanently shift from real estate to equities? Will there be enough incentives for financialization of savings?
Only time will tell.
Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story and Bandhan: The Making of a Bank.
His Twitter handle is @tamalbandyo.