From Bounty to Dampener, the Tale of RBI's Dividend to the Indian Government

The latest balance sheets of India’s central bank shows how a generous dividend payout last year may haunt both the bank and the government for some time to come.

Exactly one year ago, the Reserve Bank of India (RBI) had announced its acceptance of the recommendations of the Bimal Jalan Committee with regard to the central bank’s Economic Capital Framework (ECF).

The committee’s mandate had been to suggest what the structure of RBI’s balance sheet capital should look like and how much by way of free capital reserves the central bank should ideally build up. It is understood that these reserves are to serve as a buffer against contingencies and potential losses/likely value impairments through the systemic, operational, market and credit risks that every central bank is necessarily exposed to.

The ECF recommendations were acted upon immediately, effective the RBI Balance Sheet for the accounting year that ended June, 30 2019, and adjustments to the ECF architecture made it possible for the bank to hand out a very generous dividend of Rs 1,761 billion to the Centre.

This payout generated a lot of discussion among analysts and observers, for it consisted not only of the bank’s entire surplus (profit) of Rs 1,234 billion for the year, but also of a write-back of Rs 527 billion from earlier years’ surpluses (retained as part of the Contingency Fund (CF), the most critical component RBI’s capital funds historically).

What had allowed the RBI to dip into its CF was Jalan’s recommendation that Realised Equity (RE, comprising CF and Asset Development Fund or ADF) as a proportion of the total assets on the balance sheet be maintained in the 5.5%-6.5% band. Traditionally, RBI had maintained RE at significantly higher levels than this range, and though RE had been falling over recent years (from 10.9% of total assets in 2009 to 6.9% in 2017), it had always stayed much above 5.5%. Last year, however, the RBI decided to peg RE at the suggested band’s lowest rung of 5.5%, and released from its accumulated reserves the additional dividend of Rs 527 billion.

Critics faulted this on at least four counts. One, that this was profligacy, for if the dividend payout was to be restricted to the year’s profit, it would still be Rs 1,234 billion, which would have been nearly twice as high as the previous peak payout of Rs 659 billion (touched both in 2014-15 and in 2015-16). And while the additional payout of Rs 527 billion did not make a significant difference to GOI’s finances – it was less than 0.4% of India’s GDP in 2018-19 – its retention would have added heft to the RBI’s balance sheet (total assets in 2018-19: Rs 41,029 billion).

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Two, that for a central bank in an emerging economy, it always pays to err on the side of caution, for investors and rating agencies are seldom charmed by a central bank’s flamboyance. Three, that one year’s munificence – because it raises expectations in the government of a similarly large gift in other years as well – may come back to bite the RBI later. And finally, that in opting for the floor-level RE in its balance sheet in a particularly profitable year (surplus/profit grew 92% year-on-year), the RBI was giving up the headroom necessary for financial adjustments in tighter, less bounteous years. The Wire’s August 2019 analysis of the implications of the RBI’s decision anticipated these issues and observed how India’s central bank was allowing itself to be hamstrung by future lack of choice.

The RBI has now come out with its Annual Report 2019-20 which includes its balance sheet for the accounting year 2019-20. We will quickly run through some of this balance sheet’s highlights before we turn to the more substantive matter at hand: how last year’s dividend payout is proving to be a handicap that the bank will likely find hard to shake off.

Total assets in 2019-20 have gone up by a little over 30% vis-a-vis 2018-19, from Rs 41,029 billion to Rs 53,348 billion. The jurisdictional break-up of the assets remains fairly unchanged over these two years: roughly 28% being domestic assets while foreign currency assets and gold constitute about 72%. The substantial increase in the balance sheet size is not, however, matched by a commensurate rise in RBI’s income.

Indeed, total income in 2019-20 rose only marginally ( by less than 7%): it just touched Rs 1497 billion while in 2018-19 it had been  Rs 1404 billion ( after adjusting for the written-back provision of Rs 527 billion).

Likewise, surplus (profit for the year) grew in 2019-20 by a little under 6%, from Rs 1,234 billion in 2018-19 to Rs 1,307 billion this year. The year-on-year growth in surplus/profit in the two immediately preceding years was 92% and 47% respectively. (We will presently look at the main reason of the lower profitability this year.) And here we come to the crux of the matter. While the entire surplus of 2018-19 (and more) had been paid out to the GOI as dividend, in 2019-20 the RBI was obliged to transfer a sum of Rs 736 billion to the Contingency Fund so that it did not fall below the floor level requirement of 5.5% in Realised Equity. This explains why the dividend to the government this year is only Rs 571 billion, or about 30% of last year’s payout.

Arguably, GoI could do with a more generous helping this year, what with the severe fallout of the COVID-19 epidemic and the ballooning deficit in its finances in 2020-21 when the Indian economy is slated to actually contract by as much as 4%. Had the RBI managed to stand its ground last year (in the face of the government’s insistence on the largest possible payout) and held on to an RE level of 6.5% (rather than 5.5%), it could have handed out a much more substantial dividend (Rs 410 billion, additionally) in this time of crisis and still meet the required minimum RE. That was not to be, however.

One notable feature of the latest balance sheet is its size. Typically, the RBI grows its balance sheet by between 10% and 14% each year, but if 2019-20 is any indication, a growth rate in excess of 25% may become the norm in the medium term. This is because a struggling economy calls for significantly higher – and multilayered – support from the central bank: liquidity support to financial and currency markets, borrowing support to the central and state governments, and even the possible need to print more money, will all make their own demands felt strongly and the RBI will necessarily have to step up to help.

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In such a scenario, the bank will be required to apportion a significant corpus of its annual surplus towards maintaining the mandated capital ratios, like it had to do in 2019-20. This suggests that the generous dividend of 2018-19 may remain a flash in the pan for the foreseeable future. Had the RBI been somewhat more circumspect last year, it might have had something to build upon in the years to come.

We noted above the slender margin of profit/surplus in the RBI’s operations in 2019-20 relative to earlier years. This seems intriguing, because the loans and advances (which generate interest income) in 2019-20 rose by over 245% vis-a-vis 2018-19, as indeed they should have, what with the widely-talked-about liquidity support offered to commercial banks by way of the RBI’s Liquidity Adjustment Facility (LAF), Marginal Standing Facility (MSF) and the Special Liquidity Facility. A close look at the numbers here, however, explains the puzzle. Indeed, the net interest income on the aggregate liquidity facilities is a startling (-)Rs 130 billion, or a whopping Rs 141 billion less than in 2018-19.

A note to the accounts makes this bland observation:

“The current year’s interest income has been impacted by the net interest outgo under LAF/MSF due to absorption of surplus liquidity in the banking system.”

What this means is that the banks had parked far more cash with the RBI than they had borrowed under the much-vaunted liquidity facilities, with the result that the RBI had actually paid banks interest of Rs 130 billion on a net basis (which is arrived at by subtracting interest earned on loans/liquidity support to banks from interest paid on the deposits placed by the banks with the RBI). Indeed, while aggregate liquidity support availed of by the banks stood on June, 30, 2020 at Rs 3,222 billion, the funds they had parked with the RBI on that date were a whopping Rs 11,759 billion (or 3.5 times higher).

What this tells us is simply that regardless of the brouhaha over the great liquidity support to banks in these stressed times, the banks have simply not been borrowing, because they are unable (or unwilling, or both) to on-lend to their clients. It is extraordinary that this unvarnished truth lies in plain sight, but our policy-makers would have us believe in only their version of the ‘growth’ story.

We need to flag for the readers’ attention another apparent anomaly in the RBI’s annual report. Table XII.2 of the notes to the balance sheet provides a bird’s-eye-view of the movement of RBI’s Realised Equity over the period  2015-16 to 2019-20. It shows the ratio (suggested by the Jalan Committee to not fall below 5.5% and accepted by the RBI as such) to have been 7.5%, 7.6%, 7.05%, 5.34% and 5.38% respectively over these 5 years.

In other words, in both the years (2018-19 and 2019-20) since the RBI accepted and implemented the Jalan recommendations, it appears to have fallen short of the stipulated minimum RE threshold of 5.5%, albeit marginally. We cannot figure out why the central bank allowed this to happen, but it seems to defy common sense that so soon after embracing a new regime for its economic capital, the RBI chose to disregard one of its vital components.

In conclusion, we will hazard a guess. Since the RBI will likely be unable (at least in the medium term of 4-5 years) to match the bounty it handed to the government in 2018-19, there may be a clamour for reviewing the ECF architecture once again. One of the demands could be to further scale back the RE threshold so that annual surpluses need not be committed to shoring up the RE ratios and can be released to the GoI in full.

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Another pitch could be to also include the non-cash revaluation reserves of the balance sheet (viz., the Currency and Gold Revaluation Account and the Investment Revaluation Accounts) in the computation of the RE ratio. Such a demand was indeed voiced at the stage preparatory to the Jalan Committee recommendations, though the Committee refused to heed it for the sound reason that these reserves are essentially ‘notional’: they represent only the unrealised or potential gain from a disposal by sale of these assets at any point in time and they rise or fall in line with market prices of the underlying assets. (In other words, no actual cash flow is involved in their case.)

Though the committee got this expectation out of its way last year, it will not be a surprise if this were to make a more determined come-back next time.

Anjan Basu writes on a range of issues. He can be reached at basuanjan52@gmail.com.