Is the RBI’s Gift to the Government of India Value-Neutral?

The generous handout this year may have seriously compromised the RBI’s ability to help the Centre in any significant measure again in the near term.

The Reserve Bank of India’s (RBI) press release announcing the acceptance of the Bimal Jalan committee’s recommendations on its ‘economic capital framework’ (ECF) closes with an appropriately solemn statement.

“As on June 30, 2019, the RBI stands as a central bank with one of the highest levels of financial resilience globally,” it notes.

Since the annual report for the year ended June 30, 2019 (the RBI follows the July 1- June 30 fiscal) only came out this week, the jury is still out on the current state of the RBI’s resilience relative to other central banks. But, nevertheless, there is little doubt that India’s central bank has acquitted itself quite well in recent years in the monetary policy area, even if its record of bank regulation has been mixed at best.

The question, though, is this: has the RBI managed to send out an unequivocal message that, by ‘resilience’, it does not mean pliability? The answer to this question, sadly, is ‘no’.

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We will try and see why this is so by looking at how the bank chose to respond to the Jalan Committee recommendations.

The committee’s mandate was to spell out what, going forward, the ECF should look like for the RBI, or how much capital the bank should maintain and what the structure of its balance sheet capital should be.

Now, the capital funds that the RBI holds are composed broadly of one, the original/start-up capital and two, the reserves, which, in the RBI’s case, are classified as components of ‘Other Liabilities and Provisions’ under schedule 3 of the balance sheet and are distinct from the deposits held by the Central bank and the currency in circulation.

RBI governor Shaktikanta Das. Credit: Reuters

The RBI’s reserves

The reserves, again, fall under four main heads: the Contingency Fund (CF), the Currency and Gold Revaluation Account (CGRA), the Asset Development Fund (ADF) and the Investment Revaluation Account (IRA).

Of these, the CGRA and the IRA are ‘notional’ in the sense that they are there to reflect the movements in the market prices of the asset classes (mainly gold, foreign currency and investments) to which they relate. No cash flow is involved in their case and the net credit balance in the CGRA account only indicates the unrealised or potential gain from the disposal by sale of those assets today.

But both the CF and ADF are created out of actual positive cash flows or, what is to say the same thing, out of the RBI’s net surplus (profit) arrived at by deducting all its expenses and outgo’s from its gross income.

CF is the corpus created to take care of unexpected and unforeseen contingencies, including depreciation in the value of securities held, systemic risks and risks arising out of monetary and exchange rate policy operations. Since it provides a buffer against potential losses/value impairments likely to be caused by a whole host of risks (systemic, operational, market and credit risks), CF is also often referred to as Contingency Risk Buffer (CRB) and is identified as ‘Realised Equity’, the most important component of the RBI’s capital funds. (Its centrality to the RBI balance sheet is roughly equivalent to the importance of the CRAR, or the risk capital adequacy ratio, of a commercial bank in today’s context.) The ADF corpus is meant to be drawn upon for investments in subsidiaries and to meet internal capital expenditure etc.

As of June 30, 2018 – the date of the RBI’s latest available balance sheet – the balances in these groups of reserve funds, in billions of rupees, were as follows:

  • CF: 2321.08
  • CGRA: 6916.41
  • ADF: 228.11
  • IRA : 132.85

Expressed in percentage terms, these components accounted for 6.4%, 19.07%, 0.06% and 0.03% respectively of the total assets/liabilities appearing on the balance sheet. Together, all these reserves worked out to 25.56% of the RBI’s balance sheet as of June 30, 2018.

Among other things, the Jalan committee, in its August 23 report, recommended that going forward, the RBI maintains the CF/CRB/Realised Equity in the 6.5-5.5% band and the aggregate reserves (i.e., the aggregate of CF, CGRA, ADF and IRA), also known as Economic Capital,  in the 24.5-20% band.

Now, on August 26, the RBI’s central board decided not only to accept all the recommendations, it also chose to act on the suggestion regarding the Realised Equity Capital vis-a-vis the year ended June 30, 2019, immediately.

Lowest level opted for

What concerns us here is that the bank decided to opt for the lowest level of CF/CRB/Realised Equity band (@5.5% of the total assets/liabilities) recommended by the expert committee. What this has entailed is that the RBI has firstly decided to make over to the Government of India (GOI) not only its entire surplus (profit) of Rs 1,234.14 billion for the year, but secondly, to also release Rs 526.37 billion by way of marking down its CF/CRB/Realised Equity to 5.5% of the balance sheet as on June, 30, 2019 from 6.4% a year earlier. (It has been suggested that without this prior-period adjustment – that is, assuming that only the yearly surplus was to be made over without dipping into reserves built up in earlier years – the ratio would have been 6.8%.) Together, this means a bounty of Rs 1,760.51 billion that the Central bank is handing out to the GOI by way of dividend in the 2019-20 fiscal year the budget in respect of which was presented by the finance minister on July 5, 2019.

The word ‘bounty’ was not used rhetorically, as can be seen from the following table that sets out the RBI’s dividend payouts to the GOI in recent years:

Simultaneously, a look at how the CF/CRB has moved over the years, as a component of the RBI balance sheet, will be instructive:

Together these two tables tell us that:

  1. Beginning in 2014, the first year of the NDA government under Narendra Modi, the dividend payouts became steadily more substantial compared to previous years. 2017 saw a reduction because of the aftermath of demonetisation and 2018 witnessed a lower profit overall because, awash with liquidity, commercial banks borrowed far less from the RBI than in earlier years other than 2017, thus restricting its interest income.
  2. Beginning 2014, therefore, the CF/CRB has also either stayed at the same level or increased only marginally in absolute terms, because nearly the entire surplus (100% in 2014, 2015 and 2016) was passed on to the GOI without leaving any funds to bolster the CF/CRB corpus.
  3. As a result, CF/CRB as a component of the aggregate assets/liabilities has also declined significantly, from 10.9% in 2009 to 6.4% in 2018 (and reportedly to 5.5%, or half of the 2009 level,  in 2019).
  4.  We understand that the entire yearly surplus of Rs 1,234.14 billion was considered for release to the GOI as, taking this into account, the Economic Capital still manages to stay at 23.3% (within the band of 24.5-20% as discussed above, as recommended by the Jalan Committee).
  5.  As the expert committee was averse to the idea, mooted by some quarters in the GOI, of allowing the Revaluation Reserves (i.e, CGRA and IRA) to also be drawn upon, the proposed transfer of Rs 1,760.51 billion is the maximum permissible under the new ECF architecture. The committee rightly observed that both CGRA and IRA are unrealised or ‘notional’ reserves and there are no cash flows underlying them till the assets are actually sold/disposed of. (The same logic is recognised in respect of a corporate entity’s balance sheet as well.)

Now, the committee’s recommendations cover a great many aspects of the RBI’s capital structure, the components of the capital and their inter-dependencies, and the need to protect this capital from likely losses arising out of financial and market instability and global headwinds.

A detailed scrutiny of those recommendations is neither feasible nor, indeed, intended in this short note. Here we are looking at the alacrity with which the RBI decided to part with the maximum possible component out of its actual/ potential reserves (retained surpluses always go towards building reserves) to the GOI – and at one go. (It will not be out of place to mention that the Jalan Committee did not visualise a one-shot handout to the GOI.)

And what meets the eye is far from reassuring. Indeed, very far from it. Let us try to understand why this is so.

Economic slowdown

It is no secret that the Indian economy has slowed down considerably in recent months, with both consumption and investment refusing to pick up for several quarters at a stretch, exports barely growing and expansion of industrial output being lacklustre at best. India’s sovereign rating stands somewhat precariously at the lowest rung of the investment grade with two of three major international rating agencies while the third rater places the risk at just one notch above it.

In these circumstances, a strong and independent RBI is important for many reasons, not least of which is the messaging about how the country wishes to shape its critical institutions. The fact that the RBI decided, in what is bound to appear to many as quite an unseemly hurry, to mark down its capital in its anxiety to hand a gift to the GOI is unlikely to be missed by observers and analysts who happen to be international opinion makers.

In times of looming uncertainty, changes in policy are watched with the greatest interest and the RBI’s move will be one such.

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A lively debate is already on about how India’s latest budget proposals seemed to hide more than they revealed about the actual revenue and expenditure numbers. It has been widely believed that the GOI has been cutting down on both capital and revenue expenditure because of serious funds availability issues which it is reluctant to own up to.

It is also India’s worst-kept secret that for over a year till December 2018, the GOI and the RBI were locked in a raging battle over precisely how much of its reserves the RBI should make over to the GOI to help bridge its budget deficits. Indeed, the governor of the RBI – no less – resigned in a huff over this issue, a most unusual thing to happen in a modern economy anywhere. But, undaunted, the GOI went ahead to appoint an ex-bureaucrat as the governor, put in place an expert committee to address the issue of the RBI’s ECF and, barely had the ink dried on the committee’s report, managed to receive from the RBI the biggest handout in recent history. The developments show neither the GOI nor the RBI in a kindly light.

Former RBI governor Urjit Patel. Credit: Reuters

Coming from the country’s banking regulator, this is particularly indefensible. The RBI has traditionally wanted Indian commercial banks to maintain a Risk Capital Ratio of 9% even when the BASEL norms mandated it to be no higher than 8%. Seen from this angle, it is baffling how the RBI chose to opt for the lowest rung (5.5%) in the CF/CRB/Realised Equity band recommended by the Jalan Committee when, even if it chose to peg the ratio at the upper limit of 6.5%, it could have given out an additional amount of Rs 116.08 billion over and above the yearly surplus of Rs 1,234.14 billion.

In the light of the very elaborate case that the committee’s report makes for the need of more-than-ordinary caution to protect capital, the RBI’s action is likely to be seen by many as profligacy.

Let us also note that the generous handout this year may have seriously compromised the RBI’s ability to help the GOI in any significant measure again in the near term. The bank’s balance sheet grows at an annual rate of about 10/11%, so that, even to stay at the rock-bottom level (5.5%) of Realised Equity next year, the RBI may have to apportion a not insignificant portion of its surplus willy-nilly to the CF/CRB corpus, so that it will be unable to give out the entire yearly surplus even if it wanted to.

On the other hand, having identified the RBI as a large benefactor, the GOI may not be able to reconcile easily to smaller gifts from the Central bank in future.

Anjan Basu worked for one of India’s largest commercial banks for over three decades, both inside the country and outside it. He can be reached at [email protected]