Mint Explainer: The deep links between RBI balance sheet and the economy

What makes the balance sheets of central banks unique?

Central banks’ balance sheets, including that of the RBI, are unique. What makes them unique is that central banks do not need capital to carry on operations as they can replenish their capital any time simply by printing currency. However, that does not mean they are, or can be, indifferent to the health of their balance sheets. The reason is that there is an important link between central banks’ financial resilience and efficacy of their policies.

Thus, according to RBI, central banks require "financial resilience to absorb the risks that arise from their operations and from the delivery of their public policy mandate to buffer the economy from monetary shocks and financial stability headwinds". Central banks in emerging market economies have an additional role of managing external stability in the face of volatile capital flows and spill-over effects of monetary policy changes by central banks in advanced economies -- something we are seeing in operation today as dollar outflows due to policy tightening by the US Fed see the rupee fall to record lows relative to the dollar day after day, even as the RBI uses its forex reserves (little short of $600 billion but falling by the day) to smoothen volatility.

How does the central bank’s balance sheet affect money supply in an economy?

A central bank's balance sheet is not merely a statement of accounts; it is central to the money supply process. At the cost of over-simplification, a simple relation links broad money (M3), i.e. currency with the public, demand and time deposits with banks, and other deposits with the RBI, to reserve money (RM), viz., M3 = m * RM, where m is the money multiplier. The components of reserve money are mainly currency with the public, cash reserves with banks and balances of banks held with the central bank. The sources of reserve money are net domestic assets (NDA) (comprising central bank's credit to government, commercial sector and banks) and net foreign exchange assets (NFA). When RBI acquires any of these assets, it pumps in money into the system, thus increasing money supply. Changes in the liabilities and assets of the central bank, thus, lead to changes in money supply (M3).

What is the link between the central bank's balance sheet and a commercial bank's balance sheet?

Through changes in the cash reserve ratio, policy rates (repo and reverse repo), and open market operations, the central bank influences the reserves of banks and thereby, the money supply. While changes in the cash reserve ratio and open market operations have a direct impact on the volume of resources of commercial banks, changes in the policy rates influence the cost of funds.

Why are central bank balance sheets in the news?

Central bank balance sheets, more correctly the balance sheet of the US Federal Reserve, is in the news as the Fed begins to shrink its balance sheet as part of its two-pronged approach – the other being to raise the Fed rate - to tighten monetary policy in response to rising inflation (8.6% in May 2022).

Following the covid-19 pandemic, the Fed expanded its balance sheet – some would say it ballooned – as it tried to avert an economic meltdown by pumping money into the system – buying bonds and giving out money. In the process, the Fed’s balance sheet jumped from $4.7 trillion in March 2020 to over $8 trillion by late 2021. Now that the Fed needs to withdraw this extra money, it can do so in two ways: selling securities or ceasing to reinvest in maturing securities.

However, a sudden or outright reduction in the size of its balance sheet is bound to rock financial markets. So, it would first rather reduce the pace of buying the bonds, thereby reducing the pace of expansion of the balance sheet, a process known as tapering, a gradual reduction such that it does not shock the recovery process.

How are profits of central banks treated?

Different countries treat the profits of their central banks differently. In India, profits of the RBI are credited to reserves and are shown as liabilities of the RBI. When these are transferred to central government, reserves are reduced to that extent from the liabilities side. On the assets side, net RBI credit to central government gets reduced by the amount of RBI's profits transferred. If RBI incurs a loss and if the loss is met out of reserves created for the purpose, the amount of reserve money would remain the same.

If RBI transfers its entire profit to the government and no reserves are maintained for contingent losses in future, then in the case of losses in future, RBI will have to transfer the loss to the government by way of increase in net RBI credit to central government. As a result, reserve money would increase to that extent.

In India, transfers from the RBI have often come to the aid of a beleaguered government looking for resources to tide over a fiscal crunch. A few years ago, the tussle between the government and the RBI over the quantum of reserves to be transferred led to not only the ouster of the then RBI governor Urjit Patel, but also the setting up of an expert committee to "review the extant economic capital framework of the RBI" under the chairmanship of former RBI governor Bimal Jalan.

The recommendations of the committee were accepted by the government and subsequent transfers to the government have been governed by them. In May 2022, RBI transferred a sum of ₹30,307 crore to the government as surplus for 2021-22, sharply lower than the ₹99,126 crore transferred in the previous year, after keeping the contingency risk buffer at 5.50% of its balance sheet.

In a nutshell, balance sheets of central banks are important for a host of reasons and need to be viewed with circumspection.

What are the main items in the RBI’s balance sheet?

The RBI’s balance sheet lists the assets and liabilities of the Banking and Issue departments separately. Under the RBI Act, the only liability of the Issue Department is 'Notes in Circulation'. The assets of the Issue Department comprise broadly gold coins and bullion, rupee coins, rupee securities and foreign securities.

The Banking Department balance sheet is made up of assets and liabilities arising from the banking business of the RBI. Deposits come to the RBI from three broad sources, viz., government, banks and others. ‘Other liabilities’ is a residual head and includes reserves and provisions, the most important of which is the Contingency Reserve (CR).

What is the main source of income for RBI?

The main sources of income are interest on domestic foreign securities and foreign deposits; discount and rediscount charges; and commission on management of public debt. The largest proportion of expenditure is by way of staff expenses and interest payment.

(Draws from the lecture on RBI’s balance sheet management by Y.V. Reddy, former RBI governor, in November 1997)