Six years after demonetisation: Strengthen RBI governance

It was on November 8, 2016 that the Indian government announced the demonetisation of Rs 500 and Rs 1,000 currency notes. (File image)

In the annual calendar of India’s economic history, November 8 has a permanent place. It was on this day in 2016 that the Indian government announced the demonetisation of Rs 500 and Rs 1,000 currency notes.

The decision led to furious commentaries, both for and against demonetisation, and the debates continue.

The government stated three reasons for demonetisation. Firstly, fake currency notes were mainly high-denomination notes. Secondly, and related to the first, fake currency notes are used to finance terrorism and drug trafficking. Thirdly, high-denomination notes are used to store black money.

Read : Demonetisation, 6 years on: Cash remains the king, black money stays on, fake notes on the rise

Thus, the government decided to withdraw the legal tender status of all Rs 500 and Rs 1,000 currency notes that had been issued.

The goals of demonetisation were laudatory, but the execution soon ran into problems. The Rs 500 and Rs 1,000 notes could hardly be considered high-denomination notes because they collectively comprised 86 percent of all the currency notes. If the two denominations were indeed high-denomination notes, their percentages would have been much lower.

After demonetisation, the government launched a new Rs 500 note and a Rs 2,000 note, making the whole exercise futile.

Brunt of Demonetisation

Not surprisingly, there was chaos amid the general public as people rushed to deposit their old notes in banks. The demonetisation decision was taken during the Diwali festivity, which was followed by the wedding season, and this resulted in several changes to government notifications on the frequency and amounts of cash withdrawals permitted.

Ironically, the brunt of demonetisation was faced mostly by people who were not the targets. There were early signals that black money was not stored as currency notes, and this was eventually reflected in the data released by the Reserve Bank of India. Counterfeiting stopped briefly and resumed as the forgers figured out the new designs.

There had been two earlier cases of demonetisation in India – in 1946 and 1978. In those times, notes of Rs 10,000 and Rs 5,000 denomination were demonetised. Few people held them and it did not create wider public problems. Even then, demonetisation was not successful in flushing out black money from the system because people have other ways of hiding such unaccounted money.

The government soon switched the goalposts and claimed that demonetisation would help to usher in digital payments, which in turn would facilitate higher formalisation of the economy, lessen the cash economy and counter black money.

While it is true that demonetisation helped to quicken the pace of digitalisation, it also created multiple problems. Demonetisation was too crude a measure to make people switch to digital payments. There are many other countries with similar socioeconomic profiles as India wanting to push digital payments, but none used demonetisation as a means to that end.

It's also not clear whether demonetisation helped reduce the cash economy in India. The latest data shows that currency in circulation has touched almost Rs 32 lakh crore, which is about 80 percent higher than the figure of Rs 17.7 lakh crore on the eve of demonetisation.

While the overall trend of currency in circulation was dented, the pre-demonetisation figure was attained one and a half years later in March 2018.

Central Bank Autonomy

In fact, both currency in circulation and digital payments are rising, which is a trend in other countries, too. This is because while people are using digital means to make payments, they are also keeping currency for emergencies – lessons learnt during the pandemic.

In the discussion on demonetisation, one aspect is usually missing – the autonomy and governance of the central bank. The government’s demonetisation notification mentioned that the RBI’s central board advised the government to withdraw the legal tender status of the two high-denomination banknotes.

While the RBI board obviously acted at the behest of the government, the manner in which it was done was quite brazen. The RBI board comprises 21 members, of which only 10 positions were filled before demonetisation. A decision as important as demonetisation was taken by less than half of the board’s strength.

It was truly a wakeup call on the central bank’s governance and autonomy. RBI officials who had fought for autonomy and better governance suddenly saw all their efforts disappear.

The timing of demonetisation was even more ironic, given that the RBI had taken a major step in autonomy and governance a month earlier. In October 2016, the RBI adopted an inflation-targeting framework and appointed a monetary policy committee to vote on interest-rate decisions. However, a month later, one of the most important decisions in the RBI’s history, with a huge bearing on monetary policy, was taken without involving the MPC.

The impact of demonetisation seems to continue on the RBI’s governance and autonomy. The RBI has never really had a full board ever since, and when members resign, new ones are not appointed on time.

The drop in the RBI’s board membership creates worries over another looming demonetisation, but thankfully there has been none.

The functioning of the RBI’s central board at full strength should be one of the top priorities for the government. This is even more important at this stage, when central banks are confronted by multiple challenges.