Reserve Bank without its Reserve

Reserve Bank without its Reserve

 

This is not the best of times for an economist to don the mantle of the governorship of the Reserve Bank of India. Whether it is the worst of the times- that only future can tell. Be that as it may, the public spat between the political executive and RBI management needs an objective assessment of their respective positions.  Whether RBI needs more or less autonomy is an issue that can be debated “ad nauseam” but the facts need to marshalled and evaluated before the central bank gets pilloried on the altar of political expediency.

The issues in dispute are quite clear. Firstly, per the estimation of the central government, RBI’s reserves are way above the prudential level that is required to be maintained in accordance with the international best practices.  The sovereign, being the owner, has legitimate claim on the excess reserve which must be transferred to the government on demand. It is rightly argued that a central bank has two primary sources of income, namely seigniorage and a tax on the banking system. The authority to collect seigniorage and tax revenue always rests with the sovereign. RBI earns these incomes only as an agent of sovereign. Other incomes of a central bank, at least most of them, are returns on investments made out of these two incomes.

The second issue clearly falls within the statutory remit of RBI.  In 2002, RBI introduced a supervisory framework called Prompt Corrective Action (PCA). Under PCA,   RBI has identified 3 parameters, namely capital to risk weighted assets ratio (CRAR), net non-performing assets (NPA) and return on assets (ROA) and has specified certain thresholds for each of them. RBI can initiate, at its discretion, punitive action against any commercial bank, found in breach of these thresholds. A bank under PCA faces severe restriction on sanctioning of new credit to borrowers below certain rating grades. Today 11 public sector banks are under PCA.  RBI has also tightened the extant rule for classification of NPA. In 2001, RBI had allowed certain relaxation in classification norm for loans under corporate debt restructuring mechanism.  This forbearance was withdrawn with effect from April, 2015. Through another circular issued on February 2018, RBI has made it mandatory to initiate a resolution plan for stressed asset as soon as a loan gets classified as NPA. There has been huge outcry from corporate borrowers as well the government demanding relaxation of the stringent norms specified in this circular. It has been argued that RBI’s rigid approach is starving the real sector of much needed credit.

Let us first take up the issue of transfer of fund from RBI reserves to government.  Any transfer would entail a corresponding sale of asset. As on June 30, 2018, 73% of RBI’s assets were held in foreign currencies. Sale of domestic assets would immediately suck liquidity out of the market, putting upward pressure on yield- obviously not an outcome desired by the government.  So the only option available to RBI is to sell foreign assets. RBI’s foreign assets are recorded in two separate books of account, namely that of issue department and banking department. The foreign assets recorded in the book of issue department are maintained as backing of RBI’s monetary liability. A dilution of this backing would severely undermine people’s trust in Indian currency. So it can be safely presumed that the government would expect reserve fund transfer by sale of foreign assets of the banking department. As on June 30, 2018, the foreign assets of the banking department stood at around 8 trillion INR or 117 billion USD. How large is this reserve? The following table gives various indicators of a reserve’s adequacy.

Table 1: Adequacy of Foreign Exchange Reserve of RBI

Sr. No Particulars 2016-17 2017-18
1 Forex asset of Banking department of RBI (in billion  INR) 9320 7984
2 The amount at 1 in billion USD* 144 117
3 Banking Departments Forex asset as% of Short term external debt 163.7% 114.2%
4 Banking Departments Forex asset as% of Yearly Import 0.04% 0.03%
5 RBI Balance sheet size (in billion INR) 33040.94 36175.94
6 RBI BS in billion USD 511.31 528.89
7 External liabilities (billion USD) 905 1037.3
8 6 as % of 7 56% 51%
9 RBI BS to Indian  GDP 22.5% 20.3%
  • RBI balances are as on June 30.
  • Using June 30 exchange rate.

It is apparent from the above data that the discretionary component of RBI’s foreign exchange assets has registered a significant decline during the accounting year 2017-18.  The coverage of India’s short –term external debt by RBI’s discretionary foreign assets has also declined significantly during 2016-17.  At the end of December 2017, the banking department’s forex asset formed only 53.9% of India’s external liability on account of portfolio investment.  The portfolio investment is very sensitive to the interest rate changes in USA as  it affects risk adjusted dollar rate of return on investment.  High redemption of portfolio investment would put pressure on USD-INR rate and RBI has to ensure a smooth and calibrated movement in the exchange rate. Given the declared policy stance of US FED, RBI can ill afford to be complacent about the adequacy of its foreign exchange reserve held by the banking department.  Thus any liquidation of RBI’s foreign exchange assets to finance transfer of fund to the government would be a criminal dereliction of fiduciary duty that RBI is entrusted with.

As regards adequacy of capital of central banks, it would be wrong to compare a central bank with commercial banks. For a commercial bank, the capital is the last buffer between solvency and insolvency, absorbing losses as they occur. For a central bank, this is ruled out by definition. As long as the domestic public is ready to hold central bank currency, there is no outside limit to a central bank’s power to create domestic liquidity. The recent “quantitative easing” policy of US FED and some other OECD countries is a testimony to this power of central banks.  However, a central bank has no inherent power to create foreign currency liquidity.  A central bank of an emerging market economy like India needs to build up foreign exchange reserve to assure foreign lenders/ investors about the capability of the bank to defend the value of central bank currency. Although “central banks need not have capital nor even positive net worth to function in a technical sense” ,loss of trust in central banks may lead to hyperinflation and  downgrading of country rating. Central banks of many advanced countries maintain very little capital, despite having a very strong balance sheet. Since these countries are financially strong enough to borrow in their own currencies internationally, there are no economic compulsions for the central banks of these countries to maintain a high capital to asset ratio. But for emerging market economies external currency risk can be a binding constraint on a central bank’s ability to maintain stability of the financial sector.

The following tables provide a cross-country perspective about how central banks of other emerging countries are managing their balance sheet in regards to its size and currency composition.

 

Net Foreign Assets of Central Bank as % of Total Assets of Central Bank Central Bank Asset Size as % of GDP at market price
Country 2016 2017 2018 June 2016 2017
Indonesia 75.0% 76.0% 73.5% 16.4% 16.7%
Korea 72.2% 65.6% 66.6% 29.3% 27.2%
Malaysia 90.4% 91.4%   36.6% 33.6%
Mexico 92.5% 89.6% 94.1% 19.5% 17.4%
Brazil 41.3% 39.9% 42.9% 45.7% 46.8%
China 99.3% 99.2% 99.5% 0.3% 0.3%
Thailand 89.5% 86.4% 84.8% 46.3% 47.6%
Russian Federation 72.7% 73.2% 75.1% 35.7% 36.2%
South Africa 77.7% 78.3% 78.8% 18.0% 16.1%

 

Based on above data, it would be difficult to argue that RBI is pursuing an overtly conservative policy in regard to managing its balance sheet size and composition. For a country like India, where the commercial banking sector is largely owned and controlled by the government, capital adequacy of a central bank alone is of little consequence.  If both the central bank and public sector banks are owned by the government, then capital adequacy has to be assessed at the consolidated level rather than at stand-alone level.  In the absence of such a consolidated balance sheet we can look at a surrogate measure namely, capital adequacy at the consolidated banking sector level. The BIS data, given below, in this regard is quite revealing.

 

Country Total Equity ( Asset-Liability) of the banking sector  data as on June 2018
India 0.52%
UK 6.97%
USA 12.00%
France 6.35%
Germany 6.59%
Italy 8.15%
Ireland 8.46%
Canada 6.27%
Turkey 11.32%
Spain 7.96%
Australia 7.20%

It is obvious that Indian banking sector is lagging way behind the banking sector of developed countries in respect of capital adequacy. In fact, the government must be made to understand that undercapitalization and not over capitalization is the bane of the Indian banking sector. Any debate on optimal economic capital for RBI would be an exercise in futility unless the broader problem of undercapitalization of the government owned commercial banks is addressed.

As regards the second issue of adoption of PCA framework and a revised stress asset resolution framework by RBI and its stringent implementation by RBI, it can be argued that regulatory forbearance cannot be discretionary otherwise it would led to a chaotic and arbitrary regulatory regime.  If dues on a loan are not paid in time, there is a 90 day window available to the lender as well as the borrower to prevent the loan being classified as NPA. To ask RBI to be flexible about period this 90 day period would be a travesty of regulatory rule making. A rule becomes rule only when it is enforced.  Any deviation must also be specified and allowed under the rule itself. A regulator would turn out to be a toothless tiger if it makes rules and then allows it to be broken by regulated entities as they please.

Although it is too early to say whether a future Dickens will describe the current time as the “age of wisdom” or “age of foolishness”, central banking in India today stands at a historical cross-road.  Either it will carry the can to the darkness of ignominy or it will uphold the high standard of professional integrity that is expected from an Institution created for this purpose.



Comments

17 responses to “Reserve Bank without its Reserve”

  1. Dr. S. S. Satchidananda avatar

    An example of clarity in thinking and data driven approach to a vexatious issue ! Enjoyed reading this timely and insightful blog and would like to recommend it to our Hon’ble FM and his cohorts !

  2. Dr. S. S. Satchidananda avatar
    Dr. S. S. Satchidananda

    A timely and insightful data-driven analysis ! I’d recommend this to our FM and his advisors !

  3. CSH Tiwari avatar
    CSH Tiwari

    Thank you Sir. Your analysis are well elaborated and convincing. GOI should take these prudent aspects in consideration before displaying their Street Smartness while dealing with RBI’s stand.

  4. Mauricio Sawina avatar

    Thanks , I’ve recently been looking for info about thistopic for a long time and yours is the greatest I havediscovered till now. But, what concerning the conclusion? Areyou sure in regards to the source?

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  6. Ram Karan Singh avatar
    Ram Karan Singh

    Earlier, I mean much earlier say prior to 1990 or even 1980, RBI was functioning silently without being or generating any news for common public, but in the wake of adoption of new economic policy (LPG) it has become almost necessary that RBI should make an arrangement for responding to the questions doubts etc. emanating from any corner. After going through the above post I feel compelled to revise my own opinion on the subject. Since I was retired 16 years ago, I had no opportunity to know the nature of assets created with the reserve with RBI

  7. […] its Foreign Exchange Reserve. In my earlier blog post I have provided the relevant numbers for RBI (here) . In this post I want to dwell on the IMF framework for assessment of FOREX reserve of a central […]

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