Demonetisation – How does it affect government finances..??

While the nation adjusts to the new normal arising out of the historic demonetization and debates its merit/demerit, it also has another important fall-out. The move can lead to huge bonanza for government in the form of sharp increase in the transfer from RBI. This would be equivalent to the amount of Rs 500 and Rs 1,000 notes that does not come up for replacement. Let’s see how..

Currency notes are issued by issue department of RBI which are injected into the economy either against non-interest bearing rupee security, gold or foreign currencies, mostly through commercial banking channel. The amount of currency notes so issued is recorded as a liability in its balance sheet, against which it shows assets of foreign currency, gold or rupee security. As per RBI’s latest annual report, the issue department has a total liability of Rs 17.1 lakh crore as of 30th June’16. Of this, about Rs 14.5 lakh is in the form of Rs 500 and Rs 1,000 notes. On the assets side, this is matched by Rs 16.3 lakh crore of foreign currency assets and Rs 0.7 lakh crore of gold (rounded off). RBI also used to issue bank notes against domestic rupee securities which were directly transferred to the government account to meet its expenditure over income, but this practice was stopped in 1997. As a result, its assets of rupee securities remains constant at about Rs 1,000 crore. (RBI keep transacting in government securities but that does not involve printing of money and is separately maintained as part of its banking department).

(Read the first part – http://indiaeconomyandbusiness.com/2016/11/09/the-surgical-strike-on-black-money/ )

What demonetisation would do to RBI’s balance sheet is quite interesting. Assuming about Rs 3 lakh crore of bank notes does not come back to RBI, the issue deptt’s balance sheet would show a liability of Rs 14.1 lakh crore but asset of Rs 17.1 lakh crore..! This would need adjustment to match the balance sheet. One way would be to remove this excess asset from the balance sheet and show as income/surplus. As per the mandate, RBI is required to transfer its surplus to the government. Over last two years, it transferred about Rs 65,000 crore each year. If this is the method adopted to match the balance sheet, RBI’s transfer to government would swell by this amount, wiping out significant part of its fiscal deficit. Of course, government may chose to run part of the deficit and spend the money on developmental projects. However, this would need caution and close calibration as higher government spending would lead to increase in money supply and run the risk of higher inflation.

Of course, the projection assumes about one-fifth of the bank notes is held as black money and in unable to find its way back. It could be less; it could be even more. As far as the accounting is concerned, RBI will have to do something and the money would eventually come back to the government.

 

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