Illustration by Binay Sinha
First, what are the practical consequences of making such a transfer? In the short run, the central bank balance sheet would contract and the government would receive an equivalent lump-sum. As it is, the RBI
transfers to the government the profits it makes from its interest income from its portfolio of securities, both foreign as well as domestic, after accounting for its expenses. But with the contraction of the central bank stock of government securities, it will suffer a reduction in the future stream of income from the interest that would have emanated from the securities it transferred or sold to fund the government. The longer-term fiscal consequence would be the same if the government issued new securities today to fund the same expenditure. Thus, raiding the RBI’s capital creates no new government revenue on a net basis over time, and only provides an illusion of free money in the short term.
Second, such funding of the government from the RBI
goes against the letter and spirit of the FRBM Act that prohibits the RBI from subscribing directly to government securities in the primary market. The use of such a transfer would erode whatever confidence that exists in the government’s intention to practice fiscal prudence.
Third, we need to examine whether the RBI’s capital is indeed excessive. In theory, a central bank can implement monetary policy appropriately with a wide range of capital levels, including levels below zero. In practice, the danger is that it may lose credibility with the financial markets and public at large, and may then be unable to attain its objectives if it has substantial losses and is seen as having insufficient capital.
As it happens, the RBI’s total assets have been around 20 per cent of GDP for a long period. Such a proportion is similar at the current time to those of the Euro area, the UK, the US, and lower than that of Japan. The proportion is much higher than that of a host of emerging market central banks. On the liability side, how much capital does a central bank need and why? In principle, the RBI needs adequate capital reserves for:
Monetary policy operations;
Appreciation of the rupee against currencies held as part of foreign currency assets (FCA) and a possible fall in gold prices with respect to the rupee. FCA currently constitute more than 70 per cent of RBIs total assets;
A possible fall in the value of bonds, both denominated in foreign currency and those in rupees, on account of rising bond yields;
Sterilisation costs related to open-market operations and other innovative means;
Credit risks arising from the lender of last resort function;
Other risks arising from unexpected increases in expenditure, such as those that arose from demonetisation.
How such risks should be provided for can be a subject of honest discussion with the possibility of different conclusions. The current practice in the RBI is to make provision for contingency reserves from the profits that accrue annually, before transferring the rest to the government. In recent years, there has also been questioning from the government whether there is need for such provisioning and on the magnitudes of provisioning that the RBI has been resorting to. Consequently, the RBI in some years has had to transfer its full profits under pressure from the government. For the first time, perhaps, in its history the RBI had to transfer an interim dividend to the government this past year to relieve some fiscal pressures. Once again the gain to the government was temporary since the transfer after the full fiscal year had to be reduced by exactly the same amount.
Are fears with regard to possible central bank losses illusory? According to the BIS 43 out of 108 central banks reported losses for at least one year between 1984 and 2005. So the maintenance of a prudent central bank balance sheet is a real issue. It may be recalled that the RBI’s balance sheet contracted during 2008-09 due to the use of its foreign exchange reserves at the time of the NAFC. The contraction was due both to the use of reserves and a reduction in their US dollar value because of external exchange rate movements. Similarly, RBI expenditure increased significantly through absorption of excess liquidity following demonetisation, when currency deposited in banks increased rapidly for a time. There was, of course, the additional expenditure incurred in printing the new currency notes as well.
It is also argued by some that the government can always recapitalise a central bank when necessary. This is certainly true in principle but is practically difficult when the government itself suffers from fiscal pressures and maintains a relatively high debt-GDP ratio, as is the case in India. What is also important is the erosion of central bank independence both in reality and perhaps, even more importantly, in optics.
Once again, better sense has prevailed and the government has not raided the RBIs balance sheet.
The way forward
This continued decade-long pressure on the RBI may have been successfully resisted both by the RBI and by saner voices within the government. But it has taken its toll on the reputation of the RBI that has been built up painstakingly over its long existence. While there can be no doubt that the RBI has stumbled every now and then in its functioning, as in the excessive monetary stimulus after the NAFC, and somewhat lax regulation of the banking sector through continuing forbearance during the 2010-13 period, overall it has functioned with great credibility, probity and responsibility. It is among the few institutions in the country that can boast such a record over as long a period of time.
For most of its history, it has had a very cooperative and productive relationship with the government, which unfortunately has been vitiated over the last decade or so. These depredations have also had an impact on the functioning of its top management during this period and diluted morale down the line. Given the stage of India’s development and the various uncertainties that now characterise the global economy and financial markets, it is of utmost importance that the government understands the need to strengthen its central bank and provide the kind of support that it deserves, so that the RBI can continue serving the country in the way it has throughout its history.
What would this entail? As a consequence of the various reports and panels suggesting curtailment of the RBI’s functions, an impression has grown over the last decade that the government and the RBI function as adversaries, leading to decreasing confidence in the authority and competence of the RBI. Whereas actions must be taken to foster a more cooperative relationship between the government and the RBI, there is a simultaneous need for strengthening the latter’s independence. Public airing of differences in key policy areas should be eschewed as far as possible. There will always be tensions between the government and the RBI in view of the different roles that they perform. Vigorous and contentious discussions between the two have always taken place but in an atmosphere of mutual trust and respect.
This must be restored. The public and markets need to be reassured that the RBI enjoys full confidence of the government. There should be clear articulation from the government of its continued support of the RBI as a full service central bank, and that it intends to strengthen its various functions as the key financial sector regulator and supervisor. This could, inter alia, include formalisation of the Board of Financial Supervision as the key body in charge of financial stability, continuation and strengthening of the Board for Payment and Settlement Systems as the key regulator for these systems, and continued functioning of the RBI as the government’s fiscal agent and debt manager.
The governors and deputy governors in most central banks have tenures of greater than five years. All such appointments in India over the last decade or so have been restricted to three years, even though the RBI Act permits tenures of up to five years. Since monetary and regulatory authorities need to have longer time horizons longer tenures promote better decision-making and also more confident exercise of independence. On its part, the RBI must demonstrate improved technical competence and performance to earn the kind of independence of operation that it should have.
fellow, Jackson Institute for Global Affairs, Yale University, and distinguished fellow, Brookings India