Implications of RBI’s fat dividend...

HIMADRI BHATTACHARYA

The dividend payout of₹�1,75,987 crore from theRBI to the governmentfor 2018-19 follows aparadigm shift in the way that theRBI’s requirement of economic cap-ital is viewed, calculated and sup-plied, as also an accounting rule-tweaking to ensure higher incomefrom forex transactions. To under-stand the signifi�cance of this devel-opment, it is useful to focus on the10-year period, subsequent to theunifi�cation of the exchange rate ofthe rupee in 1993.

This is when the RBI’s balancesheet underwent a structural shiftfrom dominance of domestic assetsto dominance of foreign assets.This change entailed importantmacroeconomic trade-off�s thatwere never well-understood orarticulated.

The trade-offThe shift, as above, resulted in alower proportionate income, onthe one hand; and higher risk ex-posure, requiring more economiccapital for the RBI, on the other.This is the fl�ip-side from the narrowperspective of dividend payouts tothe government. But the upside ofthe trade-off� has been lower struc-tural infl�ation, stronger externalstability and, possibly, lower ex-ternal borrowing cost for Indianentities. The Jalan Panel (ExpertCommittee to Review the ExtantEconomic Capital Framework) hasmissed an opportunity to articulatethis trade-off� well, which couldhave put the issues in properperspective.

The Subrahmanyam Group(1997) recommendations to bolsterthe equity of the RBI by raising Con-tingency Fund plus Asset Develop-ment Fund (CF+ADF) to 12 per centof assets of the RBI by 2005, sawsomewhat tardy growth in di-vidends, as the retention of net in-come rose and the old issue of lowincome from forex transactionslingered on. CF+ADF rose to an all-

time high at 11.9 per cent of assets in2009. In the wake of the ‘Taper Tan-trum’ in the fall of 2013, when therupee fell steeply leading to the cur-rency revaluation balance bulgingto ₹�5,20,113 crore (as on June 30,2014), a policy decision was taken toput a stop to the retention of net in-come. The ratio of CF +ADF to assetsfell in the subsequent years, as aconsequence. It is rather ironic thatin 2018, when this ratio at 7.04 percent was a tad lower than in 1998-99(the start year for strengthening itsequity by higher retention of net in-come), it became almost a self-evid-ent truth that the RBI was over-cap-italised. The bulk of the logic — orrather, the absence of it — was thatthe currency revaluation balancewas too high for comfort at₹�6,91,641 crore!

Core recommendationThe RBI will be required to main-tain adequate ‘realised equity’ —CF+ADF, in practice — to cover theother risks besides its most signifi�c-ant one, namely, market risk arisingout of its holding of domestic se-curities and foreign assets, includ-ing gold.

The revaluation balances shouldnormally be a suffi�cient risk buff�eragainst market risk, unless they fallbelow a threshold which will be de-termined each year based on theoutput of a risk model, the specifi�csof which have also been provided.

Capital confusion and pitfallsThe panel’s report, by identifyingaccounting equity — subscribedcapital, reserves, risk provisionsand revaluation balances — witheconomic capital, lays the groundfor deviation from the main tenetsof enterprise risk management. Re-valuation balances, although fall-ing under broadly defi�ned equity,are not in the same league as the CF,since they cannot be used on a ‘go-ing concern’ basis for absorbing alltypes of loss. This diff�erence is re-fl�ected in the RBI’s regulation thatpermits banks in India to reckonforex translation balance as equity

capital, but after discounting by 25per cent.

One lesson of the global fi�nancialcrisis was that only common equitymatters in crisis situations. Incid-entally, the panel acknowledgesthat several central banks do notconsider revaluation balances aseconomic capital. A practical diffi�-culty in considering revaluationbalance as the main supply sourceof the economic capital required tomeet the demand for capital formarket risk on an on-going basis isthat while the latter will be morestable over time, the former can behighly volatile and fl�eeting, leavingopen the likelihood of large gaparising between the two.

This is not merely a hypotheticalpossibility, as it actually material-ised in 2007, when the revaluationbalance had fallen to a low of 2.2 percent of the total assets. Even a back-of-the-envelope calculation wouldshow that the shortfall in realisedequity would have been as high as10 per cent of total assets. It wouldhave made no diff�erence even if theentire dividend payout that year at

₹�11,411 crore (only 1.14 per cent oftotal assets) was retained. Obvi-ously, the shortfall would have beenmore pronounced if the CF+ADRthen was lower at 5.5-6.5 per cent.

The upshot here is that revalu-ation balance alone cannot providerisk buff�er against market risk.Hence, the reversal of the Subrah-manyam Group’s recommendationto earmark 5 per cent of the realisedequity to take care of forex volatilityis unsound, based on empiricalevidence. This conclusion is un-likely to be very diff�erent even if therisk estimations turn out to besomewhat lower. It is hard to ima-gine the response of the RBI and thegovernment, should a similar situ-ation arise in the future. To some,the option to weaken the rupeecould have strong appeal.

Risk transfer mechanism The panel prefers the term ‘fi�nan-cial resilience’ vis-a-vis ‘capital’ todenote the RBI’s fi�nancial degree offreedom. It combines fi�nancial re-sources with the risk transfer mech-anism (RTM) available to the RBI for

absorbing/transferring losses tothe government. The example ofbonds issued by the governmentunder the MSS for absorbing excessliquidity has been cited as an ex-ample in this regard. But it is also afact that when the MSS was intro-duced in 2004 against the back-drop of a surge in liquidity causedby capital infl�ows, there was a tacitunderstanding that the interestcost of the bonds to be issued willbe compensated by additional di-vidend payment by the RBI.

Similar was the case in anotherRTM in 1994, when the RBI was con-strained to transfer to the govern-ment all the remaining liabilitiesunder the FCNR(A) scheme, whichwas causing fast depletion of the CF.This deal too, had an understand-ing that RBI would off�set the gov-ernment’s loss by way of higher di-vidend. Realistically, can anyoneexpect a general RTM with nostrings attached, as in the US, theUK and South Korea, the examplesof which are in the report? Notlikely in the foreseeable future, par-ticularly when one learns that thegovernment is trying to mop upeven the very modest internal re-serves of SEBI as well.

The panel’s report begins by stat-ing a view that central banks do notneed capital for their operations.While this point can be debatedendlessly with strong argumentson both sides, in the Indian context,it is almost a certainty that thefi�scal dominance over monetaryand fi�nancial stability policies ofthe RBI will get entrenched and le-gitimised, if the net worth of theRBI were to turn negative.

Around the time the RBI wasstruggling with the fi�nancial bur-den of FCNR(A) liabilities in 1993,the central bank of the Philippineswas liquidated on account of lossesunder more or less similar quasi-fi�scal activities. As the cliché goes,fact is stranger than fi�ction.

Through The Billion Press. The writeris a former Central banker and aconsultant to the IMF

Implications of RBI’s fat dividend cheque The signifi�cance of the Jalan Panel report can be better understood through the structural shift in the RBI’s balance sheet

Risk management The RBI will need to maintain adequate realised equity