Willing participant or a mute spectator?

Urjit Patel’s resignation as Reserve Bank of India governor has increased curiosity on the working of the central bank. In this excerpt from his book 'The story of the Reserve Bank of India', author Rahul Bajoria focuses on demonetisation which was backed by Patel.

The Reserve Bank found itself in a tight spot post demonetization. While on the one hand it had the arduous task of managing the huge disruption in India’s cash flow, on the other, it was the subject of significant criticism, especially from the media and several policy watchers. Former governor Rangarajan called the move a ‘standard prescription’, while former governor Subbarao welcomed the move, but cautioned the government against using the exercise to derive windfall gains from the Reserve Bank, through extinguished notes. Former governor Jalan was cautious on the implications of the move, but welcomed the spirit of reducing illicit money in which it was undertaken.

Internationally, the move attracted a lot of attention and some derision. Kaushik Basu, who had previously served as chief economic advisor under Dr Manmohan Singh, termed the exercise as ‘poorly designed and likely to fail’, adding further that ‘demonetisation will only make a minor dent in corruption. It is, however, likely to rock the entire economy. However, Kenneth Rogoff, former chief economist of IMF, called the move ‘bold and audacious’, indicating that the long-term gains would significantly outweigh the short-term pains of the exercise.

Even as academics discussed the pros and cons of the move, the remonetization exercise was much slower than expected. The government deployed the Indian Air Force to airlift new currency notes to various remote locations to replenish currency chests. The RBI even waived ATM charges for bank customers to increase the incentive to use machines rather than queue outside branches. The Reserve Bank was posting regular updates on its website, but the lack of direct communication from the bank was criticized by the media.

Governor Patel finally spoke at length on 27 November, reaffirming RBI’s commitment to remonetize the economy as rapidly as possible and advocated the use of cashless transactions to ease the temporary pain. Even Finance Minister Arun Jaitley came to RBI’s defence, arguing that those who cannot discuss everything in front of the camera should be left to focus on their work. Nonetheless, with the cash crunch remaining high, criticism was mounting, and the long queues outside ATMs and banks continued. Even the government reneged on its promise of raising the cash withdrawal limits two weeks after the demonetization.

In the meantime, the rules around who could or could not use old demonetized notes began to be changed rapidly as the government was getting feedback on various activities, right from the sowing for the rabi crop season to marriages getting disrupted due to demonetization. The government and the RBI responded favourably with some relief measures, but the solution provided were impractical in design and too bureaucratic to be implementable.

The RBI also had the headache of excess banking system liquidity coming back through the reserve repo corridor. Government bond yields had fallen sharply as banks used the excess deposits to park them into government securities. However, the party ended for banks when on 26 November, the Reserve bank unexpectedly raised the cash reserve ratio on an incremental basis from 16 September to 11 November to 100 per cent, thus taking back all the extra funds that had been deposited just before the demonetization announcement.

Later, on 7 December, the Reserve Bank met for its first MPC meeting after the demonetization announcement, where it shocked market participants and economists by keeping rates on hold, but it withdrew the incremental CRR measures as the government raised the MSS limits to absorb the excess liquidity in the system. The lack of monetary support was justified on rather flimsy reasons. The committee felt that the impact of demonetization on economic growth was still ‘clouded’, and hence it would be prudent to wait for more data before assessing the short-term impact of the note ban. In the press conference, Governor Patel justified the decision, saying, “it is appropriate to look through the transitory but unclear effects of the withdrawal of specified bank notes [….] therefore, it is prudent to wait and watch how these factors play out and impinge upon the outlook’.

Leaping before looking

The government, a few weeks into the exercise, was starting to get flak for not ‘thinking through’ the process of replacement of currency notes and was losing popular support due to implementation bottlenecks. Further, the demonetized currency notes were coming back thick and fast into the banking system, giving the impression that the entire exercise to extinguish black money was failing, and the targeted sections had managed to ‘beat the system’ to return the worthless currency notes through several channels, including the recently opened Jan-Dhan bank accounts, Indeed, in its first MPC meeting on 8 December, Deputy Governor R Gandhi reported that over Rs 11.55 lakh crore of demonetized money had been returned to the system, which was almost 75 per cent of total currency notes affected.

The government was also firmly put on the mat in the Parliament, where several opposition leaders, including former prime minister and RBI governor Dr Manmohan Singh who criticized the government on the decision to demonetize such a large sum of currency notes. In a short but powerful speech given in the Rajya Sabha, Dr Manmohan Singh called the demonetization exercise a ‘case of organized loot, legalized plunder of the common people’, and called the process of demonetization a ‘monumental mismanagement’ by the government. Dr Singh was acerbic in his criticism of the government and pointed out that GDP was to decline 2 per cent because of the demonetization exercise. While the GDP did not decline by 2 per cent, growth rate indeed fell by 3 percentage points a year down the line.

In such a situation, there was clearly a desire to shift the narrative, and the government came out with the idea of promoting ‘cashless transactions’ and the digital economy. The real motivation behind this sudden change of narrative remains unclear. Digitization was not mentioned in the early speeches around demonetization, but as it became clear that it would take a while to rebuild the currency in circulation, the government and the RBI actively started to promote cashless payments and mobile wallets. The government even formed a committee of chief ministers led by Andhra Pradesh Chief Minister N. Chandrababu Naidu to promote cashless transactions.

The Reserve Bank was having its own problems, facing criticism for being completely beholden to the government, while losing its own credentials. In a scathing editorial, The Economist magazine chided the government for doing considerable damage to institutions, particularly the RBI. The magazine questioned Governor Patel’s silence and said that RBI’s reputation for ‘probity, competence and independence’ was in tatters. Similarly, in a conference call with the media, Standard & Poor’s questioned the predictability of policymaking in India, with Kyran Curry, the analyst covering India, saying that ‘demonetization has cast a shadow over the RBI’s competence and independence’.

Former governors and employee unions raised similar concerns as well. Sometime after the exercise concluded, former governor Y.V. Reddy said that he would have advised the government against demonetization had he been the governor. He further added, ‘If overruled, I would have admitted myself in hospital and resigned after some time’. Governor Patel was grilled in a deposition to the standing committee on finance, during which he reportedly failed to provide any clarity on when the situation would normalize and when RBI would be able to provide data on how much currency had come back. In fact, it was Dr Mamohan Singh who came to Governor Patel’s rescue, asking him not to respond to some questions raised by his fellow party members.

Employee unions at the RBI and other banks had been protesting for a while against the leadership. A banking union even called for Governor Patel’s resignation for causing ‘havoc’ to the economy. The protests stepped up in January, when the RBI employees’ union wrote a letter to Governor Patel saying that there was a feeling of ‘humiliation’ over the ‘blatant encroachment’ by the Ministry of Finance on currency management. The letter further stated that ‘An image of efficiency and independence that the RBI assiduously built up over decades by the strenuous efforts of its staff and judicious policymaking has gone into smithereens in no time. We feel extremely pained.’ There was a threat of a strike in February by bank employees, who demanded complete removal of cash withdrawal restrictions.

The protest did not stop within the banking system and the RBI. Given the lack of communication, opposition political parties launched protests against the RBI, which at times created a sense of conflict. In Kolkata, Governor Patel was manhandled by workers of the Congress Party at the Netaji Subhash Chandra Bose airport, amid black flags. A similar incident took place in Gandhinagar, Gujarat, when Governor Patel was reported to have run away from a group of journalists. They were waiting for him after a speech he gave at the Vibrant Gujarat Summit on 11 January.

Printed with the permission of Rupa Publications