Did the Govt Use Rajan’s Exit to Push Demonetisation Through?

Concerns over damage to the economy from such a move is what Raghuram Rajan had cautioned against, sources say.

The government’s 8 November announcement to withdraw notes of Rs 500 and Rs 1,000 took the nation by surprise. It meant that 86 percent of the country’s currency by value would become invalid overnight.

The move is intended to deliver a body blow to decades of entrenched corruption, asserted Prime Minister Modi in his address to the nation. It’s a setback to the parallel black economy, said Finance Minister Arun Jaitley a day later.

It will also help tackle the menace of counterfeit currency, added Reserve Bank of India (RBI) governor Urjit Patel, in his sole public appearance since the announcement.

The decision, however, came with the possibility of significant near-term disruption of economic activity. Concerns over needless damage to the economy from such a move is what former RBI governor Raghuram Rajan had cautioned against, said a person familiar with the matter.

The government had been contemplating the move for some time, said this person. Rajan was asked his views, which he gave in no uncertain terms, the person added. The former governor was of the view that the extent of counterfeiting was not justification enough for such an abrupt move, said the person.

Ideologically, too, Rajan has been opposed to the concept of demonetisation. While he has not commented on the government’s current decision, in 2014, Rajan, in a public lecture, questioned the effectiveness of demonetisation.

Unfortunately, my sense is the clever find ways around it. They find ways to divide up their hoard into many smaller pieces. You do find that people who haven’t thought of a way to convert black to white, throw it into the Hundi in some temples. I think there are ways around demonetization. It is not that easy to flush out the black money.

Raghuram Rajan, Former RBI Governor

An email sent to the RBI asking whether the central bank had opposed such a move in the past went unanswered. Rajan is currently in a one-year silent period after stepping down from the post of RBI governor in September and declined comment.

Despite Rajan’s opposition, a few months after his term ended, the government announced the withdrawal of Rs 500 and Rs 1,000 currency notes. BloombergQuint could not establish the exact date when the decision was taken and approved by the RBI central board. According to a statement issued by the RBI on 17 November, the central bank stepped up production of new notes about two months ago, suggesting that the decision was taken in the early days of Urjit Patel’s governorship. Patel took over as the 24th governor of the Reserve Bank of India on 5 September.

“The Reserve Bank of India has once again clarified today that there is sufficient supply of notes consequent upon increased production which started nearly two months ago. Members of public are requested not to panic or hoard currency notes,” said the central bank in a statement that was intended to reassure citizens about the availability of currency notes.

Whose Decision Was It?

A plain reading of the RBI Act suggests that a final decision to withdraw currency notes rests with the RBI Central Board.

Two passages in the RBI Act are relevant in this context.

The central government may, on the recommendation of the Central Board, direct the non-issue or the discontinuance of issue of bank notes of such denominational values as it may specify in this behalf.

RBI Act, Chapter III, Section 24 (2)

On recommendation of the Central Board the (Central Government) may, by notification in the Gazette of India, declare that, with effect from such date as may be specified in the notification, any series of bank notes of any denomination shall cease to be legal tender (save at such office or agency of the Bank and to such extent as may be specified in the notification).

RBI Act, Chapter III, Section 26 (2)

While a cursory reading of the provisions above suggests that any decision on the withdrawal of currency notes lies with the RBI central board, the legal reading within the RBI is that the final word on such matters is the government’s.

When matters of public policy are involved, the Act does allow for a larger role for the government of the day, said a second person familiar with the matter.

An email sent to the RBI seeking clarity on the provisions of the RBI Act were not answered.

According to the first person quoted above, the question of who is the final authority on matters of currency has never been tested since so far it has been a matter of consensus. The RBI’s role is to warn the government of the consequences of any move, propose the best course of action and prepare accordingly, said this person.

HP Ranina, a senior advocate and a former RBI board member, is certain that the processes laid down by the RBI Act would have been followed in taking this decision.

The Act clearly states that the central board must take the decision on this matter. Due process was followed in this case.

HP Ranina, Senior Advocate 

Managing The Aftermath

With the decision now taken, the spotlight is on the RBI and how it will manage the economic fallout of the withdrawal of currency notes.

While views differ widely on the extent of damage the currency crunch can inflict on the economy, most analysts are predicting some hit to economic growth, with some questioning whether the long-term gains will outweigh the losses. The RBI is yet to share its own analysis and projections.

Rating agencies such as Fitch and Moody’s have acknowledged the possible long-term benefits of the move but also highlighted the short-term trade-offs.

The demonetisation of large-denomination bank notes has caused short-term disruption in India’s economy. The move has the potential to raise government revenue and encourage bank lending, but Fitch Ratings believes the positive effects are unlikely to be strong and sufficiently enduring to support credit profiles.

Fitch Ratings Report (November 22) 

Households and businesses will experience liquidity shortages, at least for a few months. There will also be a loss of wealth, as some individuals and companies will choose not to deposit funds into the formal financial system to avoid disclosing their sources. The move will weigh on GDP growth for a few quarters, dampening government revenues. Medium term, higher income declarations will boost tax revenues, and the government could receive a one-off transfer of the central bank’s gain. This could support government capital expenditure and/or fiscal consolidation, which would be credit positive for the sovereign.  

Moody’s Investors Service Report (November 24) 

(This article was published in BloombergQuint)