Demonetization and Fiscal Deficit

PM Modi’s “Surgical Strike on Black Money” on 8th November 2016 surprised the whole nation. Things are still chaotic after 3 days and will remain so at least for a few weeks.

Many messages and articles are being written about the effects of this huge demonetization initiative. One of the messages said: “Government of India is expecting 30-40 thousand currency notes will not be exchanged; which RBI will pay as special dividend to the Govt and help reduce Fiscal Deficit”

There were few queries by friends who didn’t clearly understand the correlation. Let me try to explain with my limited knowledge.

A very basic form of Balance Sheet of a Central Bank looks as follows:


Currency notes are issued by the central bank (Reserve Bank of India) and appear on Liability side of the Balance Sheet. A currency note is a promise by the RBI to redeem equivalent sum of money to the person who bears that note.

The currency note mentions: “मै धारक को XYZ रुपये अदा करने का वचन देता हूं ” OR “I promise to pay the bearer the sum of XYZ rupees”.

So it’s an obligation for the RBI and hence a liability.

Government of India has cancelled the current Rs. 500 and Rs. 1000 currency notes from 9th November 2016 and advised the citizens to deposit or exchange the notes through banks before 31st December 2016. Thus the current 500/1000 notes would “expiry” on 31st December i.e. they would cease to carry any monetary value; which in turn means that the “RBI Promise” would expire too.

Now suppose people, for whatever reasons, do not exchange currency notes by 31st December, what would happen to these notes? They would lose their value. Also, the RBI’s promise to redeem that money would also end. This means that the RBI would get to keep that amount. The liability of currency notes would end.

Assets = Liability + Owners’ Equity.

In this case, the assets remain the same but the liability (of un-returned currency notes) goes down? So to balance the equation the Equity would go up. This would be in the form of “Other Comprehensive Income” or OCI.

And since Government of India is the only shareholder of RBI, the RBI can pay the amount to Govt of India as dividend. This dividend (additional revenue) would help government reduce the fiscal deficit.

More write-ups on currency demonetization soon…


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