Script gone wrong: RBI takes demonetisation hit, cuts dividend to govt by more than half

The Reserve Bank of India (RBI) dividend to the government has come down by half. (REUTERS file photo)

The Reserve Bank of India (RBI) dividend to the government has come down by half. (REUTERS file photo)

The Reserve Bank of India’s (RBI) announcement on Thursday to more than halve its dividend payout to the government has once again put demonetisation under the spotlight, for failing to deliver on the expectations that were used to defend the November 8 decision.

It was expected that there would be a big windfall for the RBI, when the dodgy part of the cash held in denominations of Rs 1,000 and Rs 500 – about Rs 3 lakh crore — doesn’t return to the system and is written off from the central bank’s liability.

The RBI could then transfer this windfall to the government through higher dividend or some other means. The government, in turn, could use this money to build infrastructure, capitalise banks or invest in any other way to accelerate the economic growth.

The script has gone horribly wrong. We know now that most of the cash held in high-value notes, dodgy or otherwise, have returned to the system. It is another matter that the authorities continue to be in denial, maintaining that they are still counting the demonetised notes.

Worse, the RBI’s announcement coincided with the release of a research report by the State Bank of India (SBI) – the country’s largest – that severely undermines the government’s claim that the impact of demonetisation would subside in a few months and make way for accelerated growth as we speak.

According to the SBI report, in the first four months of the current fiscal year, bank credit shrunk Rs 1.5 lakh crore, or 2%, compared to the same period a year ago. The report has identified the sluggish trend in home loans and personal loans as the most worrying.

These suggest that consumer confidence hasn’t turned around and people remain wary of their economic prospects.


What is also worrying is that the informal credit network that provides fuel for the much-vibrant cash economy of India had crumbled in the wake of demonetisation. If proponents of demonetisation are to be believed, the demand that the informal credit network catered to, should have shifted to the formal (banking) sector). That clearly hasn’t happened.

The findings of the SBI report also underscore what this author had earlier argued against demonetisation: That there could be a no bigger sin that our policy-makers could commit than turning the management of a multi-layered, complicated economy such as India’s into a linear set of reductive calculations.

The fallout on RBI’s finances is another case in point.

Let alone a windfall, the RBI has not been able to protect its income, thanks to demonetisation. For 2016-17, it will pay Rs 30,459 crore in dividend to the government, compared to Rs 65,876 crore it paid last year. There are broadly three reasons for the lower payout, directly or indirectly linked to the November 8 decision:

First, the central bank is understood to have spent about Rs 15,000 crore on printing new notes. This money wasn’t budgeted, because the note-ban decision was supposed to be a surprise move.

Second, when people rushed to deposit demonetised notes, banks ended up with huge piles of cash and left the financial system with excess liquidity that could have stoked inflation or triggered other imbalances.

The RBI was forced to conduct reverse repo operations, meaning it had to borrow short-term money from the banks to suck out excess liquidity. Some estimates put the excess liquidity to be as high as Rs 8 lakh crore in early January, which means the RBI must have paid a fair amount in interest charges to the banks.

The last, but the most important, reason for the fall in RBI’s earnings relates to a decline in returns on investment in US treasury bonds, which was aggravated by the rupee’s appreciation against the dollar.

The RBI earns a good part of its income by investing India’s foreign exchange reserves in US treasury bonds. A big spurt in this income through 2015-16 had helped the central bank make a record dividend payout to the government.

In 2016-17, it was expected to moderate because interest rates in the US were softening. But the blow to the RBI turned to be harder, thanks to an appreciating rupee that further diminishes the impact of lower dollar earnings. Between July 2016 and June 2017, which is the financial year for the RBI, the rupee has risen nearly 5% against the US dollar, primarily because imports have been sluggish.

Demonetisation hit exports hard, especially in sectors that are import-intensive. It also dampened consumption spending, keeping imports and demand for foreign exchange subdued and helping the rupee appreciate.