Photo: Bloomberg
Photo: Bloomberg

Opinion | The raid on the RBI balance sheet

The specific conditions of individual countries matter when it comes to determining whether central bank capital is adequate

The attempted raid on the statutory reserves of the Indian central bank to meet the fiscal requirements of the government is being justified with two arguments—that the Reserve Bank of India (RBI) has no business to expect independence from the sovereign and that it anyway holds excess statutory reserves compared to peers. Neither argument is factually wrong. The nuances are ignored, however. More on that a little later in this column.

Capital is the buffer a central bank maintains to absorb losses. The RBI maintains statutory reserves to guard against two main risks.

It has a currency and gold revaluation account for protection against exchange rate movements as well as changes in global gold prices. It has a contingency fund as insurance for a rainy day. The former is determined by formal accounting rules. The latter is a more flexible number. The latest available RBI balance sheet shows that there is 6.9 trillion in the revaluation account and 2.3 trillion in the contingency fund.

The Indian central bank is owned by the government. There is no question of it having total independence from the political authority representing the Indian people. However, the issue here is not legal independence at all but operational independence and financial independence. A central bank is not a department of the finance ministry; it needs the freedom to use monetary policy tools to meet the goals set for it by an act of Parliament. It also needs financial independence so that it has the flexibility to use its balance sheet to maintain economic stability.

The government says that the RBI holds more statutory reserves than needed. This view was most clearly stated in the 2016 Economic Survey, through a comparison of other central bank balance sheets.

However, such generalizations are risky. Economist Alex Cukierman showed in a 2011 article that the specific conditions of individual countries matter when it comes to determining whether central bank capital is adequate. A lot depends on how wide the mandate of the central bank is, the size of shocks that it is expected to deal with, the extent of fiscal policy dominance over monetary policy, the nature of the exchange rate regime, whether the balance sheet of the central bank is dominated by domestic or foreign exchange assets.

The adequacy of statutory reserves should be examined given the fact that the RBI is a full service central bank, most of its assets are foreign securities, the exchange rate is a managed float rather than completely flexible. A comparison between the RBI balance sheet and the US Federal Reserve is really not useful in any practical sense. The institutional details are completely different, especially since the Fed balance sheet has been bloated by extraordinary monetary policy since 2009.

A more credible argument is that the RBI has no need for 2.3 trillion of contingency funds since it can easily go to the government for funds in a crisis. The only problem is that public finances are very likely to be in a mess at precisely the same time when the central bank is gasping for capital. Some countries such as South Korea give the central bank a legal right to call for extra capital from the government.

These are not issues that should be settled on the run. The RBI board should at the very least set up an expert committee on the question of how the central bank balance sheet should be capitalized—or perhaps even whether it should be capitalized at all. The sensible compromise till then would be to separate the issue of flows from the issue of stocks.

The RBI should transfer the annual flows of profits earned from seignorage to the government as dividend. The government should devise clear rules on the stock of central bank capital that is needed in the Indian context.

The open hostility between the finance ministry and the RBI is unfortunate. It comes against a backdrop of a decade of growing friction.

Successful democracies work through institutions. Framing the issue as a popularly elected government battling against a bunch of unelected technocrats is not useful, other than to score debating points. Remember that these same technocrats have been appointed by the government to deliver on goals that are defined by either law or the monetary policy agreement. One key challenge—as some RBI critics have rightly argued—is to build accountability into the arrangement.

Finally, a small anecdote about the controversial Section 7 of the Reserve Bank of India Act. C.D. Deshmukh was governor when the RBI was nationalized in 1949.

Section 7—that gives the government the power to give instructions to the central bank in the public interest, after consulting the governor—was not in the original law that established the RBI. It was added after nationalization. The RBI board wanted a provision in the law that the government would take responsibility for the consequences of any policy that was forced on the RBI through Section 7. The proposed clause never made it into the law. It is a question worth revisiting right now: Who should be held accountable in case the RBI changes course based on the Section 7 instructions given to it by the government?

Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute. Read Niranjan’s previous Mint columns at

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