Economic Affairs Secretary Subhash Garg said last week that the Centre was in talks with the Reserve Bank of India over the transfer of surplus from the earnings of the central bank. The surplus sum transferred from earnings during 2016-17 was Rs 30,659 crore, less than half of the Rs 65,876 crore transferred the previous year. Clearly, the government was expecting more — akin to a dividend payment from the RBI.
Part of the reason for the smaller surplus was the RBI’s setting aside Rs 13,140 crore for its Contingency Fund (CF), a provision that was not made last year. The RBI says the CF is meant for unforeseen contingencies — it is basically a buffer against valuation losses on bond holdings or foreign exchange assets in the event of a rise in interest rates or appreciation of the rupee. The Fund would also be helpful in a “black swan” event — such as the collapse of Lehman Brothers or of local banks that may threaten financial stability.
Over the last two decades, RBI has, in fact, built up the CF and other buffers such as an Asset Development Reserve. But its logic for making such provisions has not found takers at North Block. For three years — 2013-14, 2014-15 and 2015-16 — RBI transferred 99.99% of its surplus to the government, a massive jump from 37.20% in 2011-12 and 53.40% in 2012-13. The higher payouts were in line with the recommendations of a committee headed by Y H Malegam, a well-known chartered accountant who was on the central bank’s board. The payout from its earnings peaked at Rs 65,876 crore for 2015-16 (which accrued to the Centre in the following fiscal).
The question is, what level of reserves — call it buffer, contingency or anything else — should a central bank keep to tide over extreme financial disruptions? The government’s view has been that compared to many other central banks in the world, the RBI has been earmarking amounts far in excess of what is needed to maintain its credit-worthiness. The government’s argument is that at 26.5% of total assets — the RBI’s CF is the second largest in the world after Norway — is way higher than the median of 10%. For many central banks, in fact, this figure is just 2% or 3%, and RBI’s reserves buffer is at least Rs 3 lakh crore more than what is reasonable, goes the government’s argument. Also, the government argues that as the owner of the Indian central bank, the sovereign would infuse more capital (or recapitalise) if at all the RBI’s balance sheet were to be impacted.
An assessment of the adequate level of reserves could be subjective — from the perspective of both the Ministry of Finance and of the RBI. This is because of the differing ways in which the government and the RBI perceive and acknowledge the risks that a central bank faces or anticipates.
The RBI bases its assessment on an economic model — a risk management framework, which it has adopted to calculate the level of reserves that need to be maintained. In his recently released book, I Do What I Do, former RBI Governor Raghuram Rajan has said that based on the results of a sophisticated risk analysis by RBI staff, the board of the central bank had decided over the last three years that the an equity position (including reserves) of around Rs 10 lakh crore was adequate.
The government, on the other hand, reckons there is nothing special about the composition of the RBI’s assets, and the risk to the Indian central bank is significantly less compared to its peers. It does seem like the Ministry may be working on a benchmark to compare the RBI and other central banks. Chief Economic Advisor Arvind Subramanian has in the past made out a case for utilising the RBI’s reserves to provide capital to state-owned banks. Rajan has, however, argued against the transfer of a special dividend to the government over and above the surplus — it just amounts to putting back into the system the money the RBI made from it, he has said.
“So if the RBI were to pay a special dividend to the government, it would have to create additional permanent reserves or print more money. And to accommodate any special dividend, the RBI will have to withdraw an equivalent amount of money from the public by selling government bonds in its portfolio,” Rajan has written in his book.
In his book Advice & Dissent: My Life in Public Service, former RBI Governor Y V Reddy narrated his interaction with Jaswant Singh, the Finance Minister in 2003-04, on the cost of adding to India’s foreign exchange reserves.
This cost is basically when more foreign funds flow in, and the RBI mops it up. As foreign capital comes in, the central bank buys dollars and releases rupees which fuels liquidity, and could stoke inflation. To lower that impact and reduce liquidity, the central bank sells government bonds from its portfolio, or issues what are called “market stabilisation” bills or bonds, whose interest burden is borne by the government.
The issue was who would bear the cost. If the government did, it would add to its borrowings. If the RBI did it, its balance sheet would turn from surplus to deficit.
“We can have both the RBI’s and government’s balance sheets showing deficit, or only the government’s which is already in the red. It is good to make a central bank balance sheet a healthy one. It can serve the government better,” Reddy told Jaswant Singh. The Minister responded by saying, “I will do nothing in any way that undermines our central bank. I want our central bank to be strong. It should command respect. We will approve your proposal.”
The RBI’s approach on bolstering its reserves may be guided by a desire to ensure, to the extent possible, that it does not have to approach the government — its owner — for capital at any time. Strengthening its balance sheet in preparation for a black swan event could be its way of protecting its independence from the government. It will be interesting now to see how the arguments progress, and which view prevails finally. With the accounts for the year having been finalised and adopted, it would be extraordinary if the central bank approves a payout over and above the surplus.