Central banks are not profit-making institutions. Nevertheless, they earn profits that are incidental to the nature of operations performed by them. Typically permitted by statutory arrangements, central banks have monopoly powers to issue currency notes, which form the bulk of their liabilities. They can create potentially large amount of currency liability without any cost other than the printing cost, which forms a small fraction of the total value of currency in circulation. Corresponding assets acquired by central banks—either domestic assets or foreign assets—earn income mostly in the form of interest, and this constitutes the major source of their income.
The bigger the size of a central bank balance sheet, the larger is the scale of income, unless there is a dramatic decline in interest rates. In developing countries, domestic assets typically earn higher return than foreign assets, as domestic interest rates are generally higher than foreign interest rates.
The choice of domestic assets and foreign assets is governed by the prevailing market conditions and external sector developments. If the demand for currency is met by domestic demand, central banks build up domestic assets, whereas central banks meet foreign demand for domestic currency by acquiring foreign assets.
Profits earned from central bank operations are typically transferred to the government, who is incidentally the owner of a country’s central bank. In many jurisdictions, central banks have been assigned certain social responsibilities, and for this purpose they retain a portion of profit. Of late, central banks are exposed to market risks, as they have to intervene in the domestic as well as forex markets as and when required. Hence, central banks do maintain some reserves, appropriated from profit, against unforeseen contingencies. The Reserve Bank of India (RBI) has been transferring increasingly large and almost the full amount of its surplus income (i.e. profit) to the government of India since 2013-14, as recommended by the Technical Committee headed by YH Malegam.
The amount transferred to the government dramatically dwindled to `30,659 crore in 2016-17, from a high of `65,876 crore just a year earlier, mainly due to demonetisation and its after-effects. This has critical fiscal implication, as the fiscal arithmetic is likely to be jeopardised in 2017-18. According to the RBI Annual Report 2016-17, there is a large increase in expenditure on three counts:
– Printing of new notes following demonetisation;
– Distribution of such notes in every nook and corner of the country;
– Expenditure on the interest paid to commercial banks.
The first two reasons are understandable in the context of demonetisation of high denomination currency notes, which was more than 86% of the currency in circulation. The large increase in interest outgo deserves further elaboration. RBI earns interest at repo rate or more when it lends to commercial banks under the Liquidity Adjustment Facility, or LAF (Marginal Standing Facility, or MSF, included). Similarly, RBI pays interest when it impounds excess liquidity under LAF at reverse repo rate or more, but less than the repo rate. If it conducts auction reverse repo to mop up excess liquidity, it pays close to the repo rate, more than the reverse repo rate.
In 2016-17, net interest on LAF operations was negative `174.26 billion as against a positive income of `5.06 billion in the previous year. If RBI opts for outright sale of government securities under Open Market Operations (OMO) to reduce surplus liquidity on a long-term basis, it loses interest that could have been earned by it by holding those government securities. As OMOs are constrained by the availability of government securities, RBI generally prefers to undertake more of collateralised operations under LAF, occasionally supplemented by OMOs as and when required. After demonetisation, there was a sudden spurt in deposits in commercial banks, which turned commercial banks into an ocean of excess liquidity.
Banks had little choice but to deposit this excess liquidity with RBI, as the demand for credit was otherwise sluggish prior to demonetisation. RBI had to pay a huge amount of interest on such deposits, close to the repo rate, as excess liquidity was mostly mopped up by auction reverse repo. In fact, excess liquidity was so high that despite large reverse repo auctions, residual surplus at the end of the day—over and above the required Cash Reserve Ratio (CRR) balance with RBI—was also sizeable. In either case, the payment of interest was large due to impounding of liquidity in trillions on an enduring basis.
RBI reduced the corridor between the MSF rate and the reverse repo rate from repo plus/minus 100 basis points to repo plus/minus 50 basis points from April 2016 and further to repo plus/minus 25 basis points from April 6, 2017. As a result, while MSF rate was reduced by 75 basis points, the reverse repo rate was hiked by a similar magnitude. This has benefited commercial banks, but depleted the profits of RBI by increasing the interest outgo significantly under reverse repo post demonetisation as well as reducing earnings under repo before demonetisation. The cost was not limited to RBI’s interest outgo alone. The government had authorised the issuance of treasury securities under the market stabilisation scheme (MSS) as RBI was not having enough government of India securities to undertake reverse repo operations in multiple of trillions.
The government has to bear the cost of such issuance of securities, which has implication for fiscal discipline as well. In this context, the amendment of the RBI Act to institute a Standing Deposit Facility assumes greater importance. The Urjit Patel committee on the new framework of monetary policy had recommended to do so way back in 2014. This would have obviated the issuance of treasury securities under MSS and the attendant cost associated with it. Second, the interest rate of a Standing Deposit Facility would have been delinked from the repo rate. By keeping the interest rate on Standing Deposit Facility at a level much below the reverse repo rate, RBI could have spent less and encouraged commercial banks to be less risk-averse, if not lazy.
By Barendra Kumar Bhoi