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Tussle over RBI's Capital Conditions

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November 13, 2018

What is the issue?

  • There have been demands for years for the use of RBI’s internal reserves for fiscal purposes, and for higher dividend payments to the government.
  • But the government's claim that the RBI holds capital much in excess of what is needed is highly contestable.

What is the complexity here?

  • Capital - The likely consequences on the balance sheet have restrained banks from taking monetary policy measures to address deflationary trends.
  • E.g. in late 1990s, the Bank of Japan hesitated to take monetary policy measures to address Japan's acute deflationary situation
  • So determining the adequate quantum of economic capital for a central bank (CB) in the present era of fiat money is not very simple.
  • Backup - An appropriate backup against the monetary liabilities for macro-financial stability is the key issue here.
  • Two distinct back-up systems exist - the tax-based system and the reserve-based system.
  • In the tax-based system, the central bank’s balance sheet does not have much relevance.
  • Instead, the present and future tax revenues of the government provide the ultimate support to RBI's monetary liabilities.
  • In the reserve-based system, the central bank’s balance sheet strength and internal reserves provide the support.
  • An important operational difference here is that the central banks do not undertake quasi-fiscal activities as they have aversion towards credit risk.
  • Most central banks occupy intermediate positions between the two types.

What is RBI's case in this regard?

  • The RBI is closer to the second type, particularly in its evolution in the post-reform period.
  • The RBI’s statute does not permit buying of securities both in India and abroad which are not issued/guaranteed/supported by the sovereign.
  • The RBI began building its forex reserves after the Balance of Payment crisis of 1990-91.
  • So from 1993-94 onwards, its composition of assets has undergone a major structural shift.
  • Now, the foreign assets (including gold) are significantly higher than domestic assets.
  • The former’s share in total assets, which was about 50% in 2000, rose to about 80% in 2018.
  • Among other contributory factors, this transformation has certainly been a reason for the decline in structural inflation.
  • From close to double digits in 1990s, it has come down to 4-5% now.

What is the risk then?

  • The preponderance of foreign assets comes with a price of higher risk with lower return vis-à-vis domestic assets, necessitating higher capital.
  • Further, there exists an extra layer of risk associated with foreign assets.
  • It's because their composition is not entirely a result of the RBI’s monetary policy operations.
  • RBI buys US dollars through domestic forex market interventions.
  • But it maintains a roughly 50:50 currency and asset composition in US dollars and in other major currencies in its foreign currency assets (FCA).
  • The RBI does this not as a monetary authority but as a financial institution, with its particular risk-return strategy for portfolio management of foreign currency assets.
  • Nevertheless, the strategy entails higher risk, a key one being the timely valuation change of foreign currency assets.
  • Given all these, the RBI needs to maintain significant capital to cover all the currency, interest and credit risks that it faces.

How is the contingency fund scenario?

  • The RBI’s free reserves comprise its reserve fund, asset development fund and contingency fund (CF).
  • The CF provides the overwhelming bulk and is the first cushion for absorbing general loss.
  • It was almost entirely exhausted in 1993-94 as a result of the exchange rate guarantee.
  • This was provided by the RBI to FCNRA (Foreign Currency Non-Resident (Accounts)) deposits introduced in early 1980s.
  • Largely as a consequence of this, the RBI felt the need to adopt a policy in 1997 to build its CF.
  • So a target of 12% for the ratio of CF to its total assets was set.
  • Subsequently in 2004, a detailed review exercise in this regard was undertaken but its recommendations were not accepted, and the status quo was maintained.
  • The CF was subsequently built up, reaching a high of 10.9% of total assets in 2008-09.
  • But currently, this ratio is much lower than the target and stands at a little over 6%, and shows a declining trend.
  • The declining CF is worrying as it can have adverse implications for macro-financial stability.
  • Notably, the large balance in the currency and gold valuation account provides little comfort as it is available only for absorption of currency and gold valuation losses.

What is the way forward?

  • The RBI should adopt a policy framework to determine dividend payable to the government each year.
  • This should be done after assessing CF adequacy vis-à-vis an identified set of risks, following a rich methodology.
  • This should be supplemented by an analysis of the RBI’s earnings under the following categories:
  1. Seigniorage - the profit made by issuing currency (difference between the face value of coins and their production costs)
  2. Counterpart of capital - the earnings on investing capital
  3. Counterpart of other liabilities - the earnings on other liability items
  4. Currency risk - the valuation change of FCA, which needs to be recognised separately in the books of accounts
  • The earnings of the last three categories should be used to consolidate the CF and also to smooth dividend payments.

 

Source: BusinessLine

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