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RBI Dividend and Your Father in Law

100,000,000,000,000 INR! For those lost in the zeros, it is ten lakh crores. That’s the RBI’s stated equity position, which GOI believes is too high and wants some of it transferred to government. But RBI believes otherwise, leading to numerous committees earlier and now with the Bimal Jalan committee, being the latest one.

Why the government is suddenly so insistent on getting a pie of it?

To really appreciate it, think that you have taken a home loan of 1 crore for which you are paying hefty EMI which has constrained your ability to spend on a few items which are in your priority list (say upgrading your car, going for a European vacation or maybe some nobler purpose). Now, you suddenly realize that your FIL (father in-law) has a large emergency fund which you can coax him to part with, at least partially. Will you not feel a little greedy to get a hand on the same? The chance to pare off a large part of debt is so alluring at times. It is even more tempting when it comes easy!

The same is with our government. They have a debt or rather say a constraining factor on their ability to spend and that is fiscal deficit. India’s fiscal deficit stood at INR 6.45 lakh crore (3.39% of GDP) by end of fiscal year Mar’19 and it is rising since then. Compare that with RBI surplus fund of 10 lakh crore and hope you can understand why GOI is after RBI’s life. The surplus is just to be taken and requires no grand effort from GOI other than pursuing fervently with RBI.

Now is greed always bad? Is the government unjustified to claim a part of the surplus?

Coming back to our original comparison, there are two questions that needs answers. Does the FIL really need to maintain such a fund? Is the emergency fund maintained by your FIL too high? If so, technically then you can stake claim saying that you can use that fund more productively as you have more wherewithal’s with you e.g. invest in stock market to get better return, buy some luxuries for her daughter and so on. You can also convince him saying that if need arises, you will always be at his side and provide necessary funding. Question is whether your FIL thinks likewise.

There are two parts to the answer, one is technical and other is intent. Let us look first at the technical piece.

Why such a fund is required to be maintained by central bank and Is the emergency fund aka RBI surplus too high?

Good news is that first question has somewhat very clear answer, but the bad part is that the 2nd question has no straight answer. Let us first look at RBI’s own stated position w.r.t surplus and then we will see how a few other central banks handle the same issue.

  1. “…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 Annual Report FY1718)
  2. “The RBI Board has decided it wants the RBI to have an international AAA rating so that RBI can undertake international transactions easily, even when the Government is in perceived difficulty…. Based on sophisticated risk analysis by the RBI’s staff, the Board has decided in the last three years that the RBI’s equity position, currently around 10 lakh crores, is enough for the purpose.” (Raghuram Rajan in his speech at St Stephen’s College on his last days at office, 3rd Sep 2016; https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1021)

Internationally also, it is well recommended for central banks to retain a %age of its net profit as capital buffer. ECB (European Central Bank) occasional paper (Series # 153) states “In a nutshell, the empirical evidence seems to confirm that a weak financial position is not an optimal situation for a central bank because it could constrain policy actions and it might affect its credibility. In contrast, a sound capital base increases financial strength and the trust of market participants in a central bank’s policies”.

Question is how much is good enough? Let us first look at key points.

  1. The 10-lakh crore/ 10 trillion that RR (Raghuram Rajan) speaks off, primarily consists of Contingency Fund (CF), Asset Development Fund (ADF) and different Investment revaluation reserves (CGRA, IRA). From contribution perspective nearly 70% comes from CGRA, 25% from CF and remaining from paid up capital and rest (e.g. IRA etc.) (as per 2018 AR; it can change YoY depending on price movement, exchange rate movement etc. which influences the CGRA and IRA kitty)
  2. CF and ADF are set aside from yearly income and shown as ‘Provisions’ under Income Statement.
  3. The comparability with other central banks is a little impaired as different accounting process is followed across banks. For e.g. in case of RBI, unrealised gains/losses on valuation of Foreign Currency Assets (FCA) and Gold are not taken to the Income Account but instead recorded in the balance sheet under ‘Other Liabilities & Provisions’ while Bank of Japan, Banco Brasil records the same under Income statement. Hence for the later two, the net profit that is transferred to respective government is after the asset price fluctuation has been adjusted to the income.
  4. Still some comparison can be made! BOJ calculates Capital Adequacy ratio as [Provisions + Capital]/ Annual average of bank notes issued, where provisions are for possible losses. For BOJ it is around 8.09% (BOJ AR FY18), the same redone for RBI stands around 55%. In a different comparison, the 10 trillion INR is ~ 25% of total balance sheet size of RBI, which for BOJ on a similar comparison is around 1.6%. Same done for Banco Brasil (AR FY18), reflects 51% and ~4% respectively. A look at financial statements of other central banks e.g. Canada, Ireland, US reflects that RBI safety net seems to be on higher side
  5. This provisioning amount is not cast in stone and can change. Quoting from Fed Bank USA AR 2018 “For the year ending December 31, 2017 and through February 8, 2018, the aggregate surplus limitation was $10 billion. On February 9, 2018, the Budget Act reduced the aggregate surplus limitation to $7.5 billion…. On May 24, 2018, the Economic Growth Act reduced the aggregate surplus limitation to $6.825 billion”. Even for RBI, we have seen a dip in the CF+ADF that is provisioned as %age of total balance sheet size. From FY1314 figure of 9.2%, it stood at 7.05% in FY18. That explains why it was able to release 200 Billion INR more to GOI as dividend in FY1718 vs. FY1617. But GOI is eyeing a bigger piece!

The greed can be justified from the fact that government is much better placed in managing the utilization of such a fund compared to RBI, which has much narrower focus. Unfortunately, here is where the fear of RBI comes in and intent of government is somewhat questioned.

The fear within RBI is that lack of financial strength will impinge on its independence in discharging its primary duty around monetary policy. To quote RBI, “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).

A few considerations will make it clearer:

  1. What happens when the Government is also under fiscal stress during economic crisis (more likely) and whether it will invariably provide the necessary recapitalization/ fiscal support to RBI at time of need. With Indian government always running in budget deficit mode, which only deepens during depressed economic condition, can it be depended on? Will it not compromise RBI’s ability to effectively address monetary policy issues and thus causing a graver danger to the country?
  2. Secondly, can the above compromise the central bank independence? For example, under political compulsion, it can raise possibility of the center/ GOI trying to influence policy decision for short term gains and compromising long term stability/ economic performance.
  3. Thirdly, lack of financial strength can also lead to credibility issue and correspondingly impair RBI’s 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)

Also, that money at hands of government is better utilized can’t be taken for granted. For e.g. growth of Government spending as %age of GDP hit a maximum (13.1% QoQ) in Q4 of fiscal year FY1819. That the election was due and spending necessary is unlikely a coincidence. Recent events around allegations of trading of a four-legged animal in & around Karnataka has also raised noises around who is funding and where is the money coming from. We are not casting aspersions but wonder whether there is any great sense in impinging on RBI considering that the later has done a great job with its monetary policy.

Coming back to our earlier comparison, let me clarify on why it was apt. The FIL believes that given his condition & circumstances, his emergency fund is just the right amount to make him feel safe and comfortable, but you don’t trust him and believe otherwise. On the other hand, you are looking for quick fix that can pare your debt without much effort and believe FIL is being extra cautious leading to sub optimal usage of the money. But the FIL does not trust you enough that you will take care off him, when things go south. This epitomizes the current situation between RBI and GOI, fear on one side and greed on the other and at the core lies trust deficit!

Many are looking forward to the latest Bimal Jalan committee to resolve this issue once for all. I do suspect, after all this analysis, that it may allow release of some more funds as dividend back to GOI and it may happen in phases to cushion RBI’s resistance. The bigger interest will be served if the committee is able to create a clear framework/ rule on RBI risk provisioning so that this question is resolved once for all. There were three previous committees and it is a sorry state that despite that, the issue sustained. To end, let me echo what RR mentions in his last speech as Governor, “…. the RBI Board has adopted a risk-management framework which indicates the level of equity the RBI needs, given the risks it faces. The dividend policy of the RBI then becomes a technical matter of how much residual surplus is available each year after bolstering equity. Frameworks thus reduce the space for differences.”

As for your tussle with your FIL, I can only hope for peace and better sense at both sides! Can’t say more or else I stand to prejudice my own case as there is a ‘I’ in that ‘you’ as well!!!

Disclaimer:

The representations made in any article are the views of the author and not of the company he works. The views are made in his personal capacity and all opinions personal.

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