Among the points of dispute in the latest stand-off between the government and the Reserve Bank of India is the issue of the latter’s balance sheet.
For those willing to get into the weeds of an esoteric topic like central bank balance sheets, here are a couple of questions to ponder on:
- Does the RBI hold excessive capital on its balance sheet?
- Should it pay a part of its capital out to the government, to help the fiscal balance?
There are strong arguments to suggest that, on the face of it, there is indeed an excess of gross capital and reserves on the RBI balance sheet. But that doesn’t mean the RBI should pay an extra dividend to the government now.
One reason is that the RBI also lends funds to the government, in the form of government bonds held by the RBI. As the RBI conducts more open market operations and buys more government bonds to infuse rupee liquidity, this lending to the government will increase even further.
As such, the net capital – after adjusting for the money already lent to the government – does not appear to be excessive.
In this context, a standalone one-time payment of dividend from existing reserves and surpluses by the RBI is not advisable. It would be akin to printing money to fund the government’s deficit.
If given, any one-time dividend should be used entirely by the government to buy back its bonds that are held by RBI. That would lower the total outstanding debt of the government and improve its optical debt position, but not yield any net fiscal bonanza for this year.
To understand the issue further, let’s look at the basic balance sheet of RBI, its income streams and understand why some worry that the RBI may not be adequately capitalised.
The RBI Balance Sheet
Let’s start with the RBI’s balance sheet as of June 2018, simplified and summarised below.
The assets of the RBI include foreign currency assets (our country’s currency reserves), gold, rupee investments (government of India bonds and bills) and other assets.
On the other side, RBI has capital and reserves, rupee deposits (including banking cash reserve ratio or CRR balances, money absorbed by RBI via reverse repos, government balances etc.), and currency in circulation.
RBI’s Regular Income Or ‘Seigniorage’
Without having any commercial intent, RBI has an enviable model of regular income. It takes cheap money from the government, banks and especially us (every currency note we carry is a zero-interest loan to the RBI) and deploys it largely in interest-bearing foreign currency and rupee assets. As a result, for the fiscal year July 2017 – June 2018, RBI earned a net interest of Rs 73,871 crore.
After accounting for expenses and provisions, RBI transfers this income to the government as dividend. One of the provisions is to the Contingency Fund, which is in the nature of retained earnings.
Revaluation Gains And Losses
Besides interest income, the foreign currency assets and rupee bonds that RBI holds are subject to revaluation gains and losses. As the rupee depreciates over time, the rupee equivalent of foreign currency assets increases.
Such gains from revaluation do not pass through RBI’s income statement – they are taken directly to the balance sheet under revaluation reserves.
As of June 2018, the cumulative currency and gold revaluation reserves alone was a whopping Rs 6.9 lakh crore (see table above), which includes Rs 1.6 lakh crore added in this fiscal year. Clearly, the rupee has depreciated significantly in relation to RBI’s effective acquisition cost of foreign currency.
Likewise, the foreign currency and rupee bonds and derivative contracts held by the RBI could show mark-to-market gains or losses, through the year.
While gross revaluation gains are kept aside as revaluation reserves, cumulative losses from revaluation of assets and derivatives are directly reduced from the Contingency Fund. RBI’s holding of foreign currency bonds, for instance, had a cumulative mark-to-market loss of Rs 16,874 crore as of June 2018, which was deducted from contingency funds.
Adequacy Of RBI Balance Sheet Buffers
Commentators who believe RBI buffers are not adequate, typically only consider the extent of Contingency Fund (marked ‘A’ in the table above). At 7 percent of the balance sheet, they reckon, the number is small in relation to RBI’s broad target of maintaining a contingency fund of 8-12 percent of the balance sheet.
On the other hand, the overall buffers of the RBI should include existing revaluation reserves as well. In fact, Contingency Funds exist to provide for contingencies, including fluctuations in the value of assets. Asset valuations are already buffered to the extent of existing revaluation reserves. By this token (see ‘B’ in the table above), RBI has buffers to the tune of 27 percent of the balance sheet. As the Economic Survey of FY16 had pointed out, this level of buffers was second only to Norway among major nations.
It’s interesting to understand how the 12 percent standalone target for Contingency Funds was arrived at.
- The Subrahmanyam Committee (1997) had suggested this number, at a time when the revaluation reserves were at 5 percent of the balance sheet and so total reserves were effectively targeted at 17 percent of balance sheet.
- The Usha Thorat Committee (2004) actually called for an 18 percent buffer of total reserves, across Contingency Funds and Revaluation Reserves. Yet, the RBI continued to look at the Contingency Fund target of 12 percent on a standalone basis.
- The Malegam committee (2013) suggested that Contingency Funds need to be enhanced, but left the quantum to RBI management to decide.
Probably in light of the high overall reserves, RBI, in the Raghuram Rajan era, did not increase the quantum of Contingency Funds and paid out the entire income to the government as dividend.
However, over the last two years, the RBI added Rs 13,190 crore and Rs 14,190 crore respectively to the contingency fund, reducing the payout to the government to that extent. To me, this does seem unnecessary.
One-Time Transfer To Government?
In light of the above, does a one-time transfer of RBI reserves – particularly a portion of the Contingency Funds that are in the nature of retained earnings – make sense?
This is where one has to consider what the RBI has done with the funds. If we consider (C) in the table, RBI already held Rs 6.29 lakh crore of government bonds and bills on its books through its open market operation purchases, as of June 2018. Effectively, even if dividend has been withheld over the years, the RBI had already separately lent this money to the government. Since then, as the RBI conducts further OMO purchases, this number (C) continues to increase.
It makes sense, therefore, to reduce this number from the capital of RBI.
The net effective capital of Rs 3.4 lakh crore (Rs 9.69 lakh crore less Rs 6.29 lakh crore) is 11 percent of the netted balance sheet of Rs 29.87 lakh crore (Rs 36.17 lakh crore less Rs 6.29 lakh crore).
At 11 percent, the effective capital does not look like an overly large number – justifying a standalone payout from this to the government would be difficult. All this does not even consider the fact that any fresh payout now would simply look like monetisation of the fiscal deficit.
Central bank balance sheets can be difficult to grasp and are the subject of much debate. This note makes the case that gross capital is large on RBI’s balance sheet (and further additions to the capital by way of retained earnings do not look necessary) but given the large government debt on the RBI’s books, it is difficult to justify any one-time standalone transfer to the government now.
The broader point remains that given the sensitive nature of this topic, with implications on India’s financial credibility, no hasty decision should be taken.
Ananth Narayan is Associate Professor-Finance at SPJIMR. He was previously Standard Chartered Bank’s Regional Head of Financial Markets for ASEAN and South Asia.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
(This story was originally published on BloombergQuint.)
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