Explainer | The key bone of contention between govt and RBI – money

There are several contentious issues underlying the tussle between the government and the Reserve Bank of India. The government wants the central bank to relax rules for weak banks, to dilute disclosure norms for defaults, open a liquidity window for NBFCs and pay the government a higher dividend. The last of these issues –the surplus the RBI generates or the amount of capital it has in its balance sheet – is perhaps the most important as it can weaken the central bank.

Here’s a short explainer around the issues involved.

How does RBI generate a profit?

The RBI earns an income from interest on holding of securities, the net interest it earns from its liquidity operations, interest from deposits held with foreign banks etc. The central bank deducts its expenditure – mainly for printing currency notes, and maintaining its operations – to generate a surplus. This surplus is generally transferred to the government as a dividend.

In some years, it also sets aside money for a so-called contingency fund. This has the effect of decreasing its surplus, and thus the dividend transferred to the government. In recent years, the RBI’s dividend transfer to the government has fallen short of government expectations – because of transfers to the contingency fund –  leading the Centre to demand more from the central bank.

What is the contingency fund and why is it important?

The contingency fund is meant for meeting unexpected and unforeseen contingencies such as a rapid depreciation in the value of securities the RBI holds, risks from exchange rate policy operations etc, or risks from an unexpected event like demonetisation. The contingency fund, along with other RBI reserves such as asset development fund, and currency and gold revaluation reserve form an important part of the RBI balance sheet. They add to the RBI’s arsenal to meet unexpected disruptions and provide comfort and confidence to global investors.

So, what’s government upset about?

It has been the government’s contention that the RBI holds excessive capital, that it need not hold so much money in its reserves. It is upset that the RBI chose to transfer money to the contingency fund in the last two years even when other expenses such as printing costs have been high and thus reduce the dividend it gets. There have been questions raised about the need for such transfers. Former Chief Economic Advisor Arvind Subramanian said RBI is one of the most highly capitalised banks in the world and these excess reserves can be used to recapitalise public sector banks.

How does one decide whether the RBI has excessive capital?

That’s a tricky question to answer. As former deputy governor Rakesh Mohan wrote recently, theoretically, a central bank can operate with below zero levels of capital. But in practice, it stands to lose credibility and risks missing its objectives with low capital levels. Currently, RBI holds around Rs 10 lakh crore as provisions (revaluation reserves, contingency fund and asset development reserves), which amounts to 28 percent of its balance sheet. This, according to Arvind Subramanian, is well above the average for central banks. However, the revaluation reserve is dependent on currency and gold movements and cannot be played with. As far as the contingency and asset development funds are concerned, are just 7 percent of RBI’s balance sheet compared to 9.2 percent in 2014.

What happens if the government forces the RBI to part with its reserves?

Experts say it would be an imprudent move. Firstly, it is a bad idea to use funds built over several years to be transferred to the government in one shot to help it meet the fiscal deficit target.

Secondly, how would this work? These reserves are a liability of the RBI. If it transfers money from the contingency fund to the government, it is in effect reducing its stock of government bond holding. That would reduce its interest income. As Rakesh Mohan points out, over time, there would be no new government revenue because of this fall in securities holding. Thirdly, it will erode the credibility of the central bank as well as its ability to meet contingencies. Fourthly, it also erodes the credibility of the government, especially its commitment to fiscal prudence. Fifth, even if the funds were used to recapitalise public sector banks directly, it could create a conflict of interest with RBI owing stakes in the entities it regulates

If the govt takes the capital, can’t it give it back?

Theoretically, the government can recapitalise RBI. But in a developing economy with an already high fiscal deficit, it would be difficult, as can be seen from the track record with public sector banks.