Legal questions about demonetisation: What happens to the assets that back extinguished rupee notes

by Radhika Pandey and Bhargavi Zaveri.

There are three important questions of law associated with demonetisation. This article seeks to shed some light on the third question. 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.

In this article, we argue that unlike several other countries with precise laws governing their central banks, there is legal uncertainty on what happens to the surplus reserves or income accruing to RBI, whether as a result of a one-time demonetisation event or due to its regular operations. There is a need to re-visit the legal framework governing surplus distribution by RBI.

Lack of clarity in distribution policy

Ordinarily, when a mismatch occurs on the balance sheet of a corporation due to a sudden change in the liabilities, the resulting surplus assets are either (a) distributed as dividend to the shareholders; or (b) credited to reserves. This takes place under the rubric of a `dividend distribution policy', which is generally voted upon by the board. The circumstances in which shareholders should or should not expect dividend, and the manner in which the retained earnings will be utilised, are generally codified in the dividend distribution policy. The policy is disclosed to the shareholders, so as to enhance predictability, and governs their relationship with the corporation.

Likewise, where a central bank has surplus reserves or profits in any given financial year (whether due to a one-time event like demonetisation or otherwise in the course of its regular operations), the shareholders of the central bank (in a majority of the cases, the government) must have clarity on the distribution policy. This must be clearly spelt out to the Central Government in the law governing its relationship with RBI or in an agreement between them that is available in public domain. This is critical to ensure both (a) the independence of RBI as it pre-empts any possiblity of political pressure for distribution of surplus profits or reserves; and (b) accountability of both the RBI and the Central Government with regard to the distribution of surplus profits to the Consolidated Fund of India.

Currently, this clarity is missing. As a result, the distribution of surplus assets by RBI to the Central Government has fluctuated year-on-year, except for the last three financial years, as shown in the graph below:

Transfer to Government of India, by RBI (Percent to profits)

The graph shows that the proportion of profits transferred to the Central Government has fluctuated across the years. However, for the last three financial years, the distribution has remained constant at 99.9% due to the recommendations of the Report of the Technical Committee to review the level and adequacy of internal reserves and surplus distribution policy. See here (hereafter, the Malegam Committee Report, which is discussed in greater detail later in this article).

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:

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

The current legal framework is, therefore, inadequate as it offers no transparency with regard to these matters.

What do central banks around the world do with their profits and surplus assets?

Laws governing several central banks around the world have a numerical value, which offers clarity on the distribution policy. Several legal frameworks governing central banks across the world, precisely state the proportion of surplus assets that must be credited to the reserves, the proportion that must be distributed to the exchequer, the timing of distribution, etc. Some examples are listed below:

1. Specifying the percentage of profit which must be distributed - Some laws governing central banks mandate the specific percentage of net profits which must be distributed by the central bank. For instance, the Bank of England Act, 1946 requires the Bank of England (BOE) to pay to the Exchequer, on every 5th April and 5th October, a sum equal to 25% of BOE's net profits for its previous financial year, or such other sum as the Treasury and BOE may agree.
2. Specifying the proportion of profit which may be credited to the reserves - For instance, the Bank of Korea Act, 1997 has adopted an alternative approach by specifying the proportion of profits that Bank of Korea (BOK) may retain. It allows BOK to accumulate 30% of the profits, after providing for depreciating assets, every year. It allows the balance profits, remaining after such accumulation, to be credited to special purpose reserves, with the explicit approval of the Government. It mandates that the balance, if any, remaining after creation of such reserves must be paid out to the Government of Korea.
3. Specifying the kinds of reserves that the central bank may accumulate - The Bank of Thailand Act, 1942 specifically sets out the percentage of reserves that the Bank of Thailand (BOT) must accumulate. It requires the BOT to constitute the following reserves, namely, (a) ordinary reserves intended to cover possible loss; (b) reserves derived from the revaluation of assets and liabilities; and (c) other reserves for particular purposes as may be established by the BOT Board upon the approval of the Minister. The net annual profits of the BOT, after deduction of accumulated loss, if any, shall be provided in the following order for: (1) ordinary reserve amounting to 25 per cent; (2) other reserves for particular purposes, as specified by the BOT Board, upon the approval of the Minister. Any remaining net profits shall be paid in as state revenues.
4. Capping the accumulation of reserves - The United States follows a de-centralised system of central banking where there is no single federal reserve bank, but 12 Federal reserve banks. The Federal Reserve Act, 1913, which governs the Federal Reserve System, mandates the Federal reserve banks to first pay out dividend to the stock holders (which are essentially member banks) in proportion to their holding in the Federal reserve bank. It then allows the surplus to be accumulated as a surplus fund of the Federal Bank, but specifically caps the surplus. It mandates that the surplus, if any, remaining with the Federal reserve bank, after providing for expenses, payment of dividend and allocation to surplus, shall be distributed to the Treasury.

The takeaway from the list of laws illustrated above is that there is a quantitative indicator that imparts clarity to the treatment of surplus assets by the central bank. The indicator may be indicative of what needs to be distributed, what needs to be credited to reserves or the cap on reserves. The RBI Act lacks this clarity, thereby leading to speculation.

Reserves maintained by RBI

RBI maintains the following major funds: (a) Currency and gold re-valuation account (CGRA); (b) Investment Re-valuation account (IRA); (c) Exchange Equalisation Account; (d) Asset Development Reserve (ADR); and (e) Contingency Reserve (CR). Out of these, the first three are funds to which unrealised gains and losses on existing assets of RBI, are credited and debited. The ADR was created out of profits to meet RBI's internal capital expenditure and invest in subsidiaries and associated institutions. The CR consists of the amounts added on a year-to-year basis for meeting all other unexpected and unforeseen contingencies (Malegam Committee Report (2013)). Therefore, technically, in the absence of any specific provision in the law, which restricts the internal capital expenditure that RBI may make or the contingencies that RBI can provide for, it is perfectly legitimate for RBI to credit the windfall to its CR or ADR.

In the absence of legal clarity, the Malegam Committee was set up by RBI to review the level and adequacy of internal reserves and surplus distribution policy of the RBI. It suggested that (a) since the balances in the CR and ADR were in excess of the buffers needed, there was no need to make any more transfers to these funds; (b) the entire surplus should be transferred to the Central Government. Hence, for the three years immediately following the report of the Malegam Committee, i.e. 2013-14, 2014-15 and 2015-16, the entire surplus was transferred to the Government. This brought some consistency in the distribution of surplus. But, no steps have been taken to reform the law to ensure such consistency in future.

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.

The last couple of years have witnessed some headway in reforming the decision making processes at RBI. In 2016, the RBI Act was amended to provide clarity on the manner in which it may exercise its monetary policy functions. The current government must focus its effort on such deep institutional reforms. It is a good time to resume this process by focusing on the decision making process for allocation of surplus assets by the central bank.



Radhika Pandey is a researcher at the National Institute for Public Finance and Policy. Bhargavi Zaveri is a researcher at the Indira Gandhi Institute for Development Research.