Soon, the contentious issue of the Reserve Bank of India’s surplus reserves’ will be back on the discussion boards with the Bimal Jalan panel gearing up to submit its recommendations. The dispute that erupted last year between the RBI and the Ministry of Finance morphed into a clash of personalities rather than institutions and shifted focus to short-term economic issues rather than long-term structural changes. The Jalan panel attempts to draw clear blue waters on the fractious issue once and for all.
It all started with the government — perhaps acting from a position of strength — seeking a transfer of excess capital and even contemplating invoking Section 7 of the RBI Act, 1934 for the first time. Critics decried the move as unashamedly political both in tone and content. Then RBI Governor Urjit Patel, who carried the can for the NDA government during demonetisation, at first appeared adamant, indicating via his deputies that central banks don’t have coffers a la Uncle Scrooge, that raiding RBI’s balance sheet was harmful, and asset-stripping (polishing off surplus cash) will stoke financial trouble. However, in the end, instead of settling differences via discussion or debate to ensure policy continuity and, importantly, to avoid a colossal credibility crisis, Patel chose defeat, albeit a personal one, by calling it quits.
The government argued that RBI was conservative in assessing capital buffers, but the latter insisted on holding adequate reserves to absorb risks and uphold operational independence and autonomy. In fact, RBI’s think-tank Centre for Advanced Financial Research and Learning found that the central bank was marginally under-capitalized (net of revaluation reserves) and that its operational losses could even force it to knock on the government doors for cash. After analyzing over 45 central bank balances sheets, it concluded that RBI should more than double its core capital from the current level of 6.6 per cent.
The other camp disagrees, insisting that central banks don’t need equity broadly as they can always print money, or operate even with negative equity (central banks are insulated from bankruptcy proceedings), or that the government can mount a rescue, injecting capital in times of crisis.
Bone of contention
As on June 2018, RBI’s total assets stood at Rs 36 lakh crore, while total reserves were at Rs 9.6 lakh crore. Reserves comprise the contingency fund (Rs 2.3 lakh crore), currency and gold revaluation fund (Rs 6.9 lakh crore), asset development fund, investment revaluation accounts for foreign and rupee securities. RBI’s assets are dominated by investments in rupee and foreign assets (90.2 per cent of assets) along with investments in gold.
At the heart of the tussle is overall reserves, accounting for 26 per cent of total assets, which appears highest among all central banks. At least three committees were set up in the past two decades to determine the ideal quantum of reserves. In 1997, an internal group led by V Subrahmanyam recommended contingency reserves be kept at 12 per cent of total assets, while the Usha Thorat Group in 2004, suggested total reserves at 18 per cent. In 2013, the Y H Malegam committee didn’t assign any number, but was decisive about currency and revaluation reserves, noting that any unrealised gains out of this fund shouldn’t be available for distribution as dividend. The 2016-17 Economic Survey set a global benchmark of median 16 per cent.
In 1998, RBI had adopted Subrahmanyam group’s recommendation to achieve contingency reserves at 12 per cent of total assets by 2005. Ironically, it never met the target. Barring four years, i.e., FY02, FY03, FY09 and FY10, when reserves stood at a kissing distance of 11.7, 11.7, 11.9 and 11.3 per cent respectively — missing the 12 per cent band by a whisker — for the rest of the 16 years, it was below and around 10 per cent. Currently, it stands at 7.05 per cent.
Worryingly, starting FY13, contingency reserves to total assets started heading south, perhaps following the Y H Malegam Committee recommendations, despite not adopting them. The committee didn’t put a fixed target band, but suggested adequate amount of profits to be transferred every year towards contingency reserves. Interestingly, for three years, ie., FY13, FY14, and FY15, under former Governor Raghuram Rajan, contingency reserves remained stagnant, as RBI transferred 100 per cent profits (excluding expenditure) to government.
Unhelpfully, there’s neither an international norm nor a one-size-fits-all benchmark for such appropriation, though some central banks provide for specified percentage. For instance, in France, it’s 5 per cent of net profits, while Russia and Indonesia apportion 25 and 30 per cent respectively. A cross-country comparison shows that developed countries hold lower core capital, but that cannot be the benchmark as they are less prone to economic volatility than emerging economies and have higher sovereign credit ratings.
Moreover, experts contend that revaluation reserves are merely a number that central banks carry as an accounting entry to accommodate changes in the domestic currency value of foreign assets due to exchange rate and gold price movements. Put simply, that’s not actual cash. That boils down the task to deployable capital, or capital that can be put to immediate use in the event of an emergency, which is contingency reserves.
RBI’s think-tank study, led by Amartya Lahiri, noted that stipulating a level of capital could potentially compromise the central bank’s inflation, liquidity and credit targets. In anticipation of dividend payment demands, central banks could deviate from their preferred monetary policy to avoid the payout. A lower policy rate causes the value of central bank domestic assets to rise. Hence, it could try and prevent a rise in its capital levels above the stipulated threshold by not reducing policy rates by as much as they would have in the absence of such a mandated threshold. Also, since local currency depreciation raises central bank’s capital, it could try and avoid the resultant demand for payments to the fiscal authority by preventing currency depreciation compromising growth and external balance targets, and in turn its own operational independence.
Way forward
Should RBI make further provisions to the Contingency Fund and pass on the entire surplus to the government? Or should it reduce reserves to adjust for the excess provisions of past years? Reducing reserves implies commensurate reduction in the asset side (either through a reduction in RBI’s investment in sovereign debt or reduction in foreign currency assets) or a commensurate increase in notes issued without reducing balance sheet size or commensurate increase in government’s deposit without reducing balance sheet size, according to Bank of America-Merryil Lynch. Clarity is needed if this amounts to direct monetisation of fiscal deficit.
Liabilities
Reserve Bank’s Assets and Liabilities
Contingency Fund: Set aside for unexpected and unforeseen contingencies including depreciation in the value of securities, exchange rate risks, systemic risks, etc
Asset Development Fund: Represents a provision specifically made to make investments in subsidiaries and associate institutions and meet internal capex
CGRA: Unrealized gains or losses on valuation of foreign currency assets and gold are recorded in the currency and gold revaluation account (CGRA). Net balance in CGRA, therefore, varies with the size of the asset base, its valuation and movement in the exchange rate and price of gold. CGRA provides a buffer against exchange rate/gold price fluctuations. If CGRA is insufficient to meet exchange losses, it’s replenished from the contingency fund
Assets
Foreign investments: These include deposits with other central banks, deposits with the Bank of International Settlements, balances with foreign branches of commercial banks, investments in foreign treasury bills and securities, and special drawing rights