There is a meme circulating that the government will reap a kind of windfall gain from its monetary coup d’état. To the extent that some portion of these notes will remain unexchanged by the deadline, the argument goes, these notes will stand cancelled as liabilities of the Reserve Bank of India (RBI). With its liabilities thus reduced, the RBI can afford to fork over more surplus, known as seigniorage, to the government as a one-time bonanza.

This argument is based on a misreading of the central bank’s balance sheet. Currency notes are not the same thing as having a checking account with the central bank. Seigniorage is paid out of the RBI’s income flow but cancellation of currency notes changes only its net worth. Conflating both income and value as well as currency and credit can have seriously monetary consequences.

How does the RBI or any central bank make money? At one level, the same way any regular bank makes money: it borrows short and lends long, making the “spread" between borrowing and lending. Unlike a regular bank, however, a central bank is the government’s bank, having sovereign capital not financial capital.

Look at RBI’s latest balance sheet. Abstracting a bit, its liabilities are the deposit accounts that commercial banks have with RBI plus currency notes, comprising 16% and 53% of its liabilities, respectively, according to this year’s statement. And the assets? In the main, central banks hold bonds and a bit of vestigial gold. In emerging markets, central banks tend to hold a combination of domestic bonds and foreign-currency bonds. RBI has 93% of its assets in bonds, (22% domestic plus 71% foreign) and an ornamental 4% in gold.

Interest payments from both domestic and foreign-currency bonds comprise RBI’s actual cash income. RBI’s balance sheet also moves up and down in net worth depending on the market value of these bonds, the bulk of which are foreign-currency bonds.

What is interesting is that the vast majority of the RBI’s assets are now foreign-currency bonds earning them an interest payment in foreign exchange. These foreign bonds represent the nation’s foreign exchange reserves. Because India is a net importer on trade account, it is a net borrower on capital account. So these reserves are not savings so much as borrowed reserves, a bulwark to protect the nation from its fragile external position.

Also note that, given the low interest-rate environment globally with quantitative easing, most of RBI’s cash income at present comes from interest on domestic bonds rather than foreign bonds; the situation was the reverse before the crisis. This is even though most of its net worth in absolute terms comes from the value of its foreign bonds, which form the majority of its asset-holding.

So we can see where the profit comes from. Like all central banks in normal times, RBI does not pay interest to the commercial banks for their deposits (which represent their cash reserve requirement or CRR). And cash, currency in circulation, is basically a zero-coupon, perpetual bearer-bond; unlike other IOUs, cash does not yield an interest payment to the bearer.

RBI’s liabilities are interest-free whereas its assets are interest-yielding. This spread between interest-free liabilities and interest-bearing assets is the source of the RBI’s income, which is tax-free by law. This is where seigniorage comes from. A portion of this cash income is credited to the government after deducting running expenses and various reserves.

Seigniorage is a very small share of the RBI’s net worth (about 6%) but a substantial share of its cash income, almost 100% at this juncture. Either way, seigniorage is always paid out of an actual income flow rather than notional valuation changes in net worth.

Recall that about 70% of the RBI’s liabilities are in the form of commercial bank deposits (16%) and currency notes (53%). The balance 30% on the liability-side comprises an item called “Other Liabilities and Provisions" which is basically a balancing entry representing the spread, the difference between the RBI’s assets and liabilities. Seigniorage transfers to the government are booked as a part of this balancing provision on the liabilities side even though their source is actual income flow.

By far the largest item in this provision is held under the heading of “Currency and Gold Revaluation Account (CGRA)". This is where “unrealized gains/losses on valuation of foreign currency assets (FCA)" are parked.

This CGRA account, representing 30% of the net worth, is there for a good reason. Because RBI’s foreign-bond assets fluctuate with movements in the rupee, RBI could at any point be in the black or the red viz. its FCA holdings. When the rupee strengthens, RBI’s takes a loss on its FCA and its balance sheet shrinks, and vice-versa. This fluctuation in the balance sheet requires a buffer, which is the CGRA account.

The bottom line is that seigniorage is paid from income flow not liquidation of the balance sheet. The difference in assets and liabilities is kept as a buffer against rupee movements. This buffer is only a liquid resource for seigniorage if bonds are actually sold at a profit. The size of the buffer (the CGRA account) represents a policy choice on the part of the RBI in choosing how to deal with rupee fluctuations in the context of “borrowed reserves".

Now, where’s the bonanza? Assuming that it’s the relatively rich whose money would stand cancelled after the demonetization deadline, and further assuming that the government would spend the resulting bonanza on the relatively poor, the government’s monetary coup would amount to a expropriation of the rich in favour of the poor. Socialists should rejoice.

Yet this is a misreading of the situation based on a kind of literalism. Yes, currency is RBI’s liability (“I promise to pay the bearer the sum of..."), and in literal terms, a reduction in one’s liability is a gain. But cash is no ordinary asset, and the central bank’s no ordinary balance sheet.

We live in a world of “inside money" not fiat money. Money has value not because of sovereign fiat but because, through central banking and sovereign debt, it is a promise to pay a slice of (domestic or foreign) gross domestic product. The universalization of inside money means that the asset used as a final means of settlement is just some institution’s liability.

Thus in exchange, central bank money is just a promise to pay itself. In normal times, go to RBI and try and get it to discharge its “liability" to you, and you will just get another note in return. This is not normal liability. The normal rules don’t apply.

This circularity is also expressed in the fact that the central bank is where the government itself banks. So when RBI hands over seigniorage to the Central government, it shows up in the Central government’s bank account at the RBI itself. That is, it just moves from one line on the liabilities side to another. It remains the liability of the RBI until the government spends it.

Once seigniorage is spent, it will either take the form of someone’s income as a bank deposit or cash. Thus either the balance sheet of the banking system will expand, leading to more CRR deposits at the central bank, and over time, more cash will have to be printed. Either operation would again expand the liabilities side of the RBI. In other words, any contraction in the RBI’s liabilities might be reversed once the extra seigniorage gets spent. What looks like a one-time bonanza could just be a temporary fluctuation on the central bank’s balance sheet.

Further, the literalism of this account treats

all items on the central bank’s liability-side as

if they were qualitatively the same thing. It is

as if currency in circulation is the same thing

as having a checking account with the RBI.

Both appear as line-items on the liabilities side after all!

Yet patently, physical cash is not the same thing as a checking account with a central bank.

Recall that seigniorage is paid out of actual cash income from interest payments. In the past few years, virtually all RBI’s interest income (mainly domestic since the crisis) has been paid out in seigniorage. The “cancellation" of some currency notes would increase the net worth of the RBI but not its cash income that comes from interest payments and out of which seigniorage is paid. This bump in net worth would allow it to book more to the balancing provision in the CGRA account or indeed to the government’s own deposit account with the RBI. However, there is a difference in the source of this extra seigniorage.

Cancelled currency is not cash income in the same way that interest on bond is income: the latter is actual cash flow. So in the “bonanza" scenario, the extra would not be paid out of any extra cash flow but out of a change in the value of the stock of liabilities. This amounts to the creation of new high-powered money or, in layman’s terms, “printing money".

Switching currency notes for increased credit to the Central government might seem like a swap of like for like on the liabilities-side, but it emphatically is not. Although they technically both form part of base money or “reserve money" in RBI parlance, these two kinds of liability are qualitatively different in terms of the money multiplier.

There are serious monetary effects when one plays with the government’s checking account at RBI. It is for this very reason that RBI credit to the government, known as “Ways and Means Advances," is subject to strict limits.

Treating “currency" and “a checking account at the RBI" as qualitatively the same thing is a conceptual error. The cancellation of the former and replacement by the latter is not an exchange of like-for-like. The apparent bonanza from the cancellation of some portion of demonetized notes appears to be fictitious.

Anush Kapadia is assistant professor in the department of humanities and social sciences at the Indian Institute of Technology, Bombay.

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