90 years of RBI: How India’s central bank found itself in a tight spot post-demonetization

Speaking on the tax amnesty, Prime Minister Modi in his Mann ki Baat address on 26 June 2016 warned tax evaders that the amnesty ending on 30 September 2016 was ‘their last chance’. Soon after, in July, he cautioned tax evaders to pay their dues on time, warning them of severe action if they failed to come clean.

However, there was a general sense within the public that the government’s efforts to take on illegal wealth were hamstrung, and the measures taken were not making enough of an impact. As such, roughly mid-way through his five-year term, Prime Minister Modi was starting to appear ineffectual on his promise to reduce the role of black money, and his ‘promise’ of depositing fifteen lakh rupees in everyone’s bank accounts was being joked about by his political opposition.

8.00 p.m., 8 November 2016

As the world focused on a mercurial election for the American presidency between Donald Trump and Hillary Clinton, India’s prime minister’s office announced that the prime minister would address the nation at 8.00 p.m. local time on the evening of 8 November 2016. The address began a little bit late, and unlike his usual speeches, Narendra Modi took his time listing the various government schemes he had launched to provide social security and necessary items to the poor and marginalized. He then proceeded to criticize the persistence of corruption in India, despite its economic progress. He outlined the steps his government had taken to stifle black money generation, including agreements with foreign governments, amnesty schemes and a new law to curb ‘benami’ (nameless) property transactions.

Then came the bombshell. Roughly fifteen minutes into his speech, Modi announced that the government had decided to render the 1,000- and 500-rupee notes as illegal tender. At the time of his speech, roughly 86 per cent of total currency in circulation was in these notes. He asked Indian citizens to deposit their 1,000- and 500-rupee notes in bank accounts, giving them until 30 December 2016 to do so, roughly fifty days from the date of announcement.

India had gone through two rounds of demonetization previously, once in 1946 and then again in 1978. However, the magnitude of the 2016 demonetization was significantly larger, and its impact on India’s economy was expected to be debilitating. In a country with a large informal sector and a general lack of access to banking services, such a significant demonetization was expected to give a body blow to several sectors, including agriculture. The political reaction was one of disbelief, as the popular opinion swung significantly in favour of Narendra Modi initially, despite the negative impact on both businesses and individuals. The moniker ‘demonetization’ was never used by the government or the Reserve Bank in any of its press releases. However, the term caught on, with its Hindi equivalent ‘notebandi’ too becoming part of the popular lexicon.

The Reserve Bank closed down banks and ATMs on 9 November to become battle ready, and from 10 November onwards, the queues began to build outside India’s banks and ATMs. On the first day of banks opening their doors, RBI reported that over ten crore exchange transactions were reported. Most ATMs were out of cash, and the government had put in place restrictions on the withdrawal of cash directly from the banks and even ATMs, with a promise to raise the limits in two weeks, once the ATMs had been recalibrated to accept the new 2,000-rupee notes that were being introduced to replace the demonetized 1,000- and 500-rupee notes. India is the largest producer and consumer of currency notes, next only to China, hence the entire administrative exercise turned out to be much trickier than initially anticipated.

The government had exempted a few services, such as fuel pumps, hospitals and toll expressways from not transacting in the demonetized currency notes. However, for a few days, several businesses, such as electronics stores, departmental stores and even jewellers did significant business, transacting mostly in cash, according to anecdotal evidence. There were also long-distance tickets being booked through the railways, which were later made non-refundable to prevent money laundering through this loophole. The government swiftly moved to crack down on any conversion of ‘illegal wealth’ into gold, putting jewellers on the spot.

A willing participant or a mute spectator?

The Reserve Bank found itself in a tight spot post demonetization. While on the one hand it had the arduous task of managing the huge disruption in India’s cash flow, on the other, it was the subject of significant criticism, especially from the media and several policy watchers. Former governor Rangarajan called the move a ‘standard prescription’,669 while former governor Subbarao welcomed the move, but cautioned the government against using the exercise to derive windfall gains from the Reserve Bank, through extinguished notes. Former governor Jalan was cautious on the implications of the move, but welcomed the spirit of reducing illicit money in which it was undertaken.

Internationally, the move attracted a lot of attention, and some derision. Kaushik Basu, who had previously served as chief economic advisor under Dr Manmohan Singh, termed the exercise as ‘poorly designed and likely to fail’, adding further that ‘demonetisation will only make a minor dent in corruption. It is, however, likely to rock the entire economy’.670 However, Kenneth Rogoff, former chief economist of IMF, called the move ‘bold and audacious’, indicating that the long-term gains would significantly outweigh the short-term pains of the exercise.

(Excerpted from The Story of the Reserve Bank of India by Rahul Bajoria, with permission from Rupa Publications)