The full implications of the revisions in the RBI’s Economic Capital Framework
(ECF) recommended by the Bimal Jalan- chaired committee will be better understood after the release of the FY19 (July-June) RBI annual report. The following is based on the known RBI FY18 results.
The broad contours of the ECF and transfer are as follows. The RBI will be transferring Rs 1.76 trillion to the government, comprising Rs 1.23 trillion of surplus (dividend) earned in FY19 and another Rs 0.53 trillion deemed to be provisions in excess of the norms based on the changes in the revised ECF (the prior norms were based on the 2013 Malegam Committee recommendations). The Rs 1.23 trillion surplus includes the interim dividend paid by RBI in March 2019. Net of this, this is about Rs 0.5 trillion more than the widely quoted (but not official) estimate of a budgeted Rs 900 billion dividend payment from the RBI. Adding the excess provision will give the centre an additional Rs 580 billion.
Rationalising this excess provision is difficult. The release was on the basis of a change in the various methodologies and metrics. The first is a shift from the existing use of stressed value at risk (VaR) for measuring RBI’s market risk to adopting an expected shortfall (ES) method. While an explanation of the implications of this shift is best left to risk analytics experts, the intuition is as follows. Paraphrasing John Hull, VaR asks the question, “how bad can things get”, ES (also known as conditional VaR) asks, “if things do get bad, what is the expected loss?” While shifting, the committee has adopted a more stringent confidence level of 99.5 per cent compared to general central banks adoption of a 99 per cent level.
The second major change is in the surplus distribution policy, which is now to be based on the ‘“realised equity” level within the overall economic capital, rather than the economic capital alone. This realised equity consists of the profits from actual sale of assets plus the interest and dividend the RBI earns from the securities it holds, and which contributes to the cumulative retained earning “referred to as the Contingent Risk Buffer”.
To make sense of these concepts, the following is the published RBI balance sheet as of June 30, 2018. RBI’s capital plus reserves (including payment of dividend to the government) was Rs 10.46 trillion, or about 28 per cent of the total assets. Of this, the contingency fund (CF) was Rs 2.32 trillion (6.4 per cent of assets), representing a “rainy day” fund of specific provision made by RBI. The remainder mainly consists of revaluation accounts as RBI’s foreign and domestic assets are marked to market (MTM) and fluctuate in value with interest and exchange rates. Within this, the Investment Revaluation Account (IRA) on INR securities is Rs 0.13 trillion. The Currency and Gold Revaluation Account (CGRA) is Rs 6.92 trillion (19.1 per cent of total assets), accounting for MTM on foreign currency and gold assets. The CGRA is created so the balance sheet matches when foreign exchange (fx) reserves are restated in INR. Essentially, these represent valuation of reserves held from point of purchase. Under the RBI’s accounting policy, revaluation gains on currency and bonds is not considered as capital, and is only seen as an accounting entry (consistent with BIS norms). Broadly then, if somewhat incorrectly, realised equity (RE) is RBI’s P&L and economic capital is RE plus the MTM component of the balance sheet.
Regarding the potential implications for the centre’s fiscal outcomes, if the excess transfer is used for bridging a tax revenue shortfall, the broad contours of spends in the Budget will be maintained. If, on the other hand, budgeted revenue targets are met, the transfer can be used to craft a stimulus response. Projections of various revenue streams using the run rates of April-June FY20, with an expectation of some improvements in H2, tax revenues (net to centre after transfers to states) is expected to be about Rs 0.7 trillion short of the Rs 16.5 trillion, and disinvestment revenues by about Rs 0.25 trillion short. The additional Rs 0.58 trillion from the RBI, plus a potential further interim dividend in late FY20, can cover any potential tax revenue gap.
The other effect will be on system liquidity. While the system has been in surplus since late June 2019, it is expected to revert to a deficit in late Q3 FY20, although the deficit is unlikely to be as severe as last year. Transferring the surplus to the government in one go can help in paying the upfront Rs 700 billion recapitalisation of PSBs without having to take recourse to WMAs or cash management bills. Factoring in an interim dividend payout of around Rs 350 billion, the transfers will add around Rs 900 billion to current liquidity levels. Given our shallow liquidity deficit forecast prior to the proposed transfer, this implies that the system will now be in surplus for most of even H2 FY20, with implications for transmission to lending rates.
Will the excess provision for RBI’s FY19 be more of a one-time transfer, or can the methodology changes permit continuing payments in the next few years? The RBI’s economic capital was 23.3 per cent of its balance sheet as of June 2019, relative to the range suggested by the revised framework of 20-24.5 per cent. Financial resilience conditions in future will determine the extent of transfers feasible. Moreover, we do not expect RBI’s balance sheet to grow as much in FY20, given little or no OMOs buys, fx swaps and more moderate build-up of forex reserves.
The author is chief economist of Axis Bank. Tanay Dalal contributed to the article. Views are personal.