RBI’s balance sheet – the sequel

(The following article appeared on December 1, 2018 in Bloomberg Quint:

https://www.bloombergquint.com/opinion/dont-double-dip-into-rbis-books#gs.R94TWJk )

RBI’s balance sheet – the sequel

In continuation of my earlier article on this subject (see https://www.bloombergquint.com/opinion/understanding-rbis-balance-sheet-is-it-sitting-on-excess-capital), here are a few additional (geeky!) questions worth probing.

First, if the RBI was to hypothetically transfer some “excess” capital to the government, would this necessarily require a sale of foreign currency or domestic assets by the RBI? I make the case that this would NOT be automatically necessary.

Second, we know foreign currency revaluation gains do not pass through RBI’s P&L, they reflect directly into Currency and Gold Revaluation Reserves (CGRA) on RBI’s balance sheet. Can some of this reserve now be realized into P&L? I make the case that given the nature of accounting followed by the RBI, it is virtually impossible to “realize” this reserve in the current context.

Third, most importantly, my previous article made the case that any reduction in Contingency Funds (CF) – RBI’s retained earnings – should at best be used by the government to buy back its bonds with the RBI. Is there any further logical basis to this?

I make the case that other things being constant, an increase in CF would translate into higher lending by the RBI to the government, through RBI purchase or funding of government bonds. Any standalone one-off dividend now, without a buyback of bonds by the government, would effectively imply that the same funds would have been both lent to and now separately transferred to the government.

Let’s take each of these up questions individually.

Transferring “Excess” Capital to the Government

RBI has the luxury of creating money by passing accounting entries. To transfer say INR 2 lakh crores of its INR 2.5 lakh crores retained earnings (CF) to the government, RBI only has to pass the entry reducing its CF by the amount and crediting the government’s account with it. This entry would not impact the asset side of RBI’s balance sheet.

As the government then spent this INR 2 lakh crores, the funds would move from the government’s account to individual bank accounts with the RBI. This too would only involve entries within the liability side of RBI’s balance sheet.

Once the funds reached the banking system, it would become part of the regular liquidity management operations of the RBI. In today’s context, the banking system is short on daily liquidity – banks start the day short of their required statutory Cash Reserve Ratio (CRR) by around INR 85,000 crores. The addition of Rs 2 lakh crores would flip the start-of-day position of banks to a surplus of INR 1.15 lakh crores.

This by itself would not force the RBI to sell any of its assets – it could well let the surplus remain in the banking system and absorb it through reverse repos. In the current context, it would only reduce the need for the RBI to buy bonds through OMOs or infuse liquidity through repos in the future. 

In summary, the RBI can transfer money from its capital to the government by way of an accounting entry, without any asset side impact. This would eventually translate into a liquidity inflow into the banking system and become a part of the overall liquidity market operations of the RBI.

Realizing Currency and Gold Revaluation Reserves (CGRA)

Can the reserves in RBI’s CGRA – the considerable INR 6.9 lakh crores as of June 2018 - now be realized by the RBI selling down some of its reserves?

The annual accounts of RBI of fiscal year 2018 (RBI’s fiscal year is from July to June), are worth considering in this regard.

In the nine months between July 2017 and March 2018, RBI purchased over $ 28 Bn of foreign currency across spot and forward markets, when USDINR averaged around 64.00.

Thereafter, between April 2018 and June 2018, as INR fortunes turned, RBI sold over US$ 26 Bn across spot and forward markets, with USDINR in the 68.00 range.

However, the purchase of US$ at 64.00 and sale of US$ at 68.00 did not result in realized currency gains of over INR 10,000 crores during the fiscal, as one might have expected.

That’s because the RBI marks-to-market its currency assets every week, and takes this P&L into CGRA, outside of recognized P&L.

In other words, as INR depreciated the last fiscal, the gain in RBI’s purchase of USD at 64.00 was taken into CGRA over time, and currency reserves were already marked to 68.00 when the RBI sale intervention commenced. The entire INR 10,000 crores alluded to earlier, therefore, accrued directly to RBI’s CGRA rather than recognized as P&L.

RBI’s June 2018 CGRA balance of INR 6.9 lakh crores against foreign currency and gold assets of INR 27.8 lakh crores indicates an effective holding USDINR cost of around 48.50, assuming all its currency and gold assets was held in USD. To recognize any P&L now by sale of foreign currency, RBI would have had to follow one of weighted average or FIFO or LIFO methods of currency inventory valuation. As described earlier, it follows neither of these – it marks the whole inventory to market and takes any gains from these into CGRA, outside of P&L.

In other words, any sale of foreign currency now – at market - will simply not release any of the CGRA. The only time there would be a case to release CGRA would be if the currency reserves came down to zero – which is impracticable.

While this might sound strange, this does ensure that the RBI and the government do not manipulate currency markets solely to recognize P&L. Had the RBI been following weighted average method of currency inventory valuation, for instance, a simultaneous sale and purchase of USD today would have allowed RBI to recognize P&L against the US$ sale transactions and restate the holding cost of reserves to a higher USDINR level.

At a practical level, therefore, if the government was to try and extract the reported INR 3.6 lakh crores of “excess” capital on RBI books, this presents difficulties. The CF is only to the tune of INR 2.5 lakh crores. The balance INR 1.1 lakh crores cannot be extracted from the CGRA – not without significant changes in accounting policy. At best, therefore, RBI would have to tolerate the anomalous situation of having negative CF of INR 1.1 lakh crores, offset by a large unrealizable but positive CGRA.

The connect between Contingency Funds (CF) and RBI holding of government bonds

As discussed in the previous article, RBI’s CF has been built over time by retaining some of the seigniorage income of RBI.

The RBI earns seigniorage by earning returns on its foreign currency and government bond assets, funded by interest-free currency in circulation and very low interest-bearing government and bank balances with RBI.

To the extent the RBI pays back seigniorage dividend to the government, the coupon paid by the government to the RBI against government bonds held by the RBI remains within the banking system.

However, to the extent RBI withholds this seigniorage income and adds to its CF, that represents a withdrawal of liquidity from the banking system.

Everything else being the same, to keep the system liquidity neutral, the RBI would have no choice but to replenish the liquidity withdrawal. Surpluses can be tolerated – but systemic liquidity deficits would have to be filled by the RBI.

The most obvious way of doing this would be by RBI purchasing government bonds from the market.

All else remaining the same, all accretions to the CF by withholding seigniorage would have resulted in the RBI buying government bonds – in other words, lending a like amount back to the government. There is a connect, therefore, between the INR 2.5 lakh crores of CF and the INR 6.3 lakh crores of government bonds on RBI books.

To seek a standalone one-off dividend payment out of CF now, without any buyback of bonds by the government would therefore be a double deployment of the same money towards the government. The first time by way of a lending by the RBI to the government, and the second, a transfer of dividend. Seen in this light, the latter would tantamount to monetization of the deficit – plain and simple.

In Summary

Technically, the RBI can transfer “excess” capital from its CF to the government by way of a simple accounting entry, without necessarily entailing any asset sales by the RBI.

Given the accounting norms of the RBI, its CGRA cannot be realized into P&L without a significant change in its accounting policy.

Lastly, other things being equal, the creation and expansion of the CF would have resulted in the RBI buying government bonds, i.e. lending money to the extent of CF created to the government. Though feasible in an accounting sense, it would be disingenuous to seek a reduction in CF now by way of a one-off dividend to the government, without reducing the amount of lending by the RBI to the government – i.e., without the government buying back its bonds on RBI books. If it is still forced through without a concomitant bond buyback, it would smack entirely of a direct monetization of the fiscal deficit.