It’s funny! RBI has paid 500 Billion INR to GoI in FY1718, which is nearly 200 Billion INR more than FY1617, but the government says ‘Dil Mannge More!’. RBI already transfers the entire surplus to government after setting aside part of net income as provision for ‘rainy day’; so, what more RBI can do? Should it tap into its capital to satisfy the government which is hungry for any money that can come in to reduce the budget deficit? Or isn’t a fact that governments are better placed for optimal utilization of capital compared to the central banks!
There are 2 questions to ponder!
- Is it legitimate for RBI to set aside part of net income as provisions and deny government a better payout?
- Is it legitimate for Government to make such an ask?
To answer the above, we will first try & understand why RBI sets aside buffer, how a few other central banks behaves and whether the buffer is optimal at current level.
Primarily, many central banks prefer to maintain a buffer to mitigate against potential balance sheet losses which may impair the central bank ability to effectively intervene during crisis. During such crisis, ‘due to measures undertaken to stabilise financial markets such as the provision of emergency liquidity to the banking sector or large-scale securities purchases, exposes the central bank to credit, interest rate and exchange rate risk’ (European Central Bank, Occasional Paper Series #153)
RBI, in its annual report reiterates the same ‘It is in the public interest that a central bank should continue to perform its public policy functions effectively even during times of extreme stress. A central bank, therefore, requires a minimum level of confidence regarding its financial strength and the resources at its disposal which will allow it to effectively discharge its functions even during crises’ (RBI AR FY1718).
But one may argue that fiscal support/ recapitalization by government/ state in case of need to the central bank is default by virtue of the inherent ‘State/ Government’ ownership of central banks. There are a few weaknesses in that argument.
- What happens when the Government is also under fiscal stress during such time and whether it will invariably provide the necessary recapitalization/ fiscal support at time of need. With Indian government always running in budget deficit mode which only deepens during depressed economic condition (as is currently), can it be depended on?
- Secondly, can the above result in compromise the central bank independence? For example, under political compulsion (especially when national elections are around), can it raise possibility of the center trying to influence policy decision for short term gains and compromising long term stability/ economic performance?
- Thirdly, lack of financial strength can also lead to credibility issue and correspondingly impair its ability to implement monetary policy effectively. Several studies had concluded that “Losses or negative capital may raise doubts – however erroneous – about the central bank’s ability to deliver on policy targets, and expose it to political pressure”. Similar studies had noted that counterparties may become reluctant to deal with a technically insolvent central bank, with such a scenario potentially affecting a central bank’s ability to implement monetary policy. (Assessing the Financial Risks and Buffers of the Central Bank, Quarterly Bulletin, Central Bank of Ireland)
While the need for maintaining the buffer, the amount of buffer, the accounting for it and treatment of surplus does not follow a standard protocol across the central banks. The following table provides a snapshot.
The table list the central bank, the country, details on contingency/ provisions, how unrealized gain/ loss is treated and the treatment of surplus fund. Please note that any reevaluation reserve (parking for unrealized gain/ loss from price fluctuation of FCY/ Gold etc.) is generally not considered as ‘financial buffer’ as that can get wiped out suddenly by any price fluctuation and hence is not a dependable measure.
As note above there is no single standard for accounting that central banks follow across the globe and policy on surplus/ contingency fund is also varying. While RBI maintains contingency fund as buffer, Brazil central bank does not maintain any such buffer but accounts for unrealized gain/ loss in income statement which allows it to draw from Treasury if the price fluctuation erases BCB’s income. Hence, a lot depends on the risk transfer mechanism that is established and perhaps, also on the trust that exists between the central bank and the government. Since, Brazil has right to get covered from Treasury in event of any loss in P&L without any intervention (perhaps!). Ireland central bank, on other hand, sets aside 20% of profit normally as general reserve.
But what should be the right amount to keep as buffer? Because, by keeping unnecessary buffer also means inefficient use of funds. The government, at-least theoretically, can put such funds to better use for the nation rather than the central bank. The answer to what is the right amount, unfortunately, does not have a perfect or easy answer.
Let us look at 3 points:
- How has been the movement in the CF & ADF balance for last few years? The amount that was provided for by RBI in the income statement for last 4 years under CF (Contingency fund) and ADF (Asset Development Fund) is detailed below. As evident, the %age of CF+ADF to total assets is perhaps lowest among last 5 years and since we are not in best of economic condition, it is not best of time to be at lowest. Can RBI do safely even below 7%? That will need some more deliberation and may be a point for discussion in subsequent articles.
- How do RBI capital base compare with others? Let’s look at Japan, whose central bank provides a detailed calculation of Capital Adequacy Ratio (CAR). As per the report, BOJ stands at 8.09% and the detailed calculated is provided in the below table. If we extrapolate the same methodology to RBI’s books and then we arrive at 13.7%. We need to tread cautiously though as a developing country like India runs different sets of risks compared to a developed country like Japan and also, we are not sure whether this is the best method for calculating the CAR.
- Lastly, we look at the extent of potential buffer being maintained (for those who are retaining part of profit/ net income): If we take the FY1718 value, then RBI’s provision transferred to CF is nearly 22% of the net income (141.9 divided by sum of 500-transferred to GoI & 141.9). Compare this with 20% for Ireland and 50% of profit for BOE (but BOE resets the retained earnings in Balance sheet after post calculating comprehensive income (refer the table earlier). For BOE, retained earnings as %age of total assets stood at mere 0.4% (3033 Million Pound/ 606,813 M pound: FY18)
These variabilities due to uniqueness of each country and its economic considerations is well recognized by RBI. To quote them:
“The provisioning requirements of a central bank should be linked to a target level of financial resilience to be achieved/ maintained. In the case of central banks where the distribution arrangements result in continuous substantial transfers without considering the overall level of provisions and risk transfer mechanisms, the financial strength of the central bank may progressively weaken” (RBI AR FY18)
Now, let us come to the next question on whether it is legitimate for the Government to ask such transfer beyond what RBI has already given. Technically, RBI is one arm of the government and hence government definitely can ask for the same, but question lies on propriety of such an ask. Let us look at a few news snippets:
- “The government’s fiscal deficit touched 114.8 per cent of the full-year estimates at the end of November, stoking concerns that the gap between the target set for FY19 and the final tally could widen.” (ET, Dec 28, 2018)
- “Speculation is mounting of possible cash handouts to farmers and tax exemptions to shore up voter support ahead of polls due by May. Economists at Nirmal Bang Equities Pvt. and Kotak Securities Ltd. predict a fiscal gap of 3.5% of gross domestic product (GDP) in the year through March, compared with a targeted 3.3%.” (livemint, Jan 16, 2019)
- “A series of vote-catching measures planned by Prime Minister Narendra Modi as he braces for a difficult General Elections may cost more than $14 billion, two sources with direct knowledge of the matter said. Much of the cost of the extra spending or revenue losses would have to be borne by the government that will take charge after the election due by May.The spending is also likely to delay plans to reduce the government’s budget deficit, a key indicator of the nation’s economic health” (Business Today, Jan 18, 2019)
- “An interim dividend from RBI is the only way for them to cover these incremental expenses,” said Indira Rajaraman, a professor at the National Institute of Public Finance and a former board member at the RBI. “So the fiscal deficit will be higher than 3.3% but not a whole lot higher.” ((livemint, Jan 16, 2019)
The timing of such an ask raises the question of propriety. The above snippets question the generally accepted theory that excess fund is better kept with government for better utilization rather than with central bank. At national election time when stakes are so high, the government may not be expected to utilize the fund for long term betterment of the country but will most probably, like to utilize the same towards very short term, narrowly focused objective which not only compromises the economic health of the country but also puts the subsequent government under additional risks. The new government (irrespective of who is elected) will not only be saddled with greater deficit but also lack of any additional cushion from RBI.
Also, questions are already being asked on the sudden resignation of Urjit Patel as Governor and appointing of a non-economist & ex bureaucrat at the helm and whether that can compromise RBI independence because that would be very unfortunate as one of the main reason for central banks to maintain financial buffer is to maintain some semblance of independence/ at arm-length from the government. Recently a few ex RBI governors have pointed out that RBI is part of government and this shout of independence does not make sense but here independence means ability to discharge its duties in the right spirit & most effectively without unnecessary interventions from government. Bodies like RBI are checks & balances that ensures that effective governance is not compromised, and subjugation is not in the best interest of the nation.
As next steps on this raging controversy, we believe that the RBI & Government should jointly sponsor a study to arrive at a more scientific manner of arriving at an adequate financial buffer. It should set some benchmark which should help in avoiding such controversies in future. Obviously, such benchmark would be a range and that would give a lower figure that should be not be breached. In the interim, RBI can take a detailed look at its current buffer level and can look at only a staggered payout to GoI (spread across a few years). The amount of payout also will need to be decided based on the comfort level of RBI and also a more scientific approach to arriving at the most optimal buffer.
Central bank finances (BIS Paper # 71, April 2013)
Assessing the Financial Risks and Buffers of the Central Bank (QB 04, October 2018, Central Bank of Ireland)
Why Accounting Matters, A Central Bank Perspective: May 2014
Annual reports for:
Bank of Japan,
Bank of England,
Central bank for Brazil,
Federal Bank- USA,
Central Bank of Ireland
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