While the entire Indian economy was disrupted by the demonetisation exercise announced on November 8, 2016, removing high-value currency notes overnight, it simultaneously stirred a serious controversy on the role of Reserve Bank of India as the principal regulator of money supply in India.

In understanding the controversial conduct of the Reserve Bank of India, a deeper study of the evolution of the central bank as the regulator of money supply is necessary.

Historically, the colonial government assumed sole note-issuing powers in 1861 with the enactment of the Paper Currency Act. That power was later delegated to the Presidency Banks. With their merger to form the Imperial Bank of India in 1921, the responsibility for issuing currency was shifted to the Imperial Bank (which is now State Bank of India). With the passage of the Reserve Bank of India Act in 1934, this power was transferred the next year to the newly established Reserve Bank of India.

This took place against the backdrop of the US Congress passing the Federal Reserve Act in 1913, giving the Federal Reserve Board the power of currency management after the financial crisis known as “The Panic of 1907”.

What is the rationale of the Indian system? What George Schuster, the Finance Member of the Viceroy’s Council said while piloting the Reserve Bank of India Bill in the Indian Assembly is instructive:

  “….when the direction of public finance is in the hands of a ministry responsible for a popularly elected legislature, a ministry which would for that reason be liable to frequent change with the changing political situation, it is desirable that the control of currency and credit in the country should be in the hands of an independent authority which can act with continuity.”

On the same page

The government as the agent of the sovereign state has a wide range responsibilities, many of which are more serious than currency management. It may not have the analytical skill and expertise either. The Reserve Bank is a body of professionals with an intimate knowledge of the economy and the monetary system of the country required to ensure stability of the financial system.

While Section 24 of the RBI Act vests the sole power to issue currency notes with the bank, Section 26(2) empowers the Union government to declare that a note of particular denomination ceases to be legal tender. In declaring so, the government, however, has to act on the recommendation of the Reserve Bank’s Central Board. This implies that the state as the sovereign and the Reserve Bank as monetary regulator should be on the same page when decisions affecting the money supply are taken.

When the liberalisation began in the early 1990s, the need for better coordination between the Reserve Bank as regulator and government as the sovereign authority was acutely felt. To meet this requirement, Financial Stability and Development Council was set up in 2010 with representatives from both the authorities. While the goal of Financial Stability and Development Council was to maintain financial stability, it was a mechanism for better coordination between the two authorities.

The Department of Currency Management of the Reserve Bank takes care of the supply, distribution and withdrawal of currency from circulation. The actual work is attended to by currency chests owned by the Reserve Bank but managed by banks all over the country. These outlets ensure uninterrupted distribution of currency for circulation.

Informed consultation

Given this background, when the government decides to take an extreme measure like demonetisation, an informed consultation between the two is mandatory. In fact, it is in the larger public interest.

It would be relevant to recall the earlier two exercises of demonetisation in India after the Reserve Bank was set up.

The first one was in 1946 undertaken by the Viceroy’s government with a view to tackling the menace of black money during World War II. The government sought the Reserve Bank’s recommendation on its proposal. The bank was not in favour of the drastic measure. The government overruled the objections and demonetised high-value notes anyway. That, however, did not yield the desired results. Reserve Bank Governor CD Deshmukh later confirmed that the demonetised high-value notes were returned to the bank almost entirely.

The second demonetisation was in 1978 when Morarji Desai was prime minister. This time to the Reserve Bank was not convinced of the efficacy of the proposal. Once again the state invoked its sovereign power. Fortunately, the volume of high-value notes was small and the ordinary citizens were largely unaffected. But the menace of black money continued without respite.

Prior consultation

One common feature was noteworthy: the governments respected the spirit of Reserve Bank of India Act. There was prior consultation with the regulator, which articulated a divergent view based on its judgment.

In 2016, the Reserve Bank was asked to send its formal endorsement post-haste. Its central board was not in its full strength nor were the board members who attended the meeting given advance notice needed for an objective study. Governor Urjit Patel, unlike the governors in 1946 and 1978, simply endorsed the sovereign’s whim. Then all hell broke out.

Between the announcement of demonetisation on November 8, 2016, and the last day for exchanging dead notes on December 31, 2016, there were frequent changes in the directions for converting notes, withdrawing deposits from personal accounts and depositing cash. ATMs across the country were inoperational, as the supply of currency was inadequate to meet the demand. Besides, the machines could not handle the new Rs 500 notes and the freshly introduced Rs 2,000 notes because time was needed to recalibrate them.

These developments ran afoul of a cardinal principle of monetary management – namely certainty of the rules to be followed by money dispensers and users. The entire financial system was in disarray right under the watchful eyes of the regulatory authority.

Reserve Bank Governor Urjit Patel’s silence was baffling. His resignation later, in December 2018, could as well be viewed as a gesture to atone for this failure. But by that time lasting damage had been done to the credibility and stature of the Reserve Bank as an independent guardian of India’s monetary system.

Globally, India’s image as a robust economy with healthy checks and balances went for a toss. Respected journals like The Economist, The Wall Street Journal and The Forbes Magazine carried searing commentaries about the momentous strike.

One question would survive the debate, though: even if time were to be given to the Reserve Bank to arrive at an informed opinion, would the sovereign have accepted its professional advice? It was unlikely. The conduct of several other institutions created by law that could not stand up to the dictates of the sovereign and the responses of the government where the advice was at variance with the government’s intent leads to this inference.

Such conduct on each side has frayed the system of institutional checks and balances so essential for a functioning democracy.

The way forward

What should be the way forward? We start with the lessons from the controversial exercise:

  1. Although the government as sovereign is entitled to take a call on currency issue and management, the decision of 2016 was not tempered by the wisdom of the experts charged with the specific role of regulating the currency.
  2. The government’s decision ran contrary to the aims of Reserve Bank of India Act and also the mandate of the Financial Stability and Development Council.
  3. By overlooking the regulator’s role, the government did exactly what the Reserve Bank of India Act intended not to happen.

The consequences of an irrational decision by the sovereign bypassing the regulator had obviously prompted the Reserve Bank’s Deputy Governor Viral Acharya to note in a lecture in 2018, “Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire and come to rue the day they undermined an important regulatory institution.”

The 2016 demonetisation exercise did indeed set fire to the economy, which had in fact been on the road to recovery as confirmed by government’s own Economic Survey of 2015-’16.

Financial stability necessitates greater co-ordination between the Reserve Bank as the regulator and the government as the sovereign. The sovereign state should respect the principle of separation of power, bypassing it only in extraordinary circumstances.

If the need for a radical measure felt, the desire of the sovereign should be made known to an empowered group like the Financial Stability and Development Council. Such a body should take an informed decision after studying the ground realities and the likely impact as well as the logistics required to carry out the intent.

That is the singular lesson of the disastrous 2016 demonetisation for the future policy makers.

TR Bhat is a former banker and trade union activist. He is the author most recently of Reforming the Indian Public Sector Banks – the Lessons and the Challenges.

This article is part of a series looking back on five years of demonetisation prepared by the Centre for Financial Accountability. Read the entire series here.