Blog section - Legal questions about demonetisation

  • What happens to the assets that back extinguished rupee notes?

    There are three important questions of law associated with demonetisation. The demonetisation of Rs. 500 and Rs. 1000 has led to speculation about the amount of currency that will not be deposited or exchanged at all, because of fear of scrutiny by tax authorities. Some suggest that from and out of the notes in circulation, close to 20 per cent may not be exchanged or deposited at all with RBI (see here, here and here). (Others believe this will not happen). The numerical values involved are very large; 20 per cent works out to INR 3 trillion disappearing from circulation.​

    The law governing the withdrawal of legal tender in India allows the Central Government to declare that currency notes of a certain denomination will not be legal tender, except at the specified offices of RBI until such date as may be specified by the Central Government in a gazetted notification. In his speech, the Prime Minister specified March 31, 2017 as the date up to which RBI will accept the demonetised currency. However, in our knowledge, this date has not appeared in a gazetted notification (See here). Let's assume that RBI will cease to be liable to accept the un-returned demonetised notes after a certain date, which for the time being, appears to be March 31, 2017.​​

    The central bank of any country must, for every note that it issues, back itself with corresponding assets. The liability incurred on notes issued and the assets backing such liability, are reflected in the balance sheet of the central bank. Typically, these assets are government securities, bullion and foreign securities. Now, in a one-time event like demonetisation, the liabilities of the central bank may significantly plummet, as the central bank will no longer require to honour the commitment to pay on the notes that are not returned to it. This would lead to a mismatch in the balance sheet of the central bank.​

    In the past, we have seen such gains being made in other countries that have substituted currency. For instance, the Bank of Israel recorded a gain of about USD 62 million for the notes that had passed the legal date for exchange and were no longer in use. There is considerable public discourse on what will happen to the windfall made by RBI, if the above mentioned estimates were to translate into reality. ​​



  • What does the law say?

    In India, the relationship between the RBI and its sole shareholder, ie. the Central Government, is governed by the Reserve Bank of India Act, 1934 (RBI Act). As currently drafted, the provision governing allocation of surplus profits lacks details on the reserves that RBI must maintain and the proportion of surplus that RBI must distribute to the Central Government. The RBI Act contains one provision on allocation of surplus profits. Section 47 of the RBI Act says:​.

    After making provision for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation funds and for all other matters for which provision is to be made by or under this Act or which are usually provided for by bankers, the balance of the profits shall be paid to the Central Government.

    The provision implies two things (a) surplus is only the amount which is left after RBI has made adequate provision for all other matters for which provision is to be made (i) under the RBI Act or (ii) for matters which are usually provided for by bankers; and (b) the entire residual surplus shall be paid to the Central Government. There is no clarity in the RBI Act on:​.

    • The proportion of profits which may be allocated to reserve funds or the purpose of the reserve funds;
    • the cap, if any, on reserves;
    • the proportion of profits which must be distributed to the Central Government;
    • the timing of distribution of profits;
    • the manner in which these decisions must be made.


  • Conclusion

    The present legal framework is unclear on the adequacy of reserves of RBI. While this has led to widespread speculation on what will happen to any windfall that may be realised from the demonetization event, the issue of distribution of surplus by RBI is not a one time problem. This problem will continue to crop up every time RBI has surplus profits. To ensure transparency in the distribution of surplus from the central bank to the CFI and to ensure the independence of the central bank in making such decisions, revisiting the legal framework governing reserves and the surplus distribution policy, is imperative. This legal framework should offer precise guidance on i) the purpose for which the RBI can maintain reserves, ii) a cap on such reserves, and iii) the dividend distribution framework. .

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