Philosopher John Anderson once suggested that for a public institution, instead of asking “what end or purpose does it serve?”, we should ask, “of what conflicts is it the scene?”
Due to its expansive role, the Reserve Bank of India (RBI) is a site of many conflicts.
A conflict that has recently come to the fore is about the RBI’s surplus income. The main source of this income is the sovereign power to issue currency. The RBI purchases securities with currency, and after accounting for the cost of producing and distributing currency, this generates a huge surplus. Before giving dividend to the government, the RBI sets aside money for operational expenditure and for reserves to cover losses in the future.
On 30 June 2018, the capital and reserves totalled about Rs 10 lakh crore – about 28 per cent of the assets. The Narendra Modi government claims that this is excessive. The RBI disagrees. The resolution is that the RBI has agreed to transfer Rs 1.76 lakh crore to the government – Rs 1.23 lakh crore is surplus for the year 2018-19 and Rs 52,637 crore is excess reserves. This is based on the recommendations of a committee chaired by former RBI governor Bimal Jalan.
This issue had also come up in 2012-13. A committee was set up and the outcome was to transfer the entire surplus to the government for three years – 2013-14 to 2015-16. That was also a tough time for the government’s finances, just like now. This explains the current government’s incentive to pick a fight. However, it does not mean that the government’s arguments are wrong.
Are the reserves excessive?
Internationally, there is no consensus on central bank reserves. Some central banks, such as the RBI, hold large reserves. In some countries (like Israel, Chile, Thailand), they even run with negative capital. Most others are in between. Commercial banks require capital to create faith in their soundness so that there are no runs on them. Central banks do not face such threats. For the RBI, maintaining reserves to ensure a good rating also does not make sense. A central bank’s credit rating is not distinct from that of the country.
The RBI may need to maintain reserves for operational independence, so that it does not have to frequently ask the government for resources. This leads to a question about the optimal level of reserves.
From the total reserves, about 70 per cent (Rs 6.92 lakh crore approximately) are in the Currency and Gold Revaluation Account (CGRA). This account mainly covers revaluation losses on foreign currency securities. The main risk with these securities is that of rupee appreciation. The RBI books profits and losses in rupees. When rupee appreciates, foreign currency assets become less valuable in rupee terms, leading to losses for the RBI. The RBI makes profits when the rupee depreciates.
Structurally, there is a depreciatory pressure on the rupee because inflation in India tends to be higher than the countries issuing the benchmark currencies. Over time, higher inflation puts downward pressure on demand for Indian goods, and thereby the demand for the rupee. This puts a persistent pressure towards depreciation.
In the last 25 years, the maximum appreciation was about 18 per cent (between August 2006 and January 2008). The RBI reserves are sufficient to absorb about 36 per cent appreciation – that is, rupee going to about 53 per dollar. The RBI is keeping reserves for an extremely low probability event.
Interest rate risk – increase in interest rates leading to valuation loss – is small because the RBI is supposed to hold mostly short-dated securities (the purpose is to provide liquidity).
Then there is credit risk – the risk of default. Since the RBI mostly holds government securities, there is no need to hold reserves for this. Repo lending is also against risk-free securities.
Theoretically, the RBI also has a Lender of Last Resort (LOLR) function in the RBI Act, under which it may give liquidity support to the financial system. Even though LOLR is not recapitalisation, it is a risky function. Still, at the maximum, it can only justify a small portion of the RBI’s reserves.
Even if, say, someday, losses erode the RBI’s reserves, the government will recapitalise it. Paying for losses is ultimately a fiscal issue. Even with much lower reserves, this will happen rarely enough to not erode the RBI’s operational independence.
A political issue or a technical one?
The issue seems complex and technical because it involves risk management models that are the domain of finance experts. When this issue comes up for discussion, the civil servants who represent the government on the RBI board are likely to leave it to the experts. Perhaps this is why the reserves were built without adequate scrutiny.
However, underlying the models are common-sensical principles about the rationale for reserves, and optimal level of reserves.
The need for technical input does not make this decision apolitical. Instead of looking at the RBI in an isolated manner, the framework should be based on a comprehensive view of what is good for the country over a period of time. Developing this framework is a political decision with technical inputs, and not the other way around.
This is also political because central banks, like other public agencies, have an incentive to “build an empire”, sometimes even at the cost of public interest. This is why, in other countries, the framework is usually given in the law or is in an agreement between the central bank and the government. The decision about central bank surplus cannot be left only to the central bankers.
RBI got off lightly
The Jalan committee seems to have given the RBI the benefit of doubt. It seems to have largely accepted the RBI’s approach. Most importantly, it has left the CGRA untouched, based on a specious argument about it being “not distributable”. On the other reserves, the committee has said that the RBI needs to build them for a ‘rainy day’. However, when such days come, it is the government that does the heavy lifting. The committee has also accepted a more conservative approach (in terms of confidence level) in determining these reserves than is common in other countries.
For now, the outcome is that only about 5 per cent of the reserves is being transferred out. This can be seen as yet another instance of a technical body getting the better of a ministry. But it is still something.
A sustainable solution would involve including the framework for surplus and reserves in the RBI Act or in a formal agreement between the government and the RBI, along the lines of the UK. The framework should ensure optimal utilisation of surplus income – for building reserves and for fiscal purposes. Otherwise, another committee will be set up 6-7 years from now. It is good that the issue has gained salience.
Conflicts are painful but they can be useful. Alasdair Macintyre called Anderson’s insight a “Sophoclean one”, noting that it is through conflict that “we learn what our ends and purposes are”. One may hope that the RBI, at the centre of multiple storms for the better part of the last decade (raging inflation between 2008 and 2014, banking crisis, NBFC crisis, conflict on reserves, run-ins with the government, etc.), is gradually getting a better sense of what its purposes are. Here’s hoping more useful conflicts are instigated in the times to come.
The author is a Fellow at Carnegie India. Views are personal.