The Issue Department and the Currency Chest

In one line

The note issue is run in a separate department with its own assets, so that the currency is backed by something identifiable and the Bank's other business cannot touch it.

In the wording a student can write in an exam: by section 23 of the Reserve Bank of India Act, 1934 the issue of bank notes is conducted in an Issue Department kept wholly distinct from the Banking Department; by section 33 the assets of the Issue Department must at all times be not less than its liabilities and must consist of gold coin, gold bullion, foreign securities, rupee coin and rupee securities, with a minimum holding of gold and foreign securities that the section fixes; and sections 34 to 37 define the liabilities of the Department, provide for the currency chest arrangements and oblige the Bank to supply forms of currency.

Why the issue is kept separate

The separation is inherited from the Bank of England and it answers a real fear. A central bank that issues notes is also a bank that lends. If the two are mixed, the Bank can finance its lending by printing, and the note holder's claim competes with everybody else's.

Section 23 stops that by construction. The Issue Department is wholly distinct from the Banking Department, and the assets of the Issue Department are not subject to any liability other than the liabilities of that Department. Every note in circulation is matched by identified assets held for the note holders alone.

Whether the separation still means much is a fair question, and it is worth raising. Under the proportional reserve system that preceded it, the backing was a genuine constraint on how many notes could be issued. Under the minimum reserve system now in force, the constraint is nominal, because rupee securities count as assets and the Bank can acquire them. The Department survives as an accounting discipline and a discipline of transparency rather than as a limit on issue.

The assets and liabilities

Section 33(1): the rule. "The assets of the Issue Department shall consist of gold coin, gold bullion, foreign securities, rupee coin and rupee securities to such aggregate amount as is not less than the total of the liabilities of the Issue Department."

Section 33(2): the minimum. The aggregate value of the gold coin, gold bullion and foreign securities held as assets shall not at any time be less than the amount the section specifies, and of that a minimum value in gold coin and gold bullion must be held.

This is the minimum reserve system, and its history is examinable. Until 1956 India used a proportional reserve system, under which a fixed proportion, forty per cent, of the note issue had to be backed by gold and sterling securities. The proportion made expansion of the currency depend on the reserves, which was intolerable for a developing economy that needed a growing money supply. The Reserve Bank of India (Amendment) Act, 1956 replaced it with a minimum reserve system: a fixed minimum holding rather than a proportion, so that the note issue may expand without a corresponding increase in gold and foreign securities.