Bank of last resort

The RBI’s transfer of a huge surplus to the Union government does not augur well for it from an institutional standpoint and in the context of management of the economy.

At the RBI headquarters in Mumbai.

When a central bank engages in an act of legerdemain in order to satisfy an incumbent government’s demands, it can only herald more trouble for a beleaguered economy.

On August 26, the Reserve Bank of India (RBI) announced that it would be transferring a “surplus” of Rs.1.76 lakh crore to the Union Government for the year 2018-19 (the RBI follows a July-June accounting calendar). To put the magnitude of the transfer in context: this amount is 32 per cent higher than the combined amount transferred by the RBI in the preceding three years. Or, to put it another way, it is 252 per cent more than what the central bank transferred to its owner for 2017-18.

How was this huge transfer made possible? The answer to that is disturbing, both from an institutional standpoint and in the context of the management of the economy.

The circumstances in which the previous RBI Governor, Urjit Patel, departed last year was a key turning point that made this transfer possible. One of the key issues on which the government and Patel (“Hand in the till”, January 4, 2019) bitterly disagreed pertained to the extent of the government’s “rights” over the RBI’s reserves. In effect, the Narendra Modi government had demanded a larger transfer from the RBI, while the then Governor disagreed, pointing out that the reserves were of strategic importance not only for the stability of the banking sector but for the overall economy as well.

Soon after Patel’s exit, a truce of sorts was arrived at, which resulted in the appointment of a committee headed by former Governor Bimal Jalan that was to decide on the nature and extent of the central bank’s capital.

The acceptance of the committee’s report by the RBI led to the announcement on August 26 that paved the way for the transfer of the bounty to the government. The RBI paid the government Rs.1.23 lakh crore as dividend (inclusive of Rs.28,000 crore paid as interim dividend in March 2019) and Rs.52,637 crore as a one-time transfer from its capital account (Chart 1). But the fine print on how the RBI actually enabled the transfer was not known until the release of the RBI’s annual report for 2018-19 on August 29. That is revealing for a number of critical reasons.

Liquidity splurge

Since the RBI, for accounting purposes, is treated just like any other commercial firm, it too has two components to its balance sheet—the extent of its capital, especially its reserves, and the profits, which, like any other commercial entity, are distributed to its sole owner, the Government of India, by way of dividend.

First, the extraordinary profits that the central bank made last year: where did they come from? In 2018-19, the RBI’s income from the issue of domestic bonds and securities was Rs.9.99 lakh crore compared with Rs.6.30 lakh crore in the previous year. This increase of 57 per cent generated incomes for the RBI because it earns income, by way of interest, on the securities it issues.

The massive injection of liquidity into the system last year, ostensibly to wade through a deep and prolonged liquidity crisis following the collapse of Infrastructure Leasing & Financial Services Ltd (IL&FS), has revealed a new way in which a central bank can finance a government deficit. Meanwhile, there is no indication that the massive injection had any effect on the economy. If the injection of liquidity has only managed to provide a cover for a build-up of non-performing assets, there may be even more trouble in store for the Indian banking sector.

Indeed, as the IL&FS collapse started to unravel, dragging down the entire non-banking financial company sector with it, there is evidence that the malaise has spread even further. In effect, the mountain of liquidity that the RBI facilitated for 2018-19 may have had the effect of papering over a bubble that may burst sooner than later.

But even more important from a systemic point of view, especially in a situation in which there is a government-RBI continuum, without the figment of autonomy for the central bank, this raises serious questions about prudence in finance. The precedent of last year (2018-19) makes it possible for the government to use the central bank as a revenue-generating option. If last year was any indication, all that a revenue-stressed government needs to do is lean on a pliable RBI to issue more securities, secure in the knowledge that what the RBI earns by way of interest belongs to it.

Thus, what the dividend transfer implies is a deep erosion of the professional autonomy of the central bank, which requires an arm’s-length distance between the government and the RBI. This is not to suggest that a central bank ought to be completely autonomous and even be ready to work at cross purposes with a government. This distance is necessary in order to maintain an elaborate system of checks and balances to ensure that neither the government nor the central bank deviates from certain basic rules of conduct.

The surge in dividends in 2018-19 indicates a potentially serious conflict of interest situation in which the government has control of not just the policy tap but the finance tap too. This can have potentially damaging consequences for the economy at large, not just in terms of rules governing finance but the manner in which policy is administered.

Another means of highlighting the impact of the liquidity splurge is to compare it with the expansion of the RBI’s balance sheet in 2018-19. While the RBI’s balance sheet expanded from Rs.36.18 lakh crore in 2017-18 to Rs.41.03 lakh crore in 2018-19, the investments in government securities, which figure on the “assets” side of the RBI’s balance sheets, increased by Rs.3.60 lakh crore. This means that the issue of securities accounted for almost 75 per cent of the expansion of the central bank’s balance sheet in 2018-19. Surely, maintaining this pace of expansion would mean either a total abandonment of any pretence of a monetary policy regime or a drying up of this avenue as a source of recurring flow of funds into the coffers of the Union government.

Currency in circulation

The annual report showed that the currency in circulation increased by Rs.3 lakh crore between March 2017-18 and 2018-19, an increase of 5.50 per cent. This is important because the notes it prints are a straight profit for the RBI, barring the 1 per cent or so it incurs as cost. After demonetisation in November 2016, even by March 2017 the value of currency in circulation had collapsed by 20 per cent over the value in 2016.

The value of the currency in circulation increased by more than 60 per cent between March 2017 and March 2019 (Chart 2).

More critically, the 2,000-rupee note is no longer in favour. The share of this denomination spiked to reach more than half the value of all currency in circulation in March 2017 as a result of the Modi government’s attempt to inflate quickly the currency in circulation. Once this was done, its share dropped to 37 per in March 2018; by March 2019 its share declined further to 31 per cent. In fact, between 2016-17 and 2018-19, the number of 2,000-rupee notes printed plummeted from 3.5 billion pieces to 47 million in 2018-19.

Meanwhile, the 500-rupee’s share in currency value increased from 22.5 per cent in 2016-17 to 51 per cent in 2018-19.

Controversy over reserves

Among the many privileges of a central bank is the one sparing it from the need to adhere to a capital adequacy norm; such norms are applicable to all other banks. The economic capital or reserves of a central bank arise from four realms of its operation. There is, of course, the RBI’s paid-up capital that has stood at Rs.5 crore since its inception. The second component is the Asset Development Fund, which the RBI uses for investing in various subsidiaries. The Contingency Fund and the Revaluation Reserves are the two other more important components of the RBI’s reserves, which have a bearing on the safety and stability of the Indian monetary and economic system.

Not surprisingly, given that this where the bulk of the RBI’s money is, this is also the area in which the controversy has been focussed. The Modi government and its acolytes have argued that the RBI’s reserves are too big for its balance sheet and that the “excess” reserves could be put to better use by the government. Former Chief Economic Adviser Arvind Subramanian was the most articulate proponent of this view.

The Contingency Fund, the less complicated aspect of the reserves, is supposed to act as an emergency fund in the event of severe financial turmoil. In 2017-18, this fund was 6.8 per cent of the RBI’s balance sheet.

The RBI leadership was quick to opt for the lower end of a new band recommended by the Jalan Committee—between 6.5 and 5.5 per cent of its balance sheet—as the benchmark. This is in marked contrast to the levels prescribed by earlier committees—12 per cent of profits in 1997 and 18 per cent of profits in 2004.

Although the Jalan Committee’s prescriptive band now relates it to a fraction of assets, rather than a proportion of profits earlier, this does not appear to be objectionable if the purpose of the reserve is to ensure stability of the financial system.

However, critics of the government have argued that this portion of the reserves is not a prudent option, especially in the context of rising volatility in international markets. The global average for central reserves is about 6.5 per cent of the balance sheet, while in emerging market economies the average is 6.8.

These critics, even those who do not otherwise disagree with the Jalan Committee, argue that reducing the reserves from 6.8 per cent to 5.5 per cent in the current context of global volatility is imprudent. They point to the fact that the committee only prescribed a band; if anything, the reserves ought to have been closer to the higher end of the prescribed band.

The other component of the RBI’s capital has undergone significant revision, which has resulted in gains to the government. It is important to recognise that these reserves are a result of the RBI’s efforts of the past, arising from surpluses and investments made many years ago. The RBI has made changes to its accounting methodology by which it values its Revaluation Reserves, which has resulted in fortuitous gains for the Modi regime.

Change in methodology

Earlier, the value of these reserves—mainly foreign exchange and gold—was made on the basis of the notional “gains” arising from valuation of bullion and currency in the week preceding the sale/purchase.

This is by far the most important component of the RBI’s assets, accounting for more than three-fourths of all its assets. At the end of June 2019, the RBI held Rs.27.79 lakh crore in assets in the form of currency and gold.

The change in accounting methodology that the RBI adopted in 2018-19 allows it to value its assets in terms of the weighted average holding cost.

Thus, when the RBI sells currency from its reserves, it books a profit based on the historical weighted average holding cost. Moreover, the earlier methodology allowed the RBI to only move this notional profit to its reserve, not book a profit on the actual gain.

The new methodology certainly brings the RBI up to date with a better methodology for valuation, but it can create moral hazards for the central bank, especially when it is seen as being vulnerable to pressure from its political masters.

It is important to appreciate that these reserves have been built over decades, years in which the central bank invested in rupee and gold. Given that a portion of these assets were purchased many years ago, at a time when the dollar or other foreign currencies were much lower in terms of their exchange value to the rupee, any sale of foreign exchange or gold now would have the effect of boosting the value of perceived profit.

Although the RBI’s annual report mentions that the change in methodology has resulted in a gain of Rs.21,464 crore, it is remarkable that this significant accounting change—that has a direct bearing on the valuation of the most important component among its assets—is not addressed in any detail in the rest of the report. However, experts such as Ananth Narayan, professor at the A.P. Jain Institute of Management and Research, have argued that although no one can quarrel about the change in methodology, there is the possibility that the changes, meant to correct a historical accounting anomaly, may result in “the accumulated quantum of money that can be unlocked [being] very, very large”.

Given the scant information on the RBI’s methodology, Ananth Narayan, using a cruder method—underpinned by some assumptions—estimates that the RBI made a profit of Rs.53,200 crore in 2018-19 through the net sale of assets. But more important than the actual magnitude is the moral hazards arising from the temptation to book profits. Imagine this not very inconceivable situation: the rupee depreciates further, and to defend the currency the RBI sells rupees from its reserves, booking profits in the process. There is now a situation when a government might actually have a vested interest in driving the rupee down, as a means of raising revenue through the RBI’s coffers.

With government revenues, especially from goods and services tax, slowing down, the Modi regime is staring at a tax deficit that may be difficult to bridge even with this largesse from the central bank. With fiscal hawks in command and reform-mongers in control, any meaningful economic stimulus appears unrealistic. After all, a friendly banker can only do so much.