Indian rupee coins are arranged for a photograph in Mumbai, India. (Photographer: Adeel Halim/Bloomberg)

RBI Should Be Sole Judge Of Adequacy Of Reserves, Says Indira Rajaraman

The central bank, which, among other functions, acts as the lender of the last resort, should be the sole judge of the amount of reserves that it sees as appropriate, said noted economist Indira Rajaraman. That said, the Reserve Bank of India must be willing to explain and defend its views to the central board if needed, Rajaraman said in a conversation with BloombergQuint.

The amount of reserves held on the central bank balancesheet has become a point of contention between the RBI and the government. The issue is likely to come up for discussion at the board meet on Nov. 19.

Some sections in the government argue that the RBI is holding excess reserves, which should be transferred to the government. There are two material components to RBI’s reserves:

  • A Contingency Fund of Rs 2.5 lakh crore
  • A Currency and Gold Revaluation Reserve of Rs 6.91 lakh crore

Most economists agree that a transfer from the unrealised gains in the currency and gold revaluation reserve is not possible without a sale of gold or foreign currency assets. Hence, the debate is centered around whether the central bank is holding excess contingency reserves and whether it should transfer any more funds to it in the future.

Rajaraman said the decision should be left to the RBI. But it should be willing to explain its position.

The RBI, according to me, is the sole judge of what’s needed for the financial stability of the country and the financial rating of the RBI itself, as an institution in international markets. This is paramount. It has to do its own calculations but be prepared to present those calculations to the board. They have to say—why they think what they think is right.
Indira Rajaraman, Economist & Former RBI Central Board Member.

The RBI should not become a victim of the Latin Liturgy syndrome, cautioned Rajaraman drawing an analogy to sermons in latin delivered by the church, which were not understood by the people. “It has to be willing to present the calculation, defend the level they think is optimal and carry the board with them.”

 RBI Should Be Sole Judge Of Adequacy Of Reserves, Says  Indira Rajaraman

While the RBI did not transfer any funds to the contingency reserves between 2013-14 and 2015-16, it had made additional transfers in the last two years. This, in turn, has reduced the eventual transfer of surplus to the government. In 2018-19, the RBI transferred Rs 50,000 crore in surplus to the government.

The government’s demand for additional funds from the RBI has come against the backdrop of stretched government finances, even though finance ministry officials have assured the markets that the fiscal deficit targets will be met.

When asked whether fiscal strains should be a deciding factor in the RBI’s decision on reserves, Rajaraman said that would be an “appalling” precedent to set.

If there is a reach into RBI reserves in order to fill a fiscal hole, that would be an appalling precedent to set. It should never be allowed to happen.
Indira Rajaraman, Economist & Former RBI Central Board Member

NBFC Strains: Does The RBI Need To Do More?

One of the other issues of debate is whether the RBI needs to do more to help non-banking financial companies, which are facing a liquidity squeeze. Here, the RBI may need to review the extent of support it has so far provided, said Rajaraman.

“The RBI has probably been too stringent in terms of its willingness to consider the liquidity needs of the NBFCs,” Rajaraman said. “This is a serious financial crisis we are facing right now. It could have a systemic impact.”

The central bank infused Rs 36,000 crore in October through open market operations. It will pump in Rs 40,000 crore in November. In addition, the RBI has eased bank exposure norms to NBFCs and allowed for partial credit enhancement. Many feel this may not be enough to help the sector through the current crisis, particularly the smaller NBFCs.

They have to be willing to give a little on this subject, said Rajaraman.

There are multiple ways in which this can be done, including a special repo window, she explained, while adding that supporting NBFCs will also help reduce incremental strain that may be developing for small and medium enterprises.

NBFCs were the ones meeting the needs of SMEs. They are closest to the ground. They were taking care of last-mile liquidity needs of SMEs. I really think that if the liquidity needs are taken care of, to some degree, you would be able to ease the pain that SMEs may be facing.
Indira Rajaraman, Economist & Former RBI Central Board Member

Controlling The Damage

The public dispute between the RBI and government has raised concerns of a possible resignation from RBI governor Urjit Patel or his deputy Viral Acharya. If either of them were to resign, that would be a very big catastrophe, warned Rajaraman.

“It would indicate to the outside world that the government and the RBI have not been able to resolve their differences. Most of all, to the outside world. For a developing economy, which needs outside capital, it is important to show that we can work out our differences in a civilised way.”
Indira Rajaraman, Economist & Former RBI Central Board Member

Watch the full interview below:

Edited excerpts from the conversation:

It has been pointed out that this is not the first time that the government and the RBI have disagreed on issues; but this seems to be more public and acrimonious now than in the past.

During my tenure on the board from 2011-2015, the relationship between the board and the RBI was very cordial. There was no conflict of any kind. Therefore, there was a demarcation of the powers of board as distinct from those of the governor, and because there was such cordiality, it never really got examined or talked about. Many of us finished our terms on the board without a very clear idea of where the powers of the board stopped. That has come to the fore in this atmosphere of hostility. A lot has been left unspecified in the RBI act with respect to exactly where the powers of the board stop.

Is the debate over the RBI’s balance sheet informed enough? There was a random Rs 3.6 lakh crore worth number that the government wants from the RBI balance sheet. A large part of it is in revaluation reserves, which has now been pointed out as unrealised gains.

There are three components to the RBI’s reserves. There is a valuation component, which has increased over time because the value of gold has increased. There is valuation of foreign exchange and domestic securities. The third is a small part but the gold and foreign exchange are a big part of it, amounting to nearly Rs 7 lakh crore. Although this portion of reserves can be realised only when asset in question is sold, and since gold is not going to be sold, there is an issue of whether the foreign exchange holdings in that valuation reserve should be sold and the gains realized, and thereby become available for whatever the RBI may decide to do.

Aside from the valuation reserve, there is an asset and development reserve which is just like depreciation reserve of any company, and I don’t think it should be touched since it is very small. There is a contingency reserve, which in principle, something whose size can be worked out by people who have the technical expertise to do it. The contingency reserve, as the name implies, is for unforeseen contingencies but even so, just like an insurance provision, its optimal value can be based on actuarial calculations. You need technically qualified people to do that.

My surmise is that within the RBI, either a committee or the serving officers in the central bank should have worked out in principle what the optimal level of the contingency reserve should be at. The committee, of which I was a member and was chaired by Mr Malegam, did not look into this at all. It did not look in to the adequacy of contingency reserve, the optimal level based on any kind of technical calculations. I am not privy to it. When the RBI confronts a hostile board with government nominees wanting to know why the reserves are at the level that they are, the RBI should be able to discuss the issue without necessarily giving in in anyway. They should marshal the calculations that they have done, justify the level of contingency reserve, and be open to a discussion of whether the valuation reserve can be reduced in any way. What would not serve the RBI management well is if they refused to engage in a discussion. That will not serve any purpose.

Is it feasible for the RBI to transfer what it is already accumulated? And if it is so, what would be the implications of that?

Anything is feasible. Assume that the accumulated amount in contingency reserve is of the order of above Rs 2.5 lakh crore. Supposing the internal calculations of the RBI were to reveal that they don’t need that higher reserve, then they should be ready to present to the board what is the level that they consider optimal, given the volatility in exchange rates or any other volatility in financial markets for which the contingency reserve is intended. If they were to go with the government nominees on the board and decide that some of it can be released to the government, then the transfer from the reserves to the government’s account in the RBI should be possible.

What gets added to the contingency fund from here on? Surely there is nothing wrong with the capital framework being in public domain and having complete agreement between the centre and RBI on it?

The reason I am against numbers (like 12 percent, as put out by a committee) is that the RBI, as a central bank, has massive responsibility. It is a guardian for financial stability in the country and the financial profile which the country presents to the external world to international capital markets. It is a very important responsibility. If the RBI does not want to commit itself to a number like 12 percent, then it is alright. If, in the considered judgement of the RBI, they don’t want to commit themselves to a number, they should be willing at all times to defend the level of reserves at wherever they are. Under the Article 58 of the RBI Act, there is no provision for the board to direct the governor to reduce the level of reserves and hand it over to government. There is no provision in the Act for such a thing to happen. The Act does not prevent the governor from deciding based on discussions with his senior management, whether such a transfer is of public interest. I don’t see any provision which says that such a transfer should not be made but the Act protects the governor from having to do it against his will or his better judgement.

This year, the RBI transferred some money to the contingency fund. The government is squabbling that it is not enough. All of it seems to be coming from the fact that the government needs fiscal resources. That should not be a deciding factor, by any means, with you, too, suggesting that it is the RBI’s judgement and not of the government?

The RBI, according to me, is the sole judge of what is needed for the financial stability of the country and for the financial rating of the RBI itself as an institution in international market. This is paramount. RBI has to do its calculations but must also be prepared to present those calculations to the board. The RBI needs to say why they think what they say is right. It is important now since the dispute has come to open. The RBI should not become a victim of the ‘Latin liturgy syndrome’ under which the church sermons were all given in Latin and the lay people could not understand what was going on.

So, the RBI must be willing to step down from the board, present calculations, defend the level that they think is optimal, and carry the board with them. That is important. If there is a reach into the RBI’s reserves in order to fill a fiscal hole in the government of India’s budget, that would be an appalling situation and precedence and must never be allowed to happen.

Do you think the RBI needs to yield some ground on the NBFC issue?

It does appear that the RBI has been too stringent in terms of its willingness to consider the liquidity needs of the NBFCs. This is a serious financial crisis that we are facing right now. It could have a systematic impact. Moody’s, in its latest report on India, remarked on the credit squeeze facing the NBFCs. But they also said that so far, it doesn’t seem to have had any systemic consequences. The RBI is the best judge of whether or not we are approaching a systemic crisis, but they must, once again, consider the issue of the liquidity sufficiency for NBFCs. They must consider all issues and be willing to give little on that matter.

NBFCs cannot directly borrow from the RBI, but there could be ways to do this where one isn’t bailing out entities which may have run business risks too high?

Yes, there are many ways in which this can be organised. There are ways in which special repo windows can be opened. Multiple ways that it can be done. At the end of day, it is a matter of whether the RBI decides to give in a little, not because they are becoming lax or imprudent in any way, but simply because it is the need of the hour.

There is talk about the need to be more accommodative of the SMEs, but one cannot pin point where the additional stress is building on the them. Demonetisation, GST and now NBFC: there’s probably reason to believe that the SMEs have some support requirement?

The NBFCs were the ones meeting the needs of the SMEs. NBFCs are closest to the ground. They were taking care of the last mile liquidity needs of SMEs. If the liquidity needs of SMEs are taken care of to some degree, but not to the entire extent, the needs of SMEs for credit would be met more than they are met presently. In February 2018, the RBI introduced a forbearance in respect of NPA of SMEs to the banking sector which had risen due to the initial design of the Goods and Service Tax which was in place for three months. After that, the SMEs needed working capital on account of the GST payments they had to make, and on delayed payments. There was monthly payment, monthly filing. It was very stringent in the first three months. Many SMEs, which had no history of default, suddenly went into default. So, the RBI was aware of that and yielded on it. They gave a 180-day extension forbearance for SMEs which previously had no record of default but went into default because of the initial design of GST. So, it is not that the RBI has been completely insensitive to the needs of SMEs. But, the need of the hour is to focus on NBFCs, especially the smaller NBFCs. There are 11,000 NBFCs in the country and that space is very skewed. There are dozen or so NBFCs which are very large and rest are small, regionally dispersed and are serving the needs of SMEs all over the country. If the liquidity window for NBFC works in a regionally dispersed way, then that is the best way of tackling the credit needs of small-scale industry.

There is a demand for easing the banking regulation. There are three individual demands: one being the prompt corrective action demand, keeping power companies out of Feb. 12, and Basel norms which came as point of dispute. This comes from the fact that the government didn’t have money to fill the recapitalization requirements of this banks.

Whatever the motivation was for the government, in terms of these three requirements, all these issues the face-off would be best overcome if the RBI instead of looking at where the motivation is instead starts to just address each issue on its merits. In terms of Basel, Basel III is 4.5, Basel plus is practiced in India as 5.5. This is a whole percentage point higher in terms of tier 1 common equity capital. Should that be relaxed? The reason banks were placed higher than Basel III was because banks are deeply stressed.

The NPA levels are running at around 12 percent. That is a stressful situation. In that situation, any central banker in the world would applaud what RBI has done in terms of having a higher capital requirement which adds to the reputation of India as being a financially stable country with a good banking sector regulator. If that was suddenly reduced by a percentage point, it will free up credit not just for NBFCs but also for all borrowers. Is it wise or prudent to do so? The government should leave that judgement to the RBI. This is different from the PCA situation where the RBI can afford to be a little lenient. After all, when these 11 banks where singled out for PCA, the parameters were a lot worse than they are right now.

The RBI should be willing to consider that they have moved on. They have done some correction, their parameters are better, and must be lifted out of PCA if their judgement makes them confident that such a move will not be catastrophic. In all these issues, the RBI would be best served by not looking at where the motivation of where the government is coming from but by addressing each issue on its merits calmly, justifying the levels of where they are at, projecting what could happen if the Basel III requirements were to be reduced. The RBI could say 5.5 is too high so let’s settle at 5.25 or 5. That shows a willingness to compromise and that could defuse the situation.

Shouldn’t this coldness be corrected, given the fact that at the end of the day, the sovereign has two parts—the government and central bank—which need to work together?

There are preliminary indications that neither side wants a blow up. If the governor and the deputy governor were to resign, that could be catastrophic. It would indicate that the government and central bank have not been able to resolve their differences. To a developing country which needs international capital inflows, it is important to show that we can work out our difference in a civilized way and neither side has to bend to the other. The government is justified, perhaps, in a difficult situation, in a credit squeeze with possible systemic implications to ask the RBI why it is taking a particular stance, and for the RBI to come back and explain its stance, justify it, exhibit willingness to come down little bit. If both the sides act this way, we can see a way out of a big conflagration.