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 (Mint file)
(Mint file)

Opinion | An easy surrender of the country’s economic defences

The board’s decision to hand over a chunk of RBI’s reserves reduces the buffers against myriad risks

The global economy is admittedly in a strange place and even the usually reliable experts are struggling to decode an evolving economy and the central bank’s place in it. Indeed, stagnant aggregate demand despite historically low interest rates and accommodative monetary policies is forcing experts to review the limitations of central bank toolkits and instruments. In the midst of all this, the Reserve Bank of India (RBI) finds itself in a rather peculiar position.

Federal Reserve chairman Jerome H. Powell admitted to monetary policy limitations at the annual Jackson Hole symposium: “As we look back over the decade since the end of the financial crisis, we can again see fundamental economic changes that call for a reassessment of our policy framework. The current era has been characterized by much lower neutral interest rates, disinflationary pressures, and slower growth. We face heightened risks of lengthy, difficult-to-escape periods in which our policy interest rate is pinned near zero. To address this new normal, we are conducting a public review of our monetary policy strategy, tools, and communications..."

Coincidentally, the same day Lawrence Summers (former US secretary of treasury and Harvard University professor) and Anna Stansbury published a Project Syndicate article: “Tweaking inflation targets, communications strategies, or even balance sheets is not an adequate response to the challenges now confronting the major economies."

Into this world of known-unknowns, made even more dangerous by lurking unknown-unknowns, the board of RBI has decided to hand over part of its reserves—husbanded scrupulously from normal central banking operations as buffers against future volatility and myriad risks—to the government. The end use of this 1.76 trillion bonanza is still not known, but may go into an economic stimulus programme. The framework for determining RBI’s economic capital and its distribution methodology was based on the report of an expert committee headed by former RBI governor Bimal Jalan.

The surplus distribution marked the culmination of a lengthy, and somewhat acrimonious, squabble between the government and central bank that saw some rather indecorous public conduct by senior bureaucrats. Pressure had been building up on RBI to part with its reserves since 2014, especially after an over-zealous Arvind Subramanian, former chief economic adviser, overestimated the surplus that could be distributed. Things reached a flashpoint with the government threatening to invoke a rarely used provision in the RBI Act, and thereafter appointing an ideologue to the central bank’s board in a show of primacy. Sitting governor Urjit Patel was forced to resign mid-term, a rare occurrence in RBI’s history. With all that proverbial water now under the bridge, it might be important to suss out what the Jalan committee report means for RBI’s future.

The first concern is the manner in which RBI’s board accepted the committee’s recommendations and readily acted upon it. The committee has suggested that RBI’s “available realised equity"—or its economic capital, comprising capital, reserve fund and risk provisions (contingency fund and asset development fund)—should range within 6.5% and 5.5% of the balance-sheet size. The board seized upon the lower bound, which enabled a larger transfer to the government. This then sets the precedent for future transfers and risks becoming the accepted template—in years good and bad.

The second problem is the embedded belief among large sections of the government and bureaucracy about the nature of RBI’s reserves and how it should be deployed. Suggestions have ranged from using the imputed “surplus" capital to finance the infrastructure deficit to recapitalizing public sector banks and even improving the government’s non-tax revenues. An extreme suggestion has been to use foreign exchange reserves to finance imports or even the foreign capital requirements of certain government agencies, disregarding the nature of the reserves: ephemeral (given that they arise from portfolio inflows and are thus volatile) and not permanent—or, part flows and part stock.

The third issue relates to how advocates of surplus distribution have ignored a home truth. The reality is that the roots of RBI’s surplus during 2018-19 lie in the government’s policy missteps—primarily demonetization and a flawed goods and services tax structure—and thereafter the central bank’s attempts to apply band-aids and patches through an expansionary monetary policy. The board’s attitude seems to indicate that it is only bothered with transferring this year’s surplus, and is indifferent to what happens next year. It also re-emphasizes an oversized role for monetary policy in bringing about an economic revival, despite global evidence on the contrary. That apart, there are unavoidable questions about moral hazard and central bank independence: The government can impart shocks to the economy, safe in the knowledge of a central banking safety net.

The fourth dilemma arises from the committee’s risk assessment process, which spans financial and monetary stability risks, credit risk, liquidity risk, market risk and operational risk. The committee forgot to add another risk that could impact the central bank’s ability to withstand black swan events, or influence the sovereign’s credit rating: governance risk.

Rajrishi Singhal is consulting editor of Mint. His Twitter handle is @rajrishisinghal

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