Rs 3.6 lakh crore demand slapped on RBI as Centre wants one-third of reserves; the rift intensifies, but is it wise?

A new headline has struck across India, which is impacting the image of the country’s two independent institutions, namely the government and the Reserve Bank of India (RBI). Although, RBI reports to the government and the latter has the authority over it, however, the central bank has its sphere of influence to function independently. While government looks to boost Indian economy's growth on different fronts, RBI is responsible for maintaining financial stability. However, the current scenario is that, there is bad blood between RBI and government. The war between these two authorities have gone viral and public, becoming even more scarier for the investors and markets. Now, the demand of the NDA government for one-third of its reserves has come as a slap for the RBI. This new move has created tension for investors and may even affect country’s macro stability.

What has been revealed is that the Finance Ministry is seeking a transfer of Rs 3.6 lakh crore from RBI, which is more than one-third of the central bank’s reserves. Currently, the RBI’s reserves stand at Rs 9.59 lakh crore in fiscal year FY18.

According to The Indian Express report, the Finance Ministry claims that the existing economic capital framework — which governs the RBI’s capital requirements and terms for the transfer of its reserves to the government — is based on a very “conservative” assessment of risk by the central bank.

Reportedly, the government is of view  that RBI has over-estimated its capital reserves requirements resulting in excess capital of Rs 3.6 lakh crore.

Now, this comes as shocking news to market participants, foreign investors and RBI itself. The central bank is already surrounded by news claiming the exit of governor Urjit Patel, invoking of section 7 and controversies over its autonomy. This is just another shot fired at RBI independent status and hurts its credibility. 

Significantly, if RBI gives up the Rs 3.6 lakh in reserves, it would not be a good sign for India. Firstly, taking of RBI’s reserves hampers markets' confidence in Indian government’s commitment to fiscal prudence. Secondly, the government will also not get any new revenue from the central bank, as it is the highest dividend provider to them. 

Apart from this, RBI with low capital levels in its reserves, can lose its credibility. 

Interestingly, many would raise eyebrows in whether the government may use RBI’s reserves for fulfilling its bank recapitalization demand which is set at Rs 2.11 lakh crore in the beginning of this year. This will be another problem, as this would create an issue  of regulator owning banks. 

RBI’s balance sheet plays a very important role in the functioning of the country’s economy largely reflecting the activities carried out in pursuance of its currency issue function as well as monetary policy and reserve management objectives.

In FY18, RBI transferred surplus of Rs 500 billion to government, which was quite better than compared to surplus of Rs 306.59 billion in FY17. In the fiscal 2016-17, RBI’s dividend was the lowest, something that can be blamed to demonetisation drive, which costed the central bank a hefty sum for printing currencies.

RBI’s surplus to government stood at Rs 658.76 billion in FY16, at Rs 658.96 billion in FY15 and Rs 526.79 billion in FY14. 

The news of government asking for Rs 3.6 lakh crore from RBI, has already hit the opposition Congress Party’s ears. 

Congress President Rahul Gandhi says, “Rs  36,00,00,00,00,000. That’s how much the PM needs from the RBI to fix the mess his genius economic theories have created.”

Rs 36,00,00,00,00,000

That’s how much the PM needs from the RBI to fix the mess his genius economic theories have created.

Stand up to him Mr Patel. Protect the nation. https://t.co/6BI0ePFvvH

— Rahul Gandhi (@RahulGandhi) November 6, 2018

Gandhi encouraged RBI governor to take an anti-government stance saying, “Stand up to him Mr Patel. Protect the nation.”

Former RBI governor Raghuram Rajan has also gone public and spoke at length about the issues between the central bank and Centre. 

In Rajan's view, it is possible for Centre and RBI not to be in agreement, but still be respectful of each other's territory. RBI does not takes decisions out of political or self-interest, instead the central bank has to take a view on India’s financial stability.

Well, the public spat between RBI and government does not likely to end in near-term. Is government’s decision wise in bringing down RBI’s reserves by one-third? All eyes are now watching on RBI to what will be its next step. Will RBI fall into the finance ministry’s demand or will there be another course of meeting set to discuss further resolutions. 

But for now, let’s understand how important it is for RBI to maintain its reserves. 

There was a detailed analysis done by the central bank on RBI’s balance sheet back in 2005, indicating the importance of money the central bank keeps. 

RBI set up in April 1935, is enjoined to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage  by the Preamble to the Reserve Bank of India Act, 1934.

Its balance sheet, naturally, chronicles the causes and consequences of monetary policy in the backdrop of the many vicissitudes of the Indian economic experience.

Talking about the overall central banks across countries, the analysis mentions that, firstly and foremost point to note is that, the governments fully own their central banks - even otherwise, there are restrictions on public shareholding (and dividend payout to non-government shareholders), although the equity of some central banks are traded on the exchanges.

Secondly, central banks derive their right of note issue - easily their largest operation -from the state, which is thus entitled to the profits of currency issuance as seignorage.

Thirdly, central banks usually act as sole bankers to the government. Finally, most central banks act as managers of public debt for a commission, though the degree of underwriting varies from country to country. 

The analysis said, “Most central banks now have the statutory right to buffet their balance sheets with adequate reserves before passing their profits to the government.”

A central bank balance sheet is usually analysed from the twin angles of the ability to issue currency and the ability to achieve the monetary policy objectives of price stability and growth.

From the report, it is clear that there appears to be an emerging consensus that central bank reserves act as a cushion in the sense that well-capitalised central banks are relatively more credible in a market economy because they can bear larger quasi-fiscal costs of market stabilisation, especially in case of large fiscal deficits.