Can RBI’s board opine on monetary/exchange rate/supervision policy? Yes, it can, although it seldom does. Section 7(2) vests the RBI board full powers to do “all acts and things” subject to government directions under Section 7(1) in the public interest, after consultation with the Governor. Section 7(3) also empowers the Governor and deputy governors similar powers subject to RBI board regulations. Sections 11(1) and 30 further establish the primacy of the RBI board. Section 11(1) empowers the government to dismiss any individual member—including the Governor.
In case of dismissal of the whole board, Section 30 requires the government to entrust the “superintendentence” of RBI to a designated agency and explain it to Parliament within 3 months. This begs the question: Does the RBI board have the necessary technical expertise to comment on policy issues?
Should RBI step up liquidity injection? Yes, there have been arguments for large-scale RBI OMOs to offset FX intervention and avoid a liquidity crunch. Delay in RBI OMOs has pushed up yields, adding to FPI debt outflows and aggravating ` depreciation, on the one hand, and straining credit markets, on the other. Although some are calling for sector specific RBI support to NBFCs/HFCs and support to SMEs, it is important to first provide sufficient overall liquidity. RBI’s de facto 2+% SLR cut is not of much use unless banks can sell G-secs even if they are willing to fund NBFCs/HFCs that have been refused finance by MFs. Nilesh Shah, of Kotak MF, estimates that 25% of MF investment of $35 billion may not be rolled over.
An RBI special window against bank lending to MFs or NBFCs or HFCs will not help. After all, MFs are not facing panicky redemptions but are reportedly cutting back investment in NBFC paper. Dilution of PCA norms, if finally done, will restore credit flow to even more credit-worthy SMEs only if there is sufficient liquidity via RBI OMO or CRR cuts to begin with. Cutting CRAR from 9% to the 8% Basel III requirement will ease banks’ capital requirements but credit flow will still require liquidity injection through RBI OMO.
RBI has to inject about $33 billion of durable liquidity. Durable liquidity, in stark contrast, has shrunk by $7 billion so far this fiscal. While RBI has sold $24 billion of FX, it has OMO-ed $17 billion (including November). If FPI flows do not revive ($16+ billion outflow), it will likely need to sell another $10-15 billion. This will likely need a 1% CRR cut releasing $15+ billion; we expect RBI to inject $35+ billion/`2000 billion via OMO in December-March to arrest further hikes in lending rates. This translates into monthly OMOs of `500 billion during December-March with inflation set to average 3.8% till March; and we estimate that the money market will persist in a large `1000+ billion deficit in December, even after `500 billion OMO.
Are RBI’s reserves adequate? Contingency reserves, at 7.1% of book, are well above the BRICS (ex India) average of 2%. We regard as positive media reports suggesting that the RBI board could form a committee to look into this issue, especially as the mid-1990s’ 12%-of-book benchmark was drawn up before the 2003 Fiscal Responsibility and Budget Management Act put an end to monetisation of the fiscal deficit. Overall reserves, at 27% of book, are also far higher than the 18% recommended by the 2004 Usha Thorat group.
Government surplus with RBI is at Rs 1675 billion/$23 billion/0.9% of GDP as of March 2018. This emanates from state government surpluses (parked in intermediate T-Bills), higher than expected small savings as well as deferred expenditures. Contingency reserves are at Rs 2321 billion/$32 billion/1.3% of GDP as of June 2018. This is essentially built out of interest income from RBI’s G-sec and FX portfolios. If RBI earns Rs 10 from its existing FX portfolio, it invests the same in an additional FX asset with a mirror entry in the Contingency Reserve in its net non-monetary liabilities (NNML) account. Hence, the transaction set is liquidity neutral.
Contingency reserves came into focus in the mid-1990s after RBI incurred huge losses on the exchange rate guarantee on the then non-resident FX-denominated FCNRA scheme. While these were fiscalised, RBI began publishing the data under Contingency Reserves. Although a 1997 RBI technical group recommended that it build up Contingency Reserves to 12% of balance sheet, this was never really achieved. While another 2004 RBI technical group proposed to limit overall reserves at 18% of book, this was not accepted by the RBI board. The RBI’s Malegam committee has made transfers to RBI reserves discretionary.
Currency and Gold Revaluation Account is at Rs 8000 billion/$111 billion/4.4% of GDP as of June 2018. This is built out of revaluation of RBI’s gold and FX portfolios. `1 of depreciation adds about Rs 400 billion to RBI’s revaluation reserves.
This begs 3 questions: Won’t drawdown of RBI’s reserves generate liquidity? Yes, and our OMO requirement would come down by a like amount. If RBI transfers the same $10 of interest on FX reserves to the government, it will result in issuance of cash after public spending. This implies that the additional $10 will now be mirrored in public spending than RBI’s net worth.
Will RBI need to sell FX/G-secs to fund reserves transfer? Not really. The matter is straightforward in case of Contingency Reserves, as explained above. In case of revaluation reserves, RBI can technically recognise past unrealised gains through the P&L and pass it to the government for public spend. As the central bank, RBI generates liabilities by creating assets.
Does the law allow the government to drawdown RBI reserves other than surplus transfer? The RBI Act places no bar as long the government maintains `5 crore of reserve funds under Section 46. Section 47 enjoins RBI to transfer its annual surplus to the government, after provisions, but does not place any restriction on transfers beyond that. After all, contingencies will not arise only during the scheduled August transfer of surplus.
Edited excerpts from BofAML’s India Economic Viewpoint (November 14)