RBI’s Economic Capital - Debating the Right Questions

The following article appeared on CNBCTV18 on January 14, 2019. Link attached:

https://www.cnbctv18.com/economy/rbis-excess-capital-heres-why-this-obsession-seems-fairly-pointless-1950971.htm 

RBI’s Economic Capital - Debating the right questions

The expert committee set to review the Economic Capital Framework of the RBI has been tasked with suggesting an “adequate” level of capital that the RBI needs to maintain.

There are persuasive arguments that suggest the RBI holds more than adequate capital.

However, there are additional, related questions that are critically important to debate.

One, what has the RBI done with its “excess” capital – has it stuffed cash in a mattress somewhere, and denied useful funds to the country?

Two, what could be the consequences of RBI transferring its “excess capital” to the government?

These are important questions, particularly in light of our extraordinary fiscal and monetary context.

Looking past cynical accounting, the quality and extent of our fiscal deficit has seriously deteriorated in recent times. This is even before any extraordinary pre-election fiscal doles.

On the monetary side, RBI’s huge purchase of Government of India (GOI) bonds in the name of injecting durable liquidity is already facilitating this fiscal splurge.

Any additional standalone RBI transfer of “excess capital” will tantamount to our central bank creating fresh money for the government to spend.

Which brings us to the overarching question that truly merits a quality debate.

Can we emerge unscathed from this fiscal and monetary context?

Does RBI have a stuffed mattress?

I agree with the broad point made by many commentators, including former Chief Economic Advisor Arvind Subramanian, that the RBI holds more capital than is required. Specifically, RBI has been building a Contingency Fund out of its income while practically ignoring the buffer it holds in the form of enormous currency revaluation reserves.

However, I disagree with the imputed inference that the funds have been denied to the country and should now be used for purposes such as recapitalizing the country’s banks.

RBI’s excess capital is not stuffed in any mattress in Mint Street – it’s part of the fungible pool of funds (alongside bank balances, government balances and currency in circulation) that the RBI has deployed into foreign currency reserves, and over INR 8 tn of GOI bonds.

Suggestions that the capital should be used to recapitalize government owned banks ignore the fact that the funds have already been deployed.

In fact, given the appropriate level of foreign currency reserves is an independent decision, any excess capital has already been lent back to the government in the form of GOI bonds held by the RBI.

A fresh standalone transfer of excess capital to the government now, even as the RBI continues to hold government bonds, would be simple creation of money.

At best, any transfer to the government could be used solely to buy back the GOI bonds held by the RBI, allowing the government to reduce its outstanding debt.

Finally, this obsession for recapitalizing banks using RBI’s excess capital seems fairly pointless. We have already crafted a fairly cute but effective method for recapitalizing banks through recap bonds issued to banks, with minimal impact on liquidity and reported fiscal deficit. Why look for a cuter solution now?

Our fiscal and monetary context

Here is a quick summary of our fiscal and monetary context.

Government data for eight months of FY19 show that the center’s net total tax income has grown only by 4.4% year-on-year, well short of the 19.1% budgeted. At this rate, the center will end INR 1.85 tn (1% of GDP) short of tax revenues alone.

Higher food and fuel subsidies and spending on schemes will pressure the expenditure budget as well, even as state and central governments ponder mega pre-election doles.

Worryingly, unlike any rational household, we are borrowing more to pay our current bills than for productive investments. In fiscal speak, we are expanding our revenue deficit, while shrinking our capital spending.

In addition, the FRBM act was modified in 2018, and the government is no longer bound to bring down revenue deficits over time.

To address the headline deficit, we will undertake cosmetic accounting surgery. Expenses and refunds will be pushed to the next year, and government-owned entities (including the RBI) will be squeezed for every paisa. We do need to revise the government’s cynical accounting standards.

On the monetary side, in this year of fiscal strain, the RBI could purchase 80% of the central government’s net market borrowing from the market. Bizarrely, the RBI and some analysts justify this in the name of durable liquidity infusion. There are multiple instruments available to infuse liquidity besides GOI bond purchases – including CRR cuts, and long-term lending to banks against GOI bonds. These can infuse liquidity without distorting GOI bond markets as outright bond purchases do.

Any standalone payout from the RBI to the government will add to this monetary support for fiscal largesse.

Do I worry too much?

In warning of fiscal and monetary excesses, am I clouded by old dogma that may no longer apply?

After all, developed economies have undertaken extraordinary monetary and liquidity easing in the past decade. And yet, inflation in the west has remained remarkably well-behaved, and markets have emerged out of the global financial crisis.

In India as well, CPI inflation is very low. Can some fiscal and monetary expansion spur our economy with manageable side effects?

We heard these arguments in 2010-12 as well, and I remain skeptical.

India’s CPI is depressed on account of food deflation and muted rural spending. Fiscal doles could lift rural spending. Food prices could mean revert, as production adjusts to prices. Finally, as we saw during 2010-12, fiscal doles risk an eventual spike in import demand and our current account deficit. As it is, our financial services ecosystem remains wobbly.

This fiscal and monetary experiment could leave us vulnerable to a twin deficit and financial stability crisis, unless our prayers for sustained low oil prices or similar manna from heaven are answered.

The debate on the appropriate level of capital with the RBI will be incomplete without this larger debate on the consequences of our fiscal and monetary context.