Markets have turned a tad Shakespearean about the eventual outcome of the Bimal Jalan-led committee on the RBI’s excess reserves — to be, or not to be, that is the question. Is it to be that the committee will award a fiscal bonanza to the government? Or will the committee advocate no actual transfer to government coffers, and instead ask for the excess funds to retire public debt on the RBI’s balance sheet? Or will it radically declare that there are no excess reserves to discuss whatsoever?
Inextricably linked to this has been inevitable alarm over whether central bank autonomy is at stake. According to those in favour of defending the RBI’s reserves, the government’s excessive reliance on them for bridging short-term fiscal slippage may prove to be myopic. After all, the reserves provide insurance for the RBI against shocks such as rupee appreciation, a drop in the value of bonds or the need to undertake sterilisation. Given India’s overall fiscal fragility, it may be a tall task for the government to replenish the RBI’s capital base under an economic emergency. Others believe the RBI is being overly cautious and holds excess capital that can be put to better use.
But how much is too much excess capital reserve for the RBI? The answer isn’t simple — with little consensus on how to define either “excess” or “capital”. The size of the RBI’s balance sheet is Rs 36 trillion, of which 27 per cent (Rs 9.7 trn) can be broadly classified as capital reservess. The controversial bit is that over 70 per cent, Rs 7 trn, comprises revaluation reserves, which track changes in the RBI’s foreign currency and domestic assets. Some opine that these are temporary and an accounting phenomenon, and excluding them would bring down the available “core” capital available to as low as 7 per cent of the balance sheet (Rs 2.3-2.6 trn).
What qualifies as “excess” depends crucially not just on the chosen definition of capital, but also the choice of stress-testing methodology. Typically, the extent of excess is judged on the ability of the central bank’s balance sheet to withstand shocks to its portfolio (estimating value-at-risk). Here again, there are differences in opinion, with estimates of the RBI’s excess capital ranging from it being under-capitalised to the RBI holding excesses as high as Rs 4.5 trn. To place this in context, the latter would be enough to nearly wipe clean the central government’s annual revenue deficit.
The Jalan-committee ruling will have inevitable macro implications. If excess reserves are indeed identified — which some sources place as high as Rs 3 trn — then a direct transfer to the government will amount to a fiscal windfall, which will eventually lead to the creation of reserve money in the system. This will be positive for growth, and over time could exert inflationary pressures if not offset by pruning the RBI’s domestic assets. With liquidity in the banking system increasing, this would alleviate, to some extent, the impetus on the RBI to inject liquidity through open market operation buybacks. The level of government debt stock would remain unchanged.
The delay in arriving at the committee’s consensus makes it increasingly unlikely that the final budget for FY20 on July 5 will include some fiscal support from the RBI. As a result, the government may struggle to hold the fort at a fiscal deficit of 3.4 per cent of GDP, as it faces strong headwinds from poor actualisation of tax revenues in FY19 and the incremental pressures from tackling a cyclical domestic slowdown and rural reflation.
If the committee rules that these reserves are meant to to retire government debt off the RBI balance sheet, then it will not lead to reserve money creation, or any near-term impact on the fiscal deficit, growth and inflation. However, as India’s medium-term fiscal consolidation target is to bring the public debt ratio down to 60 per cent of GDP, a hypothetical transfer of Rs 3 trn could reduce it by 1.4 per cent of GDP. The government may choose to use this space to accelerate its fiscal consolidation in coming years, or alternatively use it to increase the fiscal deficit without adding significantly to overall debt. The committee may also suggest ploughing the excess capital into public sector banks to recapitalise them and bolster their lending capacities.
These conversations are part of a broader discourse in which the RBI is becoming increasingly more sensitive to growth concerns. Part of it is algebraic — a flexible inflation targeting framework applied to a poor growth and low inflation paradigm is a recipe for policy easing. We’ve seen 75 bps of rate cuts this year, and we believe there’s appetite for more. More implicitly, it has led to a conversation about RBI’s broader responsibility towards growth. The traditional model of the government fiscally resuscitating growth and the RBI standing by to prevent an overheating of the economy has been turned on its head. Instead, questions are being raised on higher real rates, the RBI’s regulatory responsibilities, pros and cons of pro-cyclical bank rehabilitation, and if the RBI’s capital reserves can be deployed elsewhere more productively.
These are not unwelcome conversations. They suggest the RBI’s subtle shift from being the aloof gatekeeper to an active participant in the growth story. However, in this subtle realignment of priorities, it is of paramount importance that the RBI’s autonomy is preserved so that it can do its core job of controlling inflation and maintaining financial stability. After all, it’s not worth distracting the gatekeeper to the extent that the gate is left unguarded.
Varma and Nandi are chief economist (India and Asia ex-Japan) and India economist, respectively, for Nomura