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The sudden resignation of Urjit Patel from the post of the Governor of the Reserve Bank of India (RBI) was surprising and almost a historic act. There have been a lot of recent controversies regarding the RBI’s independence in relation to the Union Government (UG). A lot of central banks like the Federal Reserve of the US enjoy almost full independence in their functioning. In that respect, the RBI does not have it. In case of the other central banks, the government has no role in the choice of key functionalities. But in case of the RBI, the central government enjoys the power of selecting the RBI governor and also his/her deputies. 

A section of observers think that one of the main reasons behind Patel’s resignation was the RBI’s opposition to transfer a considerable portion of its reserve capital to the central government as the finance ministry has been running short of adequate revenue requirements. Bringing 11 PSU banks under PCA norms and the controversy over liquidity management after the IL&FS crisis were also some of other important considerations. It is known that there has been a tug of war between the RBI and the Government of India (GoI) in transferring a portion of excess funds from the RBI to GoI. Now the question is, how far is the transfer justified and how much reserve capital can be transferred without hampering the financial stability of the country if any unforeseen and unfavourable circumstance arises.

The status of capital in the RBI

It is seen that the capital base of the RBI has been increasing constantly for the last one decade. The balance sheet was close to trebling itself as it rose from Rs. 14.08 trillion in FY 2008-09 to Rs. 36.18 trillion in 2017-18. This expansion has been possible because of the sharp increase in the value of rupee value through foreign securities/currencies held by the RBI. The RBI has to maintain foreign currency reserves for ensuring adequate supply for foreign money for various purposes. The increase of reserve money has been more pronounced as the exchange rate ascended steeply in this period. In the last few months, the exchange rate of rupees rose by close to 10%. But to maintain a balance, the assets and liability sides are to be understood.

Liabilities and assets sides of RBI

On the liabilities side, the central bank holds the issued currency and the commercial bank reserves. This is a statutory reserve that has to be maintained by commercial banks with the central bank along with cash reserve requirements. There are government reserves also on the liability side that the government keeps with the central bank as its banker. On the asset side, the central bank holds foreign assets in the form of its foreign exchange reserves, government securities and gold.

But there should be some items to maintain a balance between the assets and liabilities sides. This item is the capital and reserves which is the accumulated surplus from the RBI’s operations. The present tug of war in transferring funds is related to it.

Why is the surplus rising? One reason is that a central bank, in this case the RBI, earns a surplus because it earns income from its assets like buying and selling foreign exchanges and government securities. But it pays very less on its liabilities. For example, the RBI’s biggest liability is issued currency and does not carry any interest obligation. Moreover, very low interest is paid on loans from commercial banks and on government reserves.

How much capital should the RBI maintain?

The specialists think that there is not a fixed formula for all the central banks of the world when it comes to the quantum of surplus that is to be ideally maintained. It may differ from country to country. First, the quantity of surplus of the RBI is rising but it is more or less flat at around 25% as a percentage of GDP. There are some fluctuations. As of now, it is around 27%. A section in the RBI says that it is one of the highest in the world. But another section in the RBI thinks it is one of the least. 

There are two parts of the surplus capital. One is revaluation fund. This fund has to be adjusted depending on the changes in the value of the foreign currency and gold portfolios. A sharp depreciation of the rupee or a fall in international gold prices will eat into these reserves. Most of the reserves that the RBI holds are in the form of revaluation reserves. But the contingency reserves are needed for conducting the bank’s usual functions. In the post-crisis era, the increase in RBI’s capital base can mainly be attributed to the revaluation reserves.

The way forward

A recent article on this issue by Anand, Felman, Sharma and Subramanian (EPW, December, 8, 2018) observed that the RBI has a very large amount of excess capital reserve. On the analysis of market risk, they have estimated this amount to be between Rs. 5.7 lakh crore and Rs. 7.9 lakh crore. This is also high when compared to most other most central banks. Moreover, the RBI also maintains a buffer for contingency risks. But the contingency part is not at all very high according to the observation. But the study also points out that the use of excess capital of RBI by the government should not be encouraged. If this money is used as a component of the budget, then this will increase inflation in the economy. The money is known as ‘outside money’. This money if injected into the economy would cause a sudden oversupply of money. The study pointed out, “So to be clear, transfers from the valuation reserves should only be used for operations like recapitalizing PSU banks and retiring debt.”

The study has also pointed out that a clear rule needs to be framed between the RBI and the government to ensure that the capital of the RBI should not come down below a stipulated level. The benefits of using the excess capital of the RBI will be without “compromising the integrity of the central bank’s balance sheet and without undermining its policy effectiveness.”