Modi’s war on RBI

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Published: Sunday, 11th November 2018

As the RBI and the government prepare for a crucial meeting of the RBI board on November 19, the discussions have boiled down to one critical question, and it carries a Rs 3.6 lakh crore tag. This is the amount of money the government wants the RBI to transfer as dividend or surplus. The pressure is not new; it has been on for a while but has an air of a definitive conclusion this time. This is creating the fear and the worry of government interference in the functioning of RBI crossing all boundaries, leaving the helpless central bank with no option but to react keeping in mind the advisory role it has to play. This was reflected in RBI Deputy Governor Viral Acharya’s speech on October 26, the content of which is truly educative for the government. The government should seriously reflect on the advice and work sensibly as the owner of the RBI. The right of ownership should not be misused to invoke Section 7 of the RBI Act, 1934.

The burning issue that has surfaced is the demand for transfer of Rs 3.6 lakh crore (about $48 billion) “surplus” (dividend transfer) from RBI to the government. That is nearly six times the surplus already transferred in 2018-19. Why does the government want the money? Since the government claims that it is on track to maintain its targeted fiscal deficit during 2018-19, one may hazard a guess that the government wants the money to recapitalise public sector banks.

In a functional tussle between RBI and the government, the government is always the winner. But more than 80 years of history shows that though the governor and his deputies are government appointees, following the rich tradition and culture of central banking, they invariably keep in mind growth, macro-economic stability and financial stability. This perforce can place them in positions or views that are different from that of the government. In the ultimate analysis, what RBI has on its priority list is non–inflationary growth with financial stability, and this does not conflict with the overall economic policy objective of the country. The government should understand this basic philosophy before it is too late, as Acharya has cautioned in his speech.

The burning issue that has surfaced is the demand for transfer of Rs 3.6 lakh crore (about $48 billion) “surplus” (dividend transfer) from RBI to the government. That is nearly six times the surplus already transferred in 2018-19. Why does the government want the money?   

Since the government claims that it is on track to maintain its targeted fiscal deficit during 2018-19, one may hazard a guess that the government wants the money to recapitalise public sector banks. Consider the following: 1. Since 1997, automatic monetisation of government deficit, that is, printing money to finance government deficit has been abolished; 2. Since 2006, the RBI is prohibited from participating in issuing government securities, as required under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003. The two together ensure functional autonomy to the RBI because the government cannot borrow, directly or indirectly, from the RBI under the rule-based fiscal system.  It can only take recourse to ‘ways and means’ advances to manage temporary cash mismatches; 3. This has to be seen in conjunction with the fact that foreign assets form the major share of RBI assets in the balance sheet. The combined effect of these three is that the seigniorage (profit made by issuing currency, especially the difference between the face value of the notes/coins and their production cost) from the RBI has been declining relative to GDP. The clamour for higher dividend from RBI is an outcome of this.

Making the fiscal authority (government) stronger in the sense of making the capitalisation bonds fiscal neutral and by that process making the monetary authority (the central bank) weaker in a globalised world will be viewed as a retrograde step. Modern central banks are not involved in such transactions. It is bad fiscal management and worse monetary management.

The transfer of surplus is a function of the RBI’s income and expenditure, after adjusting for the fluctuation in reserves account (which accounts for fluctuation in value of currency reserves, known as valuation reserve account). The valuation reserve account draws from the contingency fund (which has the free reserves) to make up losses in currency valuations, while profits accrue to surplus. The contingency fund in itself has been reduced over the years from 12% to 6% of the total foreign currency assets of the RBI.  Since the 2018-19 transfer has already been completed and the balance sheet has been finalised, there is no scope legally from the accounting angle to reopen and transfer any further amount.

One option for interim dividend transfer could be by liquidating either the domestic assets and/or foreign assets of the RBI. The selling of domestic assets (which essentially are investments in government securities) in the domestic market will adversely impact the bond yield and, when the cash is transferred to government and the government spends it, it can potentially push up inflation. Similarly, if foreign assets are liquidated and equivalent rupee resources are created by printing money, there will be an adverse impact on the exchange rate and the interest rate, with the added disadvantage of an inflation threat. If the money is used to recapitalise banks, it will still be an expenditure of the government matched by equivalent receipts transferred from the RBI. This will be deficit neutral on the books of the government. A view has to be taken whether it is a good measure to weaken the RBI balance sheet and strengthen the banks. Making the fiscal authority (government) stronger in the sense of making the capitalisation bonds fiscal neutral and by that process making the monetary authority (the central bank) weaker in a globalised world will be viewed as a retrograde step. Modern central banks are not involved in such transactions. It is bad fiscal management and worse monetary management.

Notwithstanding the purpose for which the government is asking RBI to transfer Rs 3.6 lakh crore to it, such a transfer will have adverse macroeconomic consequences, apart from weakening the RBI balance sheet. It is true that government owns the RBI, but not heeding the sane advice from the RBI will have not only immediate consequences but will also end the functional autonomy of the RBI, a loss that will be far greater in the long run.

 The critical question is the composition of our foreign assets. India being a current account deficit country, the foreign assets are not from current account surplus. Thus, the forex accumulation has been done through net capital flows. The bulk of the flows are debt flows from external commercial borrowing, NRI deposits, trade credit, etc. We are a net liability country in our international investment position and, as at end-June 2018, the net liabilities amounted to $408.4 billion. About 49% of our external liabilities are in debt.  Short-term external debt with residual maturity (all forms of debt maturing within one year) accounted for 54% of forex reserves and 54.3% of total external debt. In view of this vulnerability of our external position, should RBI liquidate close to $50 billion in forex reserves and hand it over to a government approaching elections? Even if these reserves come from accounts other than the contingency fund, they still signal a weakening of the central bank and will limit its maneuverability in the volatile global conditions that rule the world.

One important conclusion emerges from all this. Notwithstanding the purpose for which the government is asking RBI to transfer Rs 3.6 lakh crore to it, such a transfer will have adverse macroeconomic consequences, apart from weakening the RBI balance sheet. It is true that government owns the RBI, but not heeding the sane advice from the RBI will have not only immediate consequences but will also end the functional autonomy of the RBI, a loss that will be far greater in the long run.

(The writer is a former central banker)