Demonetisation update-3: extinguishing logic

With the expected reduction in liabilities in the RBI’s balance sheet (due to some people destroying their currency notes), how will the equivalent reduction in the asset side be reflected?

Will this be treated as a reserve and the RBI declare a special dividend to the GOI?

That was an email from a friend.

This is not true. It is a false argument. There is no reduction in liabilities. Liabilities will continue. All liabilities are actually extinguished in a practical sense, as and when the notes are created. It is an accounting entry in the books of RBI. That is all. If some notes are destroyed by you, RBI does not get a windfall. They have to create more new currencies. Currencies in circulation do not decline. There is no bonus, no reserve, no dividend.

Cash is fungible and it is not a one-period transaction. Currencies in circulation continue to be created. RBI routinely destroys soiled notes in plenty of quantity every year. That does not result in offsetting ‘gains or credit to non-monetary liabilities’ because the notes are replaced.

This is what a former central banker said:

Balance sheet objectives drive operations of institutions.

For RBI, policy objectives drive operations and balance sheet effects reflect the results.

Balance sheet effect is, hence, of no substantive significance.

Those who are insisting on cancellation of liabilities and on a dividend to the GoI are viewing the RBI as though it is a commercial entity that suddenly finds itself in a position of having extinguished some of the liabilities and therefore, have to figure out how to transfer its one-time gain to its ‘parent’ company. No. That is a wrong framework.

The more we spend time on this, the more we will look like the blind men who were trying to figure out the elephant, if we are not that already.

I got my moment of epiphany after a visit to the local temple on Saturday, reflecting on this matter and after reading the Bank of England’s note on how to read a Central Bank balance sheet. You can find it here. Pl. check out chart 4 in page 9.

See this from the Bank of England document linked above (thank you, Gulzar):

In most economies bank notes enter circulation through commercial banks. The process involves commercial banks drawing down banknotes in exchange for reserve balances held at the central bank. The wider population then obtains banknotes either through direct withdrawals from commercial banks or from other agents. Most central banks targeting price targets will supply banknotes on demand to commercial banks.

Finally, think of an extreme experiment. Assume all currency in circulation is extinguished. No exchange. It is gone. What does the RBI do? It has to issue fresh notes to replace them. Currency in circulation grows in line with nominal GDP growth.

I reiterate: cash is fungible. So, currency in circulation as an item in the central bank balance sheet will be steadily rising every year. There is no extinguishing of any liability in its books.

If it was so easy to do, why many governments around the world have not done it at all? Also, it would be so easy for the central bank to cancel currency notes with some serial numbers every once in a while, and declare a dividend to the government…

No special profits. No special dividends to the Government.

Bad ideas refuse to die. Pity.

Notwithstanding the above clarification, I still welcome this demonetisation and the manner in which it has been carried out. Yes. I shall elaborate that in subsequent updates.

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6 thoughts on “Demonetisation update-3: extinguishing logic

  1. Sir,
    You have quashed the argument of RBI paying dividend to the Govt due to reduction in its liability & backed it up with BOEs handbook. I am amazed at the Fixed Income fund managers in India (particularly ones who manage the biggest Fixed Income fund of USD 2.4bn) who have in their note suggested about RBI paying dividend due to reduction in liability etc. This is ridiculous on their part to jump the gun without even verifying the correct B/S functionality of RBI.

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  2. Hmm… so if RBI does not issue equivalent amount of currency in circulation as that many notes do not land up for exchange or people do not withdraw equivalent amount of currency from the chest, we end up with an effective monetary tightening in the economy unless one makes the argument that velocity of money went up because people suddenly were incentivized to use electronic payments (& that will imply a huge e-payment surge).

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      1. You touched on it in part 4 : RBI’s estimate of permanent reserves it needs to create to be in synch with economy. What if in this de-monetization process it ends up reducing reserves. Reserve estimate for an economy is always a fine art where a lot of estimates are involved in terms of velocity of money, inflationary erosion, government spending/borrowing, etc.

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