Conflicts on the Optimal Umbrella Size - the Issue of RBI Fund transfer

The six-member panel under former RBI Governor Jalan was appointed on December 26, 2018, to review the economic capital framework (ECF) for the RBI after the Finance Ministry asked the Central Bank to transfer more surplus to the government from its excess reserves (Livemint 2019). As per the estimates, the RBI has over Rs. 9 lakh crore of surplus capital with it (Livemint 2019). Besides surplus capital transfer, the government is expecting Rs. 90,000 crore dividend from the RBI in the current financial year as against Rs. 68,000 crore received in the previous year (Livemint 2019).

The finance ministry is of the view that the surplus of 28% of gross assets maintained by the RBI is well above 14% as per the global norms. The government thus believes that the RBI is being too conservative and is sitting over a huge pool which could be used by the government and will assist in reducing and constricting the fiscal deficit to 3.3% of GDP (reduced from 3.4% of the GDP set in February’s interim budget). In past, different committees were formed to decide the adequate size of the reserves. They suggested 12% contingency reserve (Subrahmanyam panel, 1997), 18% of total assets with 6% of contingency reserve (Thorat committee 2004), and the Malegam panel, 2013 did not prescribe any number but said that no excess build-up of the buffer is required. The RBI board, however, continued with the Subrahmanyam panel’s recommendations, but never really achieved the recommended target.

Figure 1. Percentage of Contingency Fund (CF) + Asset Development Fund (ADF) to total assets. Source: RBI

The balance sheet of the RBI has nearly trebled in size from FY 2009 to FY 2018 (Rajadhyaksha 2018), but upon scrutiny, as a share of GDP, the size of RBI balance sheet has remained stable. Therefore, although the contingency fund seems to have grown more than 50% from 2008-09 to 2017-18 to Rs. 2.32 trillion, the RBI’s contingency funds have barely grown over the past decade, while the revaluation funds have grown folds (Rajadhyaksha 2018).

Figure 2. Size of RBI reserves (Rs. Trillion) and its components – Revaluation Funds vs Contingency Fund Source: RBI annual reports

RBI maintains two types of reserves, first, the revaluation funds, which is a standard accounting practice and adjusts depending on the changes in the value of the foreign exchange, foreign currency contracts or government securities. Its components include Currency and Gold Revaluation Account (CGRA), Investment Revaluation Account (IRA) and Foreign Exchange Forward Contracts Valuation Account (FCVA). The revaluation accounts are necessary because the RBI’s foreign and domestic market assets are marked to market (MTM) and fluctuate in value with interest and exchange rates. Revaluation fund is created so the balance sheet matches when foreign exchange reserves are written in INR. Thus they are actually not reserves, but an account of unrealized gains/losses and are converted into income and profits only when the reserves are sold.

The second is contingency reserves which are needed to conduct its usual functions. It is actually the contingency reserve which bears the most weight during the financial emergencies. While the Contingency fund (CF) is for meeting losses in forex market and monetary policy operations, the Asset Development fund (ADF) is set aside for investment in subsidiaries and associates and internal capital expenditure.

Therefore, what appears to the Finance ministry as 28% of the assets (total reserves) actually consists of the CGRA accounting for 19.11% of total assets and the contingency fund accounting for 6.41%  in 2017-18 (Srinivasan 2019). Thus, two-thirds of the reserves in the RBI’s balance sheet are accounting entries while one-third is capital that can actually be deployed (Rajadhyaksha 2018).

The CF is the economy’s umbrella during the rainy days and is built through the annual surpluses in the profit and loss accounts after subtracting the government’s dividend. But in 2013-14, Raghuram Rajan decided to transfer the entire surplus to the Centre without disturbing the reserves, and this remained continued. Therefore, the CF has witnessed no rise, and so what seems to be 50% increment in the CF is simply a mathematical illusion owing to its small base.

Table 1. Amount (Rs. Crores) and as percentage - surplus given to centre. Source: RBI annual reports

The Economic Surveys of 2015-16 and 2016-17 along with the former Chief Economic Advisor A. Subramanian had highlighted the overcapitalization of RBI as compared to the US and UK central banks which had a capital-to-assets ratio below 2%. However, what it failed to notice is that such central banks are also the owners of international reserve currencies; do not hold too much foreign currency and need not worry a lot about the exchange rate risks, at least when compared to the rupee. The ECB’s foreign currency assets and revaluation reserves constitute about 16% and 8% respectively, while that of RBIs are 78% and 20% respectively. But before comparison could be made, they need to be brought to the same base. And so, had ECB’s foreign currency assets been 78%, its revaluation reserves would have been (78%/16%*8%) 39%, as against 20% of RBI’s. Similarly, when the capital to assets ratio of 27% of the RBI is compared using similar fashion to that of the Federal Reserve, Bank of England, Bank of Japan and Bank of Russia, it comes out as 10%, 18%, 43% and 28% respectively, which shows that in no ways RBI is overcapitalized (V.K.Sharma 2018).

According to a report by the Bank of America Merrill Lynch, halving of the contingency reserves to a would release 1.282 lakh crores and would bring the level down from 6.5% to 3.25%, which would still be 50% higher than central banks in BRCS. But again, what is required is to look from a broad perspective and at the entire economy. Every country has its own way of handling the issue of central bank’s capital, depending on its economic characteristics, and India should not try to imitate any. For example, amongst BRICS, only India is a large (and net) importer and thus is exposed to the swings in the sentiments in a much different way and to a different degree.

Table 2. Net Exports in BRICS (million USD). Source: CIA World Factbook

Although the diction of the committee would be a mere recommendation to the RBI board, and it would finally be the board who will take the final steps. But the actions to follow, depending on the directions they go, might significantly affect the credibility and raise questions of independence of the Reserve Bank of India. (Jose 2018)

References

Jose, Tojo. 2018. "RBI’s Capital Reserve –Components and Controversies." Indian Economy, November 26.

Livemint. 2019. "RBI capital transfer: Jalan panel likely to get extension to finalise report." Livemint, July 31.

Mishra, Asit Ranjan. 2019. "Jalan panel to recommend transfer of surplus RBI reserves to govt in tranches." Livemint, July 17.

Rajadhyaksha, Niranhan. 2018. "Is Reserve Bank of India hoarding too much capital?" Livemint, November 15.

Srinivasan, Raghuvir. 2019. "Challenge to the Reserve Bank of India’s reserves." The Hindu, November 2018.

V.K.Sharma. 2018. "Is the RBI Over Capitalised? Only if You Compare Apples With Oranges." The Wire, December 3.

The World Factbook, Central Intelligence Agency. 6 December 2017. Net exports. Accessed August 2, 2019.