Economic Survey Eyes RBI’s Reserves To Resolve Bad Loans...Again.
The seal of the Reserve Bank of India hangs on a wall at the headquarters in Mumbai. (Photographer: Scott Eells/Bloomberg)

Economic Survey Eyes RBI’s Reserves To Resolve Bad Loans...Again.

The Arvind Subramanian-authored Economic Survey has once again argued that the Reserve Bank of India (RBI) is sitting on too much capital, which, if transferred, can be used by the government for various purposes, including the resolution of bad loans. The Survey suggests that the RBI can “return” as much as Rs 4 lakh crore to the government.

A similar suggestion had been made by Subramanian last year, only to be dismissed by his former colleague and then RBI governor Raghuram Rajan.

The Survey for 2016-17, released on Wednesday, says the RBI continues to hold “excess capital”. To make that judgment, the Survey relies on data from across global central banks which measures the ratio of shareholder equity to assets. The data shows that the Indian central bank has the fourth highest amount of equity as a percentage of balance sheet. India is also well above the median in this regard.

If there is a demonetisation windfall, the RBI will stand out even more as an outlier in terms of government capital in the central bank.

Source: Economic Survey
Source: Economic Survey
There is no particular reason why this extra capital should be kept with the RBI. Even at current levels, the RBI is already exceptionally highly capitalised. In fact, it is one of the most highly capitalised central banks in the world. So, it would seem to be more productive to redeploy some of this capital in other ways.
Economic Survey

The Survey goes on to ask, “Assuming that the RBI returns Rs 4 lakh crore of capital to the government, what are the uses to which this capital can be put?”

The Survey suggests that these funds can be used to recapitalise banks or to fund the proposed Public Sector Asset Rehabilitation Agency, which is essentially a government sponsored bad bank. The agency has been suggested as a centralised solution to the bad loan mess facing domestic banks.

The funds can also be used to extinguish government debt to show that it is serious about fiscal consolidation, the Survey added.

How Can This Be Done?

The Survey goes on to explain how such a transfer of capital can be achieved and also seeks to address concerns about conflict of interest if the capital is used to recapitalise banks.

The Survey suggests the transfer take place in the following way:

  • In stage 1, the RBI’s balancesheet shrinks as it uses its holdings of government securities (assets) to pay a dividend to the government. This, in turn, reduce the capital on the RBI’s balancesheet (liabilities)
  • In stage 2, the government issues fresh bonds to recapitalise banks
  • Since the bonds would be issued by the government to banks, the RBI would not end up owning a piece of the entities they regulate
It cannot be emphasized enough that any strategy to use the excess capital must be done carefully that in no way undermines or circumvents the relevant laws. It must also be done with the full cooperation of the RBI to ensure that the RBI’s independence and credibility are in no way undermined.
Economic Survey

The Opposing View

In an interaction with journalists on April 5 2016, former RBI governor Raghuram Rajan had opposed any move to reduce the amount of capital held by the central bank.

Rajan had made two arguments. The first was that the RBI is only holding the bonds on behalf of the government. As such, the capital held by the central bank should be counted as the assets of the government. He had added that it useful to hold this capital on the books of an entity which has a “pristine rating”.

The second argument made by Rajan was that if the RBI were to reduce its assets, its ability to absorb government borrowings by buying bonds would stand reduced. “Any money extra that we give to the government, reduces our buying of government bonds directly,” Rajan had said at the time.

The Economic Survey does not address these concerns but does respond to another concern raised about the possible vulnerability of the central bank’s balance sheet should its capital be reduced. This concern pertains to the fact that a large chunk of the RBI’s assets are held in the foreign assets, in particular reserve currencies like the dollar. What would happen if the dollar were to depreciate sharply? Could that lead to the RBI’s capital getting wiped out?

The Survey says this is unlikely. The rupee would need to appreciate by 16.3 percent relative to today’s value for this to happen, says the Survey.

International Precedent

The Survey argues that its suggestion is not unprecedented and cites instances in the past when central bank assets have been transferred to respective governments.

  • The U.S. Federal Reserve gave $19 billion from its surplus capital to finance transportation projects in 2015
  • In 2004, the Bundesbank, extinguished its old deutsche mark currency and counted it as income in the profit and loss account
  • The Bank of Israel recorded a gain of ILS 220 million in its 2010 financial statements for the face value of notes that had passed the legal date for exchange and were no longer valid for use
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