The Big Reverse

by Meera Sanyal

  The CBI had earlier arrested another employee of RBI Mysore in a separate case in which currency worth over `6 lakh was converted by him, using his influence over officials of the State Bank of Mysore.

  A senior RBI official from the RBI printing press in Mysore was arrested in connection with the seizure of `5.70 crore in new currency notes.

  On 23 December, the CBI conducted raids at 11 premises of Vaidyanath Urban Cooperative Bank in Maharashtra, and recovered `10 crore demonetized notes. Investigations were also commenced against the Mumbai District Central Co-operative Bank as a large sum in old currency notes was deposited in the bank post-demonetization.

  On 28 December, the Enforcement Directorate arrested the manager of Kotak Mahindra Bank’s Connaught Place branch for converting `35 crore demonetized currency into new notes, and having alleged links with hawala traders.

  One of the saddest consequences of demonetization was that banking, once a highly respected profession, and bankers, who were looked upon as trustworthy and credible partners, came to be looked upon with suspicion, and bankers as a bunch of people in cahoots with the corrupt.

  Autonomy of the RBI

  Another regrettable consequence of the note ban was that, as a consequence of their actions, the RBI began to be perceived as a ‘rubber stamp’ for the government’s decisions.

  To add to the government’s discomfiture, two former RBI Governors also spoke out against the erosion of RBI’s autonomy.

  Y.V. Reddy (RBI Governor, 2003–2008)56 said, ‘Credibility and public trust are of utmost need for a central bank, not just as an issuer and custodian of currency, but also to ensure financial stability in India’s $2 trillion economy… For a central bank, reputational risk is the worst risk, credibility is the worst risk. And if this is happening … I would say that it is a national problem now and it is not just a political issue.’57

  On 10 January 2017, Bimal Jalan (RBI Governor, 1997–2003)58 joined the debate and said the autonomy of the RBI was sacrosanct. ‘The autonomy of the RBI – that is a very fundamental fact and we have to maintain it … on monetary policy issues, there should be consultation with the government. But the government should agree with the RBI’s final decision, even if it is difficult.’59

  It was not just former Governors of the RBI who were concerned about the RBI’s loss of autonomy. Feeling ‘humiliated’ by events since the demonetization announcement, the United Forum of Reserve Bank Officers and Employees wrote an open letter to Governor Urjit Patel on 13 January 2017.

  It stated, ‘The autonomy and image of RBI has been dented beyond repair’ due to mismanagement. ‘An image of efficiency and independence that RBI assiduously built up over decades by the strenuous efforts of its staff and judicious policy making has gone into smithereens in no time. We feel extremely pained.’60

  ‘The RBI has been discharging the role of currency management for over eight decades since 1935,’ it continued, and ‘the central bank does not need any assistance and the interference from the finance ministry is absolutely unacceptable and deplorable.’

  Signed by four signatories61 representing over 18,000 employees of the RBI, the letter urged the Governor to act: ‘May we request that as the Governor of RBI, its highest functionary and protector of its autonomy and prestige, you will please do the needful urgently to do away with this unwarranted interference from the Ministry of Finance, and assure the staff accordingly, as the staff feel humiliated.’

  With the credibility, role, and autonomy of the RBI being so openly questioned by former Governors and RBI employees, in addition to the media and Parliamentary committees, Urjit Patel clearly started feeling the heat. In a much-publicized event, he ‘literally started running’ out the back door of an auditorium in order to avoid reporters.62

  But, in fairness to Urjit Patel, could the RBI have rejected the government’s advice to undertake demonetization? The legal provisions make for interesting reading.

  Section 7 of the Reserve Bank of India Act, 1934 states, ‘The Central Government may, from time to time, give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.’

  Section 26(2) of the Reserve Bank of India Act, 1934 states that on the recommendation of the RBI’s central board, the government may, by notification in the Gazette of India, declare that with effect from a date specified in the notification, any series of banknotes of any denomination shall cease to be legal tender.

  Therefore, as per Section 7 of the RBI Act, it is clear that the Central Government was within its rights to give directions to the RBI, and as per Section 26(2), the RBI board could legitimately recommend the withdrawal of the `1,000 and `500 notes as legal tender.

  Given the above, it is possible that Patel and the RBI board may have felt that legally they had no option other than to agree with the government. However, to judge whether they discharged their duty to the standards of autonomy that the RBI was reputed for, another set of questions is more relevant.

  Did the government consult the Governor, as required under Section 7? Did he believe the move would be in public interest? Did he analyse the data, weigh the costs and benefits of the move, and assess if demonetization was the appropriate policy intervention to tackle black money, corruption, counterfeiting and terrorism? What were the RBI’s assumptions about money supply and velocity when it took the decision? Did he have any concerns regarding the implementation? Did he share these with the government? If so, was he overruled? And if he was, what could he have done under the circumstances?

  Y.V. Reddy, in a candid interview,63 was clear in what he would have done. He said that he would have told the Prime Minister that it was impossible to carry out demonetization and to effect the replacement of currency on such a massive scale. He said, ‘First I would have tried to impress upon the government that it should withdraw only `1,000 notes so as to minimise the disruption. If the government still wanted to go ahead with removing 86 per cent of currency in circulation, I would have conveyed my inability to execute it.’ Though he said he may not have resigned, he would definitely have gone on sick leave.

  Could it be that Raghuram G. Rajan, confronted by the same issues, had decided to return to academia rather than continue for a second term as Governor? We will probably have to await his memoirs to know. In the meanwhile, it appeared that Urjit Patel had not lived up to the standards of his predecessors, nor sadly to those he had once set himself.

  In a paper co-authored by Urjit Patel in 2012, on inflation in India and the role of the RBI in taming it, Patel had been scathingly critical of the then RBI Governor, saying: ‘…disquieting and obvious questions need to be raised on public policy grounds… The central bank head is pleading hopelessness or a form of muddled eclecticism,’ and concluded by lamenting that ‘answers have been scarce’.

  The larger point the paper made was that policy issues need to be grounded in rigour, costs and benefits should be weighed carefully, and only then should specific policy interventions be devised. It also rightly articulated the need for the head of the central bank to be open to suggestions and provide answers to questions raised.

  Commenting on this paper, Praveen Chakravarty, a Senior Fellow at IDFC Institute, opined, ‘Urjit Patel, the meticulous researcher of 2012, would have concluded that there was no substance in the government’s theory of an inordinate rise in currency in circulation or high-denomination notes in the last five years. Urjit Patel, of the 2012 vintage, would not have waited to release detailed numbers of currency deposits in banks, he would have explained the basis for radical policy decisions such as rationing currency in the nation in the absence of a financial emergency and would have been very transparent about the decision-making process of the RBI, about one of the most significant central bank decisions taken globally in recent history.’64

  My Perspective

  One of the most regrettable consequences of demonetization has been its impact on the reputation
of bankers and the loss of respect and credibility that the RBI has had to suffer.

  India’s central bank has been one of the most highly regarded institutions in the country. Widely respected by their peers globally, successive Governors of the RBI had been credited with taking a firm and autonomous stance on numerous issues, notwithstanding pressure from the MoF and the Central Government.

  It is clear from what he has said that Governor Rajan had raised red flags about the note ban and cautioned the government about proceeding without adequate preparation. The logistic challenges and preparations needed for the step were also clearly articulated in the April 2016 SBI Ecowrap report.

  Despite these clear warnings, no mitigating actions were taken in the 10-month planning period to avoid inconvenience to people and to prevent grievous damage to the economy. By passively agreeing to a step that extinguished 86.9 per cent of the Currency in Circulation, without any clear plan or preparation for remonetizing the system, the Governor and the Board of RBI abdicated their duty to the people of India.

  If they did so under pressure from the government, then, as a nation, we should reflect gravely on the dire consequences that occur when the autonomy and independence of critically important institutions like the RBI are eroded.

  3

  Lessons from History

  Those who cannot remember the past are condemned to repeat it.

  – George Santayana

  I recall as a child watching Mumbai – or Bombay as it was known then – with fascination as it began to reach for the skies. As we stood at the edge of Marine Drive beside the rocks, watching the reclamation of Nariman Point and Cuffe Parade, our father told us that one day there would be tall skyscrapers where we stood.

  It was magical to see these tall towers take shape before our eyes. One evening, we went for a stroll past the Gateway of India. Clutching my father’s hand, I was peering cautiously into the cavernous depths of what was to be the foundation of the new addition to the Taj Mahal hotel when I heard some urchins shouting, ‘Dollar, dollar!’ Startled, I looked up to see them running behind a tourist. Perplexed by a word I had not heard before, I asked my father why they were not asking for money. He smiled and gave me my first lesson on economics and currencies. In closing, he said to me half-jokingly: ‘One day you will be walking on the streets of New York, and children will run after you asking for the rupee.’

  While I would never wish for children to run after me in any city, anywhere in the world, the image my father painted that day represented a rupee so strong that it would be a cherished currency all over the world. Since that time, I have often viewed economic policies through the prism of whether they will make the life of our children easier, our economy more robust and resilient, and our currency stronger. In the process, I have found that there is a great deal to be learnt from history.

  It is interesting that the note ban of November 2016 was not India’s first experiment with demonetization. Were the learnings from previous demonetization experiences in India taken into account? Or, for that matter, were lessons from other countries taken into account? This chapter takes a brief walk into history to see if we can answer these questions.

  A Brief History of the Indian Rupee1

  The Indian rupee (INR or `2) is the official currency of the Republic of India. It draws its name from the Rupiya, the silver coin first issued by Emperor Sher Shah Suri in the sixteenth century and later continued by the Mughal emperors.

  The paper rupee was introduced in India in the late eighteenth century. As the Mughal Empire collapsed and colonial agency houses grew more influential, many of them established banks and started issuing banknotes. However, more widespread use of banknotes came with the note issues of the Presidency banks established by government Charter, namely the Bank of Bengal (est. in 1806 as the Bank of Calcutta), the Bank of Bombay (est. in 1840) and the Bank of Madras (est. in 1843).

  With the governance change that followed the first War of Independence in 1857, the Paper Currency Act of 1861 divested these banks of their right to issue currency notes, and the management of Indian currency was entrusted to the Government of India, specifically to the Mint Masters, the Accountant Generals, and the Controller of Currency. The first set of British India notes were the Victoria Portrait series, issued in denominations of 10, 20, 50, 100 and 1,000. To facilitate security, the Victoria Portrait series notes were cut in half. One half was first sent by post to the intended recipient. On confirmation of its receipt, the second half was dispatched by post!

  Due to widespread forgeries, the Victoria Portrait series was withdrawn and replaced by the Underprint series, which had several improved security features, such as wavy line watermarks, guilloche patterns, and a coloured underprint. In 1923, a new series, the King’s Portrait, with the picture of George V, was introduced. These notes were issued by the Government of India, until the passage of the Reserve Bank of India Act in 1934.

  British India currency notes were printed in Great Britain until the Currency Note Press was established in Nashik in 1928. By 1932, the Nashik Press was printing all of India’s currency, with the enhanced security features.

  The RBI was formally inaugurated on 1 April 1935 with its central office in Calcutta. It took over the functions of the Controller of Currency and issued its first note – a `5 note, bearing the portrait of King George VI, in January 1938. This was followed by `10 in February, `100 in March, and `1,000 and `10,000 in June 1938.

  The George VI series continued till 1947, and thereafter as a frozen series till 1950, when the first post-Independence notes were issued by the RBI, using the Lion Capital of Sarnath as the main feature, in place of King George’s portrait.

  The 1946 Demonetization3

  On 12 January 1946, `1,000, `5,000 and `10,000 notes were demonetized through the passage of the High Denomination Bank Notes (Demonetization) Ordinance.

  The rationale for the demonetization by the pre-Independence government was ostensibly to force unscrupulous businessmen to declare their black money. During World War II, they had supposedly made huge fortunes supplying the Allied war effort and were suspected of concealing their profits from the tax department. A similar step was undertaken in the UK in 1945, where the Bank of England had called in notes of £10 and higher denominations.

  Indian nationalist leaders, who were not consulted on the decision, disagreed with the move. Rajendra Prasad, who would become the first President of India, declared, ‘While we Congressmen have no sympathy with profiteers and dealers in the black market, it is not right to penalise honest people who, in good faith, have their savings in notes of demonetized value… A large number of people belonging to the middle and lower middle classes will be hit hard.’

  Rajendra Prasad went on to lucidly point out how the problem had been created in the first place: ‘Many of the wartime ordinances succeeded in complicating the problems which they were intended to solve and in creating opportunities for corruption. The new ordinances are not going to fare any better.’

  It was reported that absolute secrecy was maintained. Only eight officials knew about the demonetization plan, including the RBI Governor and the Finance Member of the Viceroy’s Council (the equivalent of today’s finance minister), and these officers took notes and typed drafts themselves! No carbon copies were made or kept. The ordinance was flown in a special plane to Poona for the Viceroy’s signature and then flown back.

  A time limit of 10 days, till 23 January (later extended to 9 February 1946), was fixed for the exchange of demonetized notes by ‘genuine holders’ at the Reserve Bank of India. Those exchanging notes could only do so on the basis of declarations explaining the source of earnings. The exchange was not permitted if the explanation of the source of income was not satisfactory.

  There were quite a few complexities to deal with. It was believed that about 60 per cent of the currency was held in the Princely States and, therefore, the cooperation of the maharajas and princes was essential. It was finally ag
reed that while Indian princes would not be exempt, they would be allowed to use a special form approved by the crown representative in their state. There was also the issue of Indian currency which was held and used in the Persian Gulf that had to be dealt with.

  As an aside, this is an interesting bit of history. The Indian rupee traditionally enjoyed wide currency in the Persian Gulf – Kuwait, Bahrain, Qatar, and the Trucial States (now the UAE). On presentation by banks in these areas to the Reserve Bank, these notes were redeemable in foreign currency equivalent. This clearly presented a major challenge during the 1946 demonetization, as ‘black money’ from India could effectively be laundered through the Gulf route.

  Post-Independence, the problem was compounded. Though India had started off with a comfortable foreign exchange position, this was rapidly depleted. To prevent malpractices that could exploit the traditional currency arrangements with the Gulf, a separate series of notes exclusively for circulation in the Gulf were issued in the 1950s. The notes had the same design but were different in colour and carried the prefix ‘Z’. The notes were issued in the denominations of one, ten and hundred rupees and were redeemable only at the RBI’s Bombay office of issue. As the Gulf States issued their own currency, these notes were withdrawn over a period of time from the early 1960s and ceased to be used around 1970.

  It is interesting to note that the then Governor of the Reserve Bank, Sir Chintaman Dwarakanath Deshmukh, disagreed with the move to demonetize.

  According to a note recorded by Sundaresan, the Joint Secretary, Ministry of Finance, who had drafted the scheme, ‘The Governor stated that the Finance Member had given him the impression that the scheme would be launched only when there were signs of the onset of an inflationary spiral. The Governor saw no special signs of such a situation. It appeared to him that the main object of the scheme was to get hold of the tax evader. The Governor wondered if this could be called an emergency to justify the promulgation of an Ordinance, just before the newly elected Legislative Assembly met. The Governor wanted government to be satisfied that there was no harassment to honest persons. As a currency authority, the Bank could not endorse any measure likely to undermine the confidence in the country’s currency.’