Understanding RBI's balance sheet: Is it sitting on excess capital?

(The following appeared on Bloomberg Quint on November 2, 2018

https://www.bloombergquint.com/opinion/understanding-rbis-balance-sheet-is-it-sitting-on-excess-capital )

RBI Balance Sheet – Capital & Reserves

For the geeks out there, willing to get into the weeds of an esoteric topic, here are a couple of hot, topical questions.

Does the RBI hold excessive capital on its balance sheet? Should it pay a part of its capital out to the government, to help the fiscal balance?

I believe there are strong arguments to suggest that on the face of it, there is indeed an excess of gross capital and reserves on the RBI balance sheet.  But that doesn’t mean the RBI should pay an extra dividend to the government now.

For one, the RBI also lends funds to the government, in the form of government bonds held the RBI. As the RBI conducts more open market operations (OMOs) and further buys government bonds to infuse Rupee liquidity, this lending to the government will increase further.

The net capital (after adjusting for the money already lent to the government) does not appear to be excessive.

In this context, a standalone one-time payment of dividend from existing reserves and surpluses by the RBI is not advisable – it would be akin to printing money to fund the government’s deficit.

At best, any one-time dividend should be used entirely by the government to buy back its bonds that are held by RBI. That would lower the total outstanding debt of the government, improve its optical debt position, but not yield any net fiscal bonanza for this year.

Let’s take a look at the basic balance sheet of RBI, its income streams, understand why some worry that RBI may not be adequately capitalized, and draw some overall conclusions.

RBI Balance Sheet

Let’s start with the RBI’s balance sheet as of June 2018, simplified and summarized below.

The assets of the RBI include foreign currency assets (our country’s currency reserves), gold, Rupee investments (government of India bonds and bills) and other assets.

On the other side, RBI has capital and reserves, Rupee deposits (including banking CRR balances, money absorbed by RBI via reverse repos, government balances etc.), and currency in circulation.

RBI’s Regular Income (“Seigniorage”, to the geeks)

Without having any commercial intent, RBI has an enviable, regular income model. It takes cheap money from the government, banks and especially us (every currency note we carry is a zero-interest loan to the RBI) and deploys it largely in interest-bearing foreign currency (FCY) and Rupee assets. As a result, for the fiscal year July 2017 – June 2018, RBI earned a net interest of INR 738 bn.

Net of expenses and provisions, RBI transfers this income to the government as dividend.

One of the provisions is to the Contingency Fund, which is in the nature of retained earnings.

Revaluation gains and losses

Besides interest income, the FCY assets and Rupee bonds that RBI holds are subject to revaluation gains and losses. As the Rupee depreciates over time, the INR equivalent of foreign currency assets increases.

Such gains from revaluation do not pass through RBI’s income statement – they are taken directly to the balance sheet under revaluation reserves.

As of June 2018, the cumulative currency and gold revaluation reserves alone was a whopping INR 6,916 bn (see table 1), which includes INR 1,617 bn added in this fiscal year. Clearly, the Rupee has depreciated significantly in relation to RBI’s effective acquisition cost of foreign currency.

Likewise, the FCY and INR bonds and derivative contracts held by the RBI could show mark-to-market gains or losses, through the year.

As an aside, while gross revaluation gains are kept aside as revaluation reserves, cumulative losses from revaluation of assets and derivatives are directly reduced from the Contingency Fund alluded to earlier. RBI’s holding of foreign currency bonds, for instance, had a cumulative mark-to-market loss of INR 169 bn as of June 2018, which was deducted from contingency funds in table 1 above, and does not form part of revaluation reserves.

Adequacy of RBI Balance Sheet Buffers

Commentators who believe RBI buffers are not adequate, typically only consider the extent of Contingency Fund (marked “A” in the table above). At 7% of the balance sheet, they reckon, the number is small in relation to RBI’s broad target of 8-12%.

On the other hand, the overall buffers of the RBI should include existing revaluation reserves as well. In fact, Contingency Funds exist to provide for contingencies, including fluctuations in the value of assets. Asset valuations are already buffered to the extent of existing revaluation reserves. By this token (see “B” in the table 1), RBI has buffers to the tune of 27% of balance sheet. As the Economic Survey of FY16 had pointed out, this level of buffers was second only to Norway amongst major nations. 

It’s interesting to understand how the 12% standalone target for Contingency Funds came about. The Subrahmanyam committee (1997) had suggested this number, at a time when the revaluation reserves were at 5% of balance sheet – and so total reserves were effectively targeted at 17% of balance sheet. The Usha Thorat Group (2004) actually called for an 18% buffer of total reserves, across Contingency Funds and Revaluation Reserves. Yet, the RBI continued to look at the Contingency Fund target of 12% on a standalone basis. The Malegam committee (2013) suggested that Contingency Funds need to be enhanced, but left the quantum to RBI management to decide.

Probably in light of the high overall reserves, RBI in the Rajan era did not increase the quantum of Contingency Funds, and paid out the entire income to the government as dividend. The last two years, however, RBI added INR 132 bn and 142 bn respectively to the contingency fund, reducing the payout to the government to that extent. To me, this does seem unnecessary.

One Time Transfer to the Government?

In light of the above, does a one-time transfer of RBI reserves – particularly a portion of the Contingency Funds that are in the nature of retained earnings – make sense?

This is where one has to consider what the RBI has done with the funds. If we consider (C) on table 1, RBI already held INR 6,297 bn of government bonds and bills on its books through its Open Market Operations (OMO) purchases, as of June 2018. Effectively, even if dividend has been withheld over the years, the RBI already had separately lent this money to the government.

Since then, as the RBI conducts further OMO purchases, this number (C) continues to increase.

It makes sense therefore to reduce this number from the capital of RBI, and the net effective capital of INR 3,401 bn (INR 9,698 bn less INR 6,297 bn) is 11% of the netted balance sheet of INR 29,878 bn (INR 36,176 bn less INR 6,297 bn).

11% effective capital does not look like an overly large number – justifying a standalone payout from this to the government would be difficult. All this does not even consider the fact that any fresh payout now would simply look like monetization of the fiscal deficit.

At best, some of the gross capital can be reduced with a concomitant buyback by the government of the bonds on RBI books – essentially netting off some of (B) on table 1 with (C) on table 1. That would allow the government to reduce its overall outstanding debt, but without any bonanza for this fiscal.

Conclusion

This is by no means a definitive piece on this subject. Central bank balance sheets can be difficult to grasp and are the subject of much debate. This note makes the case that gross capital is large on RBI’s balance sheet (and further additions to the capital by way of retained earnings does not look necessary), but given the large government debt on RBI books, it is difficult to justify any one-time standalone transfer to the government now.

The broader point remains that given the sensitive nature of this topic, with implications on India’s financial credibility, no hasty decision should be taken.