Last November, with the objective of striking a decisive blow against the black market economy which is estimated to be worth around one-fifth of the formal economy, Indian Prime Minister Narendra Modi demonetised all 500- and 1,000-rupee notes, representing 86 percent of the total currency in circulation. Naturally, demonetisation on such a gigantic scale will inflict short-term pain and inconvenience on the population and the economy. In order to restore normalcy and replenish liquidity as soon as possible, the Reserve Bank of India (RBI) has been running its printing machines round the clock and supplying replacement notes to the country’s banks. As the supply of new notes falls far short of demand, it is natural for people to become hysterical at times. It will take some more time for the financial system to settle down. Although there are supporters and opponents of the move, all are unanimous on the need to control the menace of the black economy. 

The RBI Act, Section 6 (2) states that the general superintendence and direction of the RBI’s affairs and business shall be entrusted to a central board of directors. Section 26 (2) states that, on the recommendation of the central board, the central govern­ment may declare that any series of bank notes of any denomination shall cease to be legal tender save at such office or agency of the RBI and to such extent as may be specified in the notification. So, as per the RBI Act, the demonetisation should be done for any series, not all series of 500- and 1,000-rupee notes as has been done now, and at the initiative of the RBI. 

Government versus central bank

Currently, there seems to be no solid rationale pertaining to monetary or financial issues for the central board to take such an initiative, especially when banknotes issued prior to 2005 were replaced starting in April 2014. Moreover, a study conducted by the Indian Statistical Institute, Kolkata last August revealed that just Rs4 billion, or 0.024 percent of the total currency in circulation, was fake. The study also showed that the value remained constant for the last four years as Minister of State for Finance Arjun Ram Meghwal informed the Rajya Sabha. Therefore, it follows that the demonetisation was done not from the perspective of monetary management but fiscal management.

In India, currency notes are issued by the RBI and the government of India only guarantees them. The RBI is responsible for monetary management and overseeing depository financial institutions, which means that probable risks and costs with respect to monetary management and financial sector regulation and supervision will be borne by the financial system itself including the RBI. After all, it is for this reason that central banks are organised and function separately from the government under acts passed by parliament in countries around the world. 

However, the Indian government, by its decision and involvement concerning demonetisation, is implicitly assuming risks that could arise in the monetary and financial sector. If demonetisation erodes trust and confidence in the currency and credit system and depository institutions, a bigger crisis could unfold which will require substantial government resources to mitigate it. In such a case, the regular activities of lending and repayment could also be disturbed, worsening the problem of liquidity, non-performing assets and financial instability. 

Less likely to succeed

There is no provision for a constitutional body to fight corruption in the Indian constitution. Moreover, attempting to attain a fiscal policy goal through a monetary policy tool does not seem to be logical, practical, consistent and legal. The costs and risks in any sector should be borne by the stakeholders who enjoy the profits and other benefits accruing from the sector. The general public or ordinary taxpayers cannot be made vulnerable to such costs and risks by the government’s intervention in the sector. It is for this very reason that a separate regulatory institution like the RBI was created to relieve the government of such a burden. Unnecessary and illegal encroachment on the purview of other institutions will prove to be inefficient and unproductive besides being burdensome to the people in general. 

Demonetisation, if justified by law, should be carried out at the initiative of the RBI, and not as per the active direction and leadership of the Indian government as has been done recently. It seems that the entire move, along with the terms and conditions of the present demonetisation, seems to have been initiated and set by the Indian government in pursuance of a fiscal policy consideration, which is shrinking the black economy and extending the regulated economy. In the advanced economies of the world, the problem of the black economy has been tackled by formulating and implementing suitable acts, rules and guidelines. India could have done this too instead of attempting to attain a fiscal policy goal through a monetary policy tool which, as a result, is less likely to be successful.

Basyal is a former executive director of Nepal Rastra Bank and former senior economic advisor to the Ministry of Finance