Depleting strategic reserves could undermine its capacity to withstand macroeconomic shocks
Why does the Reserve Bank of India need capital? Strictly speaking, it can operate perfectly well without capital. It isn’t really a firm where capital represents start-up costs and shareholders’ commitment. With capacity to create infinite domestic liquidity, RBI doesn’t need to reassure anyone; it is the most reliable obligor of the rupee!
Assume then that RBI has zero capital. Like all central banks, it has a monopoly over provision of domestic currency; like most, it can create demand for its liabilities by imposing reserve requirements upon commercial banks. Responsibilities range from maintaining price stability (primary) to meeting growth, exchange rate and financial stability objectives. RBI can very well perform these tasks using the foreign and domestic assets that remain on its books.
As long as net retained earnings are positive, there would be no material impact upon either profitability or policies. But, what if there are losses?
RBI functions in a world of uncertainty. Its ‘firm’, the Indian economy, is exposed to various shocks, including oil prices. As a safeguard, it stocks FX reserves, available for use to conduct monetary policy for promoting internal and external stability. A majority of its assets are foreign currency which are the main source of income. But, FX asset values fluctuate with exchange rate movements and are exposed to financial risks. Losses happen, can be persistent and can accumulate over time. Deterioration of the balance sheet would, therefore, cripple its ability to stabilise the external sector, preserve value, meet international commitments to IMF and other countries.
Losses would also have to be financed. That could be through injecting reserve money—now or in future. There would be either an immediate impact on domestic liquidity or through influenced expectations for future reserve money growth; depending upon consistency with monetary stance, this could threaten RBI’s ability to control. Other options for countervailing actions could involve financial repression, which is contrary to ‘market-friendly’ means. Losses could also be covered by debt instrument transfers, if there is flexibility (interest expenditure and limits on government debt outstanding are allocated at the outset in the budget) and capability. But with such capital infusions, RBI would run the risk of placing monetary policy at the whims of the government.
So, if we value central bank independence, price stability is a concern. If the rupee value and overall financial stability is to be maintained, then RBI needs capital to help absorb losses over short time periods. Minus capital, it can’t operate effectively and independently with a negative balance sheet and under/or conflicting constraints despite all its monopoly powers; to do so, its net income must always be positive.
In that case, how much capital does it need? That is a relative matter; specific to every central bank, balance sheet structure and economic policies. Two examples provide illustration.
From Indian economic history—Losses can happen
Following the balance-of-payments crisis and July 1991 devaluation, RBI’s Exchange Fluctuation Reserve Account was drawn down in meeting exchange losses on the FCNR(A) Scheme. This account was restocked by drawing upon the contingency reserves in turn; the latter nearly evaporated by mid-1993. Subsequent rebuilding of the contingency reserves took many years; RBI was fortunate its foreign income could be enhanced by the sharp rise in world interest rates. Then in FY04, an upturn in the interest rate cycle cost the bank
R6000 crore by way of depreciated values of domestic and foreign securities. Good luck or misfortune, as the case may be, but that’s why central banks provision against their exposure and don’t take risky rides. They lose independence and credibility if they do.
The contingency fund (CF) is “…for meeting unexpected and unforeseen contingencies, including depreciation in the value of securities, risks arising out of monetary/exchange rate policy operations, systemic risks and any risk arising on account of the special responsibilities enjoined upon the RBI”.
From other countries: Comparing the similar
Cross-country comparisons of central banks’ capital levels are complicated because of the wide variation in balance sheet structures, which influence profit outcomes. For instance, Bank of Canada can safely operate with a very low capital base because its balance sheet is not exposed to any significant foreign currency risk or gold as in the case of other central banks; its FX reserves are not on its balance sheet and majority assets are securities issued/guaranteed by Canada, so it’s virtually assured of a profit. Quite similar in structure is the US Federal Reserve balance sheet with major holdings being treasury securities and a small part of FX reserves; gains and losses have a marginal impact.
By contrast, FX reserves are the largest balance sheet asset (86% in 2015) of Norges Bank of Norway, an oil nation with a challenge of managing volatile revenues. Here, profits/losses are impacted by exchange rate movements and risk exposure is high, to manage which Norges Bank maintains a 40% equity-asset ratio—the highest globally. Agreed guidelines with the government stipulate transfer of profits to an adjustment fund until it has reached 40% of net FX reserves and 5% of G-sec holdings; the intent, like RBI’s CF, is to provision against potential losses from fluctuations in asset values. Structurally quite similar to RBI’s balance sheet and associated risk exposure.
There is no set or ideal capital level for central banks because of such peculiarities. Divergence of FX reserves policies is a good example because the central bank balance sheet is subject to large profit and loss shocks, requiring substantial amounts of capital. So the Economic Survey, 2015-16 proposal (Box 1.6: Addressing the Twin Balance Sheet Challenge, page 19) that argued for redeploying some of RBI’s capital on the ground so that its 32% equity-asset ratio was way above the global median (16%) and all but one country (Norway), missed a very important point—that a large chunk (68% as on June 24, 2016) of RBI’s asset holdings is FX reserves.
Ironically, a year before the Survey (2014-15) had espoused the cause for building FX reserves of $750 billion to a trillion to match the Chinese muscles, though wishfully thinking they be earned from current account surpluses in the long run! If it is India’s strategic objective to build up adequate FX reserves’ stock, being fully aware that these could be from capital accounts with all the associated risks, it is prudent RBI maintains a matching contingency fund.
Fiscal constraints spilling over to the central bank’s balance sheet?
The question is what is the optimal level of contingency reserves—the risk management practices? As determined by RBI’s internal working groups, a target of 12% of total assets applies for transfers from RBI’s gross profits to the CF; in 2013, the Malegam Committee (Technical Committee I, June) noted this, recommending that adequate profits be transferred each year to build up sufficient buffer. Surprisingly though, the Malegam Technical Committee-II found CF balances—at 8.4% of total assets in FY14—exceeded required buffer, advising against further funds transfer (the full policy review and recommendations of this report are not public yet).
With zero transfers to contingency reserves for three successive years since then, the CF-assets ratio is down from 9.3% in FY13 to 7.7% in FY15—a coincidence with fiscal consolidation by the government here? Assuming zero transfers this year too, the contingency fund is likely to weaken further to 6.8% in FY16. It need be flagged here that in FY14, RBI’s FX reserves were sharply depleted; the trend reversed sharply in FY15 and FY16 with net accretion closer to $90 billion.
It is apparent RBI is no cash cow. Its reserves have been built over several years to meet clearly defined stability goals. Attempts to treat its balance sheet as part of consolidated public sector accounts are fraught with macroeconomic risks. In cognition of the fiscal strains, RBI has been transferring 100% profits for last three years; it could be doing the same in the current year. Dipping further into its contingency reserves would weaken buffers and set a bad precedent for future governments to find excuses at the slight hint of fiscal stress. Indeed, a good accounting practice means setting provisioning-transfer rules that are inviolable—observed in most countries to keep distance between governments and central banks.
Post-Brexit, raiding RBI’s balance sheet at a time of heightened volatility in global capital flow could send wrong signals to international investors and rating agencies—restraint would be better counsel. If the government has fiscal constraints to adequately capitalise public sector banks, it must consider other reform options.
The author is a New Delhi-based economist