Explained: RBI transfer of ‘surplus’ to government

The Central Board of the Reserve Bank of India (RBI) decided to transfer a sum of ₹1,76,051 ($24.4 billion)  crore to the Government of India (Government) comprising of ₹1,23,414 crore of surplus for the year 2018-19 and ₹52,637 crore of excess provisions identified as per the revised Economic Capital Framework (ECF).

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Background :

Why Government wanted it :
  • The government has argued that relatively lower transfers crimped public spending for infrastructure projects and social sector programmes, considering the pressure to meet deficit targets and to provide space for private firms to borrow.
Why Central Banks(RBI) has to Maintain it : 
  • After the global financial crisis when central banks had to resort to unconventional means to revive their economies, the approach has been to build adequate buffers in the form of higher capital, reserves and other funds as a potential insurance against future risks or losses.
  • The balance sheet of central banks is unlike that of the institutions that it regulates or supervises. They are not driven by the aim of boosting profits given their public policy or public interest role.
  • Their aim is primarily ensuring monetary and financial stability – maintaining confidence in the external value of the currency, of course, is a key mandate.
  • Essentially, the economic capital framework reflects the capital that an institution requires or needs to hold as a counter against unforeseen risks or events or losses in the future.
  • A higher buffer enhances the credibility of a central bank during a crisis and helps avoid approaching the government for fresh capital and thus maintain financial autonomy.
The potential risks
  • Traditionally, central banks have been factoring in risks such as
  • Credit risk — when there could be a potential default by an entity in which there has been an investment or exposure.
  • Interest rate risk — when interest rates either move up or slide, depending on the price of which securities or bonds held by a central bank or banks can be impacted.
  • Operational risk — when there is a failure of internal processes.
  • To measure these risks, both quantitative and qualitative methods are typically used.
    • These include stress tests to evaluate worst-case scenarios such as collapse of banks, value at risk and so on.

How does the RBI generate surplus?

  • A significant part comes from RBI’s operations in financial markets, when it intervenes for instance to buy or sell foreign exchange;
  • Open Market operations, when it attempts to prevent the rupee from appreciating;
  • As income from government securities it holds;
  • As returns from its foreign currency assets that are investments in the bonds of foreign central banks or top-rated securities;
  • From deposits with other central banks or the Bank for International Settlement or BIS;besides lending to banks for very short tenures and management commission on handling the borrowings of state governments and the central government.
  • RBI buys these financial assets against its fixed liabilities such as currency held by the public and deposits issued to commercial banks on which it does not pay interest.
  • Central banks do make money thanks to seigniorage, or the profits earned by issuing currency which is passed on to the owner of the central bank, the government.
  • Expenditure: 
  • The RBI’s expenditure is mainly on printing of currency notes, on staff, besides commission to banks for undertaking transactions on behalf of the government and to primary dealers that include banks for underwriting some of these borrowings.
  • The central bank’s total costs, which includes expenditure on printing and commissions forms, is only about 1/7th of its total net interest income.

What are these reserves, how will this amount help the Central government and does this move harm the RBI?

The Reserve Bank of India (RBI) has decided to transfer ₹1.76 lakh crore to the Central government from its own reserves. What are these reserves, how will this amount help the government and does this move harm the RBI?

Where do the reserves come from?

To understand what the transfer is, we must first understand where the funds come from. The central bank has three different funds that together comprise its reserves. These are the
  1. Currency and Gold Revaluation Account (CGRA),  largest and makes up the significant bulk of the RBI’s reserves.
  2. the Contingency Fund (CF) and
  3. the Asset Development Fund (ADF).

CGRA fund, which in essence is made up of the gains on the revaluation of foreign exchange and gold, stood at ₹6.91 lakh crore as of financial year 2017-18. The CGRA has grown quite significantly since 2010, at a compounded annual growth rate of 25%.

  • The CF is the second biggest fund, amounting to ₹2.32 lakh crore in 2017-18. It is designed to meet contingencies from exchange rate operations and monetary policy decisions and is funded in large part from the RBI’s profits.
  • The ADF makes up a much smaller share of the reserves.
  • Revaluation reserve is a nominal reserve. Contingency fund is a real reserve that the RBI built up from its earnings.
  • Transfer Mechanism : It is a book entry really. There is no hard cash getting carried to Delhi from Mumbai. The RBI is the bank of the government and manages its cash anyway. So the amount is debited from the RBI’s books and gets credited to the government’s books maintained with the RBI.

How much should the RBI keep?

This has been a contentious issue. The RBI and the Finance Ministry have been at loggerheads over how much should be transferred to the Centre for a while. The most recent boiling over of tensions between the two was when the then RBI Deputy Governor, Viral Acharya, spoke up about the dangers of governments infringing upon central bank autonomy. One of the ways this was happening, he said, was in the government raiding the RBI’s coffers. The government countered that the RBI had reserves far in excess of what the global norms were and, so, should transfer the excess. Finally, the government in November 2018 set up a committee under former RBI Governor Bimal Jalan to look into the issue. That committee submitted its report, and the recent transfers have been made on the basis of its recommendations.

What did the Jalan Committee recommend?

  • The Jalan Committee, as it was called informally, is actually called the Expert Committee to Review the RBI’s Extant Economic Capital Framework.
  • The committee recommended that the RBI maintain a Contingent Risk Buffer — which mostly comes from the CF — of between 5.5-6.5% of the central bank’s balance sheet.
  • Since the latest CF amount was about 6.8% of the RBI’s balance sheet, the excess amount was to be transferred to the government.
  • The committee also decided, for the year under consideration, to use the lower limit of 5.5% of the range it recommended.
  • So, basically, whatever was excess of 5.5% of the RBI’s assets in the CF was to be transferred. That amount was ₹52,637 crore.
  • Regarding the RBI’s economic capital levels — which is essentially the CGRA — the committee recommended keeping them in the range of 20-24.5% of the balance sheet.
  •  Since it stood at 23.3% as of June 2019, the committee felt that there was no need to add more to it, and so the full net income of the RBI — a whopping ₹1,23,414 crore — should be transferred to the Centre.
  • That ₹1.23 lakh crore plus the ₹52,637 crore is what comprises the ₹1.76 lakh crore that the RBI has decided to transfer to the government.
  • It must be noted that this ₹1.76 lakh crore includes the ₹28,000 crore interim dividend earlier transferred to the Centre and does not come over and above it.
  • Recommendation on a profit distribution policy has been endorsed by the Central Board meaning a more transparent and rule-based payout from next year, as in many other central banks, which could help narrow differences between the government and RBI.

  • Under Section 47 of the RBI Act, “after making provision for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation funds and for all other matters for which provision is to be made by or under this Act or which are usually provided for by bankers, the balance of the profits shall be paid to the Central government”.

Does this harm the RBI?

  • While it does not immediately do the RBI any harm, the fact remains that the central bank now has far less wiggle room in the event of a financial catastrophe, since its reserves have been emptied to their minimum levels or thereabouts.
  • That is, it has the minimum amount to deal with a crisis, but extra cash always comes in handy.
  • That said, given that the RBI’s transfers have now been as emptied as they can be, there is no scope for the government to rely on this source of funding in the near future.
  • The government in its Budget already accounted for a transfer of ₹90,000 crore from the RBI, and so the unexpected amount is ₹86,000 crore.
  • This is a one-time bonanza and does not fix the fact that tax revenues — both direct and indirect tax — are coming in much lower than they need to.
Implications : 
Reserves are a liability side item. After the transfer, the RBI’s liability side shrinks, but the asset side remains intact. So, the RBI can sell bonds from its asset side, or some of its other assets to shrink the balance sheet. But that will suck out liquidity from the system, something that the RBI has rectified after a lot of struggle in the recent past. Instead, it can print more currencies and increase the liability side. So, the currency in circulation increases.
What happens if currency in circulation increases?
If the currency in circulation is more than the demand, then the currency loses its value. That means more inflation, and as the rupee depreciates, import cost also rises and that causes additional inflation. At a time when the RBI is officially mandated to contain inflation within a specific range, increased currency in circulation works against that goal. Surely, the RBI will have to contain it at some point.

How Will Government Benefit ?

  • Normally, the money is transferred to the Consolidated Fund of India from which salaries and pensions to government employees are paid and interest payments done, besides spending on government programmes.
  • The large payout can help the government cut back on planned borrowings and keep interest rates relatively low.
  • Besides, it will provide space for private companies to raise money from markets.
  • The RBI’s transfer of ₹1.76 trillion to the government should offset any revenue shortfall from lower tax buoyancy amid slower growth this year, allowing more room to boost spending.
  • And if it manages to meet its revenue targets, the windfall gain can lead to a lower fiscal deficit. It will also make it easier for the government to meet its budget deficit target of 3.3% of GDP for fiscal 2020.
  • The other option is to earmark these funds for public spending or specific projects, which could lead to a revival in demand in certain sectors and boost economic activity.

Criticism :

  • Statistics on Goods and Services Tax (GST) collections for 2018-19 show that there was a shortfall of ~1 lakh compare to what was budgeted. This is not a minor slippage, but a windfall loss, or rather, a misplaced windfall gain.
  • Surviving on the fiscal front via windfall gains, and faltering when they do not materialise, has been an integral part of India’s fiscal trajectory in the last few years.
  • This is unsustainable, and avoidable. RBI’s mandate is to pump-prime the economy via monetary policy, while the government has to manage the fiscal front. RBI’s extra transfer this year means it has effectively taken care of the fiscal task as well. This cannot be the norm.

Way forward :

The bottom line however remains unchanged. India’s economy has weakened in the last few years. To reverse this trend and bring ‘animal spirits’ back, government needs to unleash a new round of reforms which encompass factors of production such as land, labour and capital.
Value Addition :
Seigniorage
  •  Is the profits governments make by minting currency. It is the difference between the face value of a currency note or coin, and its actual production cost.
  • For instance, if the cost of printing a ₹2,000-note is about ₹4, printing one such note and putting it into circulation fetches a profit of ₹1,996.
  • Usually central banks ‘earn’ this profit and transfer it to the Government.
  • It is normal to assume that whenever the it issues new currency, the RBI will pocket a profit. Higher denomination notes earn higher profits.

This Article will be updated on a regular basis.

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4 thoughts on “Explained: RBI transfer of ‘surplus’ to government”

  1. very detailed, thanks

    the daily posts like reading between the lines are very helpful, and the articles to read are also very much objective.

    Thanks again.

    Reply

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