An idea that is gaining traction is that the demonetisation process, apart from bumping up tax revenues, will generate significant windfall gains for the government via the Reserve Bank of India (RBI). The idea offers much food for thought and could be a novel way to monetise the fiscal deficit by demonetising some currency. The money supply would not increase and hence the classic inflationary effects of monetisation via printing new notes should not kick in.
Here’s how it will work: The first rule of accounting is that assets and liabilities must match on a balance sheet. In the RBI’s balance sheet, currency is a liability with a promise to pay the bearer. All currency is, therefore, matched by assets. For the RBI, assets consist of net domestic assets (bullion and government bonds) and net foreign assets (bullion held abroad and hard currency assets). The total currency now being withdrawn amounts to about 11 per cent of the official gross domestic product. The quantum of the black money is unknown, but it may be assumed that some stock of that cash will not be deposited back into the banking system because holders cannot afford to draw the attention of the authorities to their activities. After the March 2017 deadline, unreturned notes will no longer be a liability for the RBI, which will then possess a surplus of assets. If the RBI transfers such a surplus to the government as some form of a special dividend, there would be a windfall benefit for the government. Such a transfer of assets could reduce the fiscal deficit on a one-time basis. Or perhaps, it may be used towards the much-needed recapitalisation of public-sector banks.
But there is a catch. Each year, the RBI transfers dividends to the government, but those dividends have always been from profits derived from operations, as shown in the profit and loss account. The RBI has many income sources, including interest income from lending to commercial banks, open market operations, where it sells and buys bonds, treasury auctions and forex trading. The central bank also revalues the assets it holds to reflect fluctuations in the value of bullion and forex. It has never paid dividends from any notional gains arising from such balance sheet adjustments nor does it provide for such notional losses. So opinions on the legal feasibility of a special dividend of this nature seem to be divided. While some say it is not possible, others have opined that the RBI Act may allow such a dividend. Even if such a special dividend is legally feasible, doing so may be a risky proposition and, as such, inadvisable. Former RBI Governor D Subbarao, for example, has spoken against any move by the government to treat currency that is not surrendered as profit. Investors may, for instance, develop a fear of the government resorting to this sort of expropriation repeatedly simply to deal with deficits or to recapitalise banks. This could lead to capital flight and a reluctance to invest in rupee-denominated assets such as masala bonds. This concept may also turn out to be useless in practice if the stock of un-returned currency is small. In rational terms, either the hoarders of black money will find a way to take a haircut and launder it or, in the worst case scenario (for them), just make anonymous donations to religious institutions or, ironically enough, political parties, as it happened during the last demonetisation in 1978.
