The Reserve Bank of India (RBI) recently decided to transfer Rs. 1.76 trillion to the Government of India (GOI). If the RBI has inadequate capital, then it should not transfer funds to the GOI. But even if the RBI has adequate capital, there is still a concern. Dr Gurbachan Singh argues that after taking a dividend/surplus on its shareholding in the RBI, GOI’s financial position is very likely to weaken.
The Government of India (GOI) has ambitious spending plans but it is financially constrained. It can act only within the parameters of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003; this restricts the fiscal deficit that the GOI can incur. In this context, the GOI has been exploring other ways of financing its expenditures such that it does not have to borrow more and in the process violate the FRBM Act. It is in this background that the GOI has been knocking at the doors of the Reserve Bank of India (RBI) to help finance its expenditures.
Given the inflation targeting regime that the RBI has adopted (with the whole-hearted concurrence of the GOI) in 2016, the GOI of course does not expect the RBI in one way or another to finance some of the government expenditures by way of issuing additional base money or high-powered money. This is because it may take the inflation rate beyond that mandated under the policy regime adopted in recent years. With this door closed, the GOI has explored another way – that of getting funds from the RBI (Government of India, 2016). This rests on the following observations:
(a) The RBI has large surplus (profits basically due to high seigniorage1 as a result of the issue of base money) over very many years;
(b) The RBI has been parting with only a part of this surplus over years in the form of a dividend to its owner – the GOI, and it has been retaining the remaining surplus;
(c) The retained surplus has in effect added to the equity capital of the RBI over the years; and
(d) The effective equity capital of the RBI is now far more than what is required to ensure the financial stability of the RBI, even after considering the size of the RBI balance sheet which has increased over time.
All this has led the GOI to the conclusion that the RBI can and should pay a part, if not the whole, of the retained surplus. The latter may be given by selling, possibly in a phased manner,2 some of the assets that the RBI has and using the proceeds of such a sale to pay the GOI. If the latter gets funds in this way, it can spend more without additional borrowing in the market so that it does not violate the FRBM Act. All this has led the media and the public to view such funds from the RBI as a bonanza for the GOI.
Is the above argument valid? This has been debatable. The opponents of the above view have basically rested their case on the ground that the effective equity capital of the RBI is not excessive and so there is hardly any scope for the RBI to part with the so-called surplus that it has. In what follows, I will not consider this aspect as this has already received considerable attention in the media.3 Instead, I will consider an aspect which has got ignored in the discussions. To focus on this aspect, I will abstract from the contentious issue of what is adequate capital for a central bank such as the RBI. The point here is that even assuming that the RBI indeed has more than adequate capital and that it actually spares funds for the GOI, there is a concern. That is the focus here.
Suppose that the transfer of funds from the RBI to the GOI does happen; the RBI has already agreed to do so after it accepted the recommendations of the ‘Expert Committee to Review the Extant Economic Capital Framework of the Reserve Bank of India’ – popularly referred to as the Bimal Jalan Committee (Reserve Bank of India, 2019). Given this transfer, it is true that the GOI can – all else being equal – raise its revenue expenditure by the amount received from the RBI without raising its fiscal deficit or its debt. However, there is still a concern.
The reason why we are concerned about debt is that if it is too high, it makes the borrower vulnerable to a crisis. In macroeconomics, the usual view is that a rising debt-to-GDP (gross domestic product) ratio is a cause for concern. However, in finance, a different metric is used. Debt is usually seen relative to the size of the balance sheet of the borrower. More specifically, the ratio of debt to the total assets of the borrower is considered. The less the assets of the borrower, the greater is the concern with a given size of the debt.
Should we follow the traditional macroeconomics approach or consider the approach in financial economics? Now the Global Financial Crisis (GFC) in and around the year 2007 (and the earlier crises such as the East Asian Crisis in 1997-98) have left us with many lessons including the following basic lesson. There is a need to consider macroeconomics alongside finance, as that inter-disciplinary approach only can provide a broad perspective within which we can tackle any vulnerability that an economy or its financial system may be facing. This implies that we should look at debt of the government not just relative to GDP but also relative to the total value of the assets that the government has4. We are now ready to address the basic issue that this column is focused on.
After taking a dividend/surplus on its shareholding in the RBI, the financial assets of the GOI fall. This is analogous to the basic idea in Corporate Finance that the value of a cum-dividend share is equal to the value of the ex-dividend share plus the dividend5. The implication is that though the public debt remains unchanged in absolute value as a result of the transfer of funds from the RBI, it becomes high relative to the assets of the GOI. It follows now that a transfer of funds from the RBI to the GOI can weaken the financial position of the GOI. In fact, rating agencies may cut their rating for GOI’s debt (it is, as evaluated by Moody’s, already quite low at Baa2 stable as on 16 July 2019).
There is a way out of this uncomfortable situation arising as a result of the transfer of funds from the RBI to the GOI. If the latter spends the funds transferred from the RBI on capital formation instead of raising the revenue expenditure, then assets of the GOI will rise. Such a rise can make up for the fall in its asset holding in the form of its effective capital ownership in the RBI. Then the financial position of the GOI will not weaken as a result of the transfer of funds from the RBI to the GOI, and the use of such funds for capital formation. Also, the spirit of the FRBM Act will not be violated (the letter of the law is not being violated anyway) as the thrust of that legislation is to ensure a sound and prudent financial condition for the GOI, which will be intact if aggregate assets stay unchanged.
But will the GOI spend on capital formation instead of raising its revenue expenditure? It will help if the GOI were to clarify its stand on this issue. It appears unlikely that the GOI will spend more on capital formation at a time when it is facing a revenue shortfall and is under pressure not to cut its revenue expenditure. In that case, the financial condition of the GOI will weaken. So, there is hardly any bonanza in any meaningful sense for the GOI as a result of transfer of funds from the RBI. This is contrary to the widely held belief in the media and even in some public policy circles.
- Seigniorage is income from the issue of base money on which no interest or very little interest is paid. It is the difference between the value of money and the cost to produce and distribute it.
- For related aspects, see Singh (2016).
- For a more academic view, see Bandyopadhyay et al. (2019), which is a study carried out at the Centre for Advanced Financial Research and Learning (CAFRAL), Mumbai. For a somewhat different view, see Buiter (2008), and Taylor (2015).
- It may be mentioned here that the approach even within macroeconomics has been questioned in the aftermath of the GFC. Reinhart and Rogoff (2009) have suggested that economists should consider debt-to-taxes ratio rather than debt-to-GDP as an indicator of vulnerability to a debt crisis.
- After a dividend is paid by a company on a share, the market price of the share falls, all else being equal, to the extent that the dividend is paid. The new lower price is called ex-dividend share price. The previous price before a dividend is paid is referred to as cum-dividend share price.
- Bandyopadhyay, S, R Devnani, S Ghosh and A Lahiri (2019), ‘Central Bank Equity: Facts and Analytics’, CAFRAL Policy Paper, January 16.
- Buiter, W (2008), ‘Can Central Banks Go Broke?’, Centre for Economic Policy Research (CEPR) Discussion Paper No 6827.
- Government of India (2016), ‘The Economic Survey 2015-16’, Volume I.
- Reserve Bank of India (2019), ‘RBI Central Board accepts Bimal Jalan Committee recommendations and approves surplus transfer to the Government’, Press Release, 26 August 2019.
- Reinhart, CM and KS Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.
- Singh, G (2016), ‘Recapitalizing the public sector banks by disinvesting in the RBI: Right and wrong’, Ideas for India, 9 May 2016; reprinted in Mint, 8 July 2016.
- Taylor, S (2015), ‘Can a central bank go bust?’, Simon Taylor Blog, 22 June.