The Reserve Bank’s balance sheet has undergone substantial transformation over the years, reflecting the shifts in
the regimes of monetary policy operations and different phases of fiscal-monetary co-ordination. In the post-reforms
period, the emergence of the market-based government borrowing programme, the Reserve Bank’s withdrawal from
the primary government securities market and substantial reduction in its contribution to various long-term funds,
changed the nature of the interface between the central bank’s balance sheet and fiscal policies. A surge in capital
inflows added a new dimension to the balance sheet of the Reserve Bank, which not only changed the composition
of assets along with associated changes in income, but also set an important milestone in the interface between the
fiscal and monetary authorities, with the fisc also sharing the cost of sterilisation with the introduction of Market
Stabilisation Scheme (MSS). Besides, the extent of the Reserve Bank’s surplus transfer to the government and
quasi-fiscal activities are other aspects that have had a bearing on the Reserve Bank’s balance sheet post-reforms.
Interestingly, the Reserve Bank’s balance sheet shrank during the crisis year 2008-09, unlike the expansion witnessed
by the central banks of several advanced economies. This is attributed to the measures taken to increase liquidity in
the system through reduction in the Cash Reserve Ratio and unwinding of the government’s MSS balances. The
Reserve Bank’s balance sheet has expanded significantly since then reflecting its liquidity management operations,
aimed at strengthening the recovery process while containing inflation.
I. Introduction
4.1 A central bank, by virtue of its exclusive
power to print money, is a unique financial
institution. Its uniqueness also stems from the fact
that it performs the functions of banker to banks
and government. Its balance sheet is, thus, of
particular interest from a public policy perspective.
Being a descriptive account of the assets and
liabilities of the central bank at any point of time, it
has significant information in respect of its monetary
operations as also its relationship with other
major players such as commercial banks and the
government. The central bank balance sheet also
depicts the impact of institutional arrangements on
the conduct of monetary policy operations (Hawkins,
2003). Illustratively, net central bank credit to the
government will be the most noteworthy item of a
central bank’s assets in a fiscal regime marked by
recourse to deficit financing. Similarly, when the
exchange rate of an economy is characterised by
a currency board arrangement, its balance sheet
will reflect its operations in the foreign exchange
market. In India, the multiple links between the Reserve Bank balance sheet and various sectors of
the Indian economy are succinctly summarised as:
“… the balance sheet of the Reserve Bank reflects
and, in a way, influences the development in the
economy – the external sector, the fiscal and, of
course, the monetary areas” (Reddy, 1997).
4.2 The inter-linkages between monetary policy
operations and the Reserve Bank’s balance sheet
have attracted the attention of policy makers and
researchers alike (e.g., Jadhav et al., 2003, 2005;
RBI, 2005). In the present Report, the intention is
to go beyond monetary operations. In tune with the
theme of the report, this chapter examines fiscal and
monetary policy operations and their impact on the
Reserve Bank’s balance sheet. Fiscal and monetary
policies are two arms of the overall macroeconomic
policy and share the basic objectives of sustainable
economic growth and price stabilisation. The
extent of monetary and fiscal policy co-ordination is
observed on several parameters, including the size
and composition of the central bank’s balance sheet,
which are considered to be important due to the
various risks faced by the central bank. The nature of the co-ordination is also highly contextual. Apart
from other factors, the level of external integration of
the economy is an important determinant influencing
the need for co-ordination. While the emphasis in
this Chapter is on finding the inflexion points in the
balance sheet of the Reserve Bank in the context
of the changing relationship between the fiscal-monetary
authorities, the chapter primarily delves
into the more recent past since the initiation of
economic reforms in the early 1990s.
4.3 The views on fiscal-monetary co-ordination
in the context of a sustainable policy framework could
be different under normal conditions as opposed
to what may be required in a crisis. While the
arguments regarding market failure, supplementary
demand support and the provision of public goods
may favour an active fiscal policy with the monetary
policy assuming a passive role, well-functioning
financial markets supported by sound government
finances tend to improve the role of monetary
policy. Policy responses, viz., quantitative easing,
monetary/fiscal stimulus measures and quasi-fiscal
activities may be considered normal and necessary
during a crisis as short-term measures, but need
to be withdrawn at an appropriate juncture to avoid
long-term distortions in the economy.
4.4 What has been the nature of the co-ordination
between monetary and fiscal policies
in India, as reflected in the central bank’s balance
sheet? What are the fiscal implications of opening
up of the economy in general and capital inflows
in particular that have an influence on the balance
sheet of the Reserve Bank? What are the major
issues relating to capital and reserves of the central
bank? This chapter examines some of these issues,
both in generalised as well as contextual strands.
4.5 The rest of the Chapter is organised as
follows. Section II analyses the impact of fiscal
operations on the central bank’s balance sheet,
while Section III deals with this issue in the context
of the Reserve Bank’s balance sheet. Various
facets relating to fiscal-monetary co-ordination that
have impacted the Reserve Bank balance sheet are
analysed in Section IV. The recent economic crisis and its impact on the Reserve Bank’s balance sheet
are covered in Section V. Concluding observations
are presented in Section VI.
II. Fiscal Policy and the Central Bank’s
Balance Sheet
A Stylised Central Bank Balance Sheet
4.6 The nature of the interaction between
fiscal policy and the central bank’s balance sheet
can be understood from a stylised central bank’s
balance sheet. The link between fiscal policy
and the central bank’s balance sheet could come
through government deposits with the central bank,
or central bank’s loans to the government, or the
central bank’s investment in government securities
(Table 4.1).
4.7 In addition to the above, the profit and loss
account of the central bank gets linked to the fiscal
operations to the extent that the government is a
recipient of profit transfer from the central bank.
As far as the reflection of fiscal operations in the
central bank’s balance sheet is concerned, following
components of the balance sheet deserve special
mention.
Government Deposits
4.8 In its traditional role as a banker to the
government, a central bank usually accepts
government deposits, which constitutes a liability for
the central bank. Changes in government deposits
affect money supply and provide a useful monetary
policy tool in countries where the central banks
have the authority to shift deposits between their books and those of commercial banks (for example,
Canada, Malaysia and South Africa). When Asian
economies faced large capital inflows before the
1997 crisis, the depositing of surplus government
funds at the central bank helped to sterilise part of
the rising stock of international reserves (Hawkins,
2003). The movements in government deposits can
be highly volatile, leading to problems for liquidity
management. There are also issues about returns
to be paid on funds placed by the government.
Table 4.1: A Stylised Central Bank Balance Sheet |
Liabilities |
Assets |
1 |
2 |
1. |
Currency |
1. |
Loans to: |
2. |
Banks’ Deposits |
|
(a) Government |
3. |
Government Deposits |
|
(b) Banks |
4. |
Capital |
2. |
Investments in |
5. |
Reserves |
|
(a) Government Securities |
6. |
Other Liabilities |
|
(b) Foreign Assets |
|
|
3. |
Gold |
|
|
4. |
Other Assets |
Loans to Government/Investment in Government
Securities
4.9 In a financially repressed regime, a central
bank may be obligated to extend credit to the
government through subscription to government
paper in the primary market auctions. Such
financing can be at highly concessional rates or
at market-related rates with the former impacting
the efficient functioning of markets and the
effectiveness of monetary management. However,
many countries prohibit central banks’ purchase
of government securities in the primary market
through the enactment and implementation of fiscal
responsibility legislations. Co-ordination challenges
remain acute for countries that lack well-functioning
financial markets and the necessary framework to
pursue an effective indirect monetary policy.
4.10 In some emerging economies, it is regarded
as desirable for central banks to make markets in
government bonds in order to develop the markets.
But in others, central banks stay away from this
activity to avoid being caught with large holdings
of government securities (Al-Jasser and Banafe,
2002).
4.11 A survey of central banks conducted by
the BIS in 1999 found that the majority of central
banks were not required, and often not allowed, to
lend to governments, either by legislation or written
agreements with their governments (Van’t dack,
1999). Particularly strong prohibitions existed in
Brazil, Chile, Peru and Poland, where lending to
the government is precluded by the Constitution. It may be inappropriate to completely ban central
bank lending in developing countries that have
very small financial sectors, as this might prevent
the government from smoothing temporary gaps
between expenditure and revenue. But it is often
argued that such lending should be limited and at
market rates (as determined by the central bank)
(Cottarelli, 1993). Thus, with a view to ensuring
fiscal discipline and avoiding multitudes of problems
emanating from fiscal profligacy, an increasing
number of advanced as well as emerging market
and developing economies (EMDEs) have adopted
a rule-based fiscal responsibility framework
(Table 4.2).
Investment in Foreign Securities: Sterilised
Foreign Exchange Intervention
4.12 Central banks generally invest in foreign
securities as part of foreign exchange reserve
management. Some central banks intervene in the
foreign exchange market to defend an exchange
rate, which may at times involve the use of
accumulated foreign exchange reserves and losses
to the central bank. Further, the return from large
amounts of international reserves may fall short of
the cost of the central bank’s domestic borrowing
in the money market (Hawkins, 2003). There are
cases when some central banks had to incur large
losses in forward transactions to protect exporters or
unhedged domestic borrowers from losses (Quirk et
al., 1988).
Central Bank Transfers to the Government and
Capital Injections
4.13 An active monetary policy requires that the
central bank balance sheet is strong and supported
by an adequate capital base to withstand losses,
if any, arising on account of the central bank’s
operations in financial and foreign exchange
markets. However, central banks usually support
fiscal authorities by transferring their surpluses as
opposed to building up capital for such exigencies.
In a few countries, central banks also pay tax to the
government (Hawkins, 2003).
Table 4.2: Fiscal Responsibility Laws in Select Countries - Main Features |
Country and Date |
Original Law |
Procedural
Rules |
Numerical
Targets in
FRL 1/ |
Coverage
2/ |
Escape
Clauses 3/ |
Sanctions |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
Argentina: Federal Regime of Fiscal Responsibility
(2004) 4/ |
1999, 2001 |
Yes |
ER; DR |
CG |
No |
Yes |
Australia: Charter of Budget Honesty (1998) |
|
Yes |
-- 6/ |
CG |
No |
No |
Brazil: Fiscal Responsibility Law (2000) |
|
Yes |
ER; DR |
PS |
Yes |
Yes |
Chile: FRL (2006) |
|
Yes |
BBR |
CG |
No |
No |
Colombia: Original Law on Fiscal Transparency and Responsibility (2003) |
1997, 2000 |
Yes |
BBR |
NFPS |
Yes |
No |
Ecuador: Fiscal Responsibility Law (2010) |
2002, 2005 |
Yes |
ER |
PS |
No |
No |
India: Fiscal Responsibility and Budget Management Act (2003) |
|
Yes |
BBR |
CG |
No |
No |
Jamaica: Fiscal Responsibility Law (2010) |
2010 |
Yes |
BBR; DR |
CG 5/ |
Yes |
No |
Mexico (2006) |
|
Yes |
BBR |
CG |
Yes |
Yes |
Nigeria (2007) |
|
|
BBR |
CG |
No |
No |
New Zealand: Public Finance (State Sector Management) Bill (2005) |
1994 |
Yes |
-- 6/ |
GG |
No |
No |
Pakistan: Fiscal Responsibility and Debt Limitation Act (2005) |
|
Yes |
BBR; DR |
CG |
Yes |
No |
Panama: New Fiscal Responsibility Law (2009) |
Law No. 2
on Economic
Activity
Promotion
and Fiscal
Responsibility
(2002) |
Yes |
BBR; DR |
NFPS |
Yes |
No |
Peru: Fiscal Responsibility and Transparency Law (2003) |
1999 |
Yes |
BBR; ER |
NFPS |
Yes |
Yes |
Romania (2010) |
|
Yes |
ER |
GG |
Yes |
Yes |
Serbia (2010) FRL provisions introduced in the 2009 Budget System Law |
|
Yes |
BBR; DR |
GG |
No |
No |
Spain: Budget Stability Law (2007) |
2001 |
Yes |
BBR |
NFPS |
Yes |
Yes |
Sri Lanka: Fiscal Management Responsibility Act (2003) |
|
Yes |
BBR; DR |
CG |
No |
No |
United Kingdom: Budget Responsibility and National Audit Act (2011) |
Code for Fiscal Stability (1998) |
Yes |
BBR; DR |
PS |
No |
No |
Notes:
1) BBR = budget balance rules; DR = debt rule; ER = expenditure rule;
2) GG = general government; CG = central government, PS=public sector; NFPS=Non-financial public sector.
3) Includes only well-specified escape clauses. In India’s FRL, for example, the escape clause is very general.
4) The FRL has de facto been suspended since 2009.
5) Also includes public bodies.
6) These countries operate (de facto) rules that are however not spelt out in the FRL.
Source: Schaechter Andrea, Tidiane Kinda, Nina Budina, and Anke Weber (2012), ‘Fiscal Rules in Response to the Crisis—Toward the “Next-
Generation” Rules. A New Dataset’, IMF Working Paper, July 2012 |
4.14 While profits are transferred to governments,
losses are usually met by reductions in capital and
reserves. At times, there is a transfer of extraordinary
profits to reserves before distributing the same to the government. The Philippines is a unique example,
where the government created a new central bank
in 1992 by injecting capital after the previous central
bank had incurred large bad debts.
4.15 There are three main issues that arise
in the context of central bank reserves. The first
question is whether central banks require reserves
at all, given that the owner in most cases is the
sovereign itself. It is widely accepted that a well-capitalised
central bank is relatively more credible
in a market economy, with the reserves serving as
a cushion against large quasi-fiscal costs of market
stabilisation, especially when the economies run
large fiscal deficits. Despite the implicit sovereign
guarantee, which can be invoked in case the central
bank faces solvency problems, central banks in
EMDEs often maintain large reserves, especially for
precautionary purposes.
4.16 The second issue is what form the reserves
should take in terms of its three constituents,
viz., paid-up capital, contingency reserves and
revaluation accounts. Most central banks appear to
prefer building up reserves by transferring part of
their annual profits, rather than augmenting paid-up
capital, while revaluation accounts are used for
adjusting to prevailing market trends.
4.17 The third major question is how the central
bank income should be apportioned between the
central bank (i.e., in the form of reserves), the
government and non-government owners if part
of the equity is held by private stakeholders. The
government, as the “shareholder”, is entitled to
receive part of the total profit of the central bank,
after a prudent proportion of the profit has been
set aside for the capital and reserves of the central
bank. There may be sound or mechanical rules
governing the size of such transfers; it may be at
the discretion of the central bank, at the discretion of
the government, or a matter of negotiation between
them. Central bank legislations often statutorily
link the size of reserves to the size of the balance
sheet, paid-up capital, annual surplus, or some
macroeconomic variable, such as GDP or money
supply. In any event, transfers to the government
seldom cross 0.5 per cent of GDP, barring
exceptions such as Hong Kong SAR and Singapore.
Most central banks distribute over half of their profits
(Kurtzig and Mander, 2003).
4.18 The size of profit transfer is an important
consideration for fiscal-monetary co-ordination.
Although governments typically appropriate the
dominant share (often up to 90 per cent), especially
given the right of seigniorage, this is often counter-balanced
by parallel restrictions on the monetisation
of the fiscal deficit.
Quasi-fiscal Activities of Central Banks
4.19 Central bank expenditure can be classified
into three categories: (i) general administrative
expenditure on wages and salaries, benefits,
equipment and premises, (ii) interest payments on
deposits of commercial banks with the central banks
and any other central bank borrowing, and (iii) quasi-fiscal expenditure which is expenditure on activities
that are additional to the central bank’s monetary
and exchange system responsibilities.
4.20 In many countries, central banks play
an important role in fiscal policy. By undertaking
financial transactions that serve the same role as
taxes and subsidies, they reduce the effective size
of the fiscal deficit. These so-called quasi-fiscal
activities (QFAs) can have a significant allocative
and budgetary impact in these countries. The
majority of QFAs performed by central banks arise
from their dual roles as regulator of the exchange
and financial systems and as banker to the
government. QFAs can involve multiple exchange
rate arrangements (typically a tax on exporters and
a subsidy to importers), exchange rate guarantees
(a contingent subsidy to the borrower of foreign
exchange), interest rate subsidies, sectoral credit
ceilings, central bank rescue operation, and lending
to the central government at below-market rates.
4.21 There are a variety of reasons why central
banks may engage in QFAs. QFAs may allow the
government to hide what should essentially be
considered budgetary activities in the accounts of
public financial institutions. Such QFAs may not
receive equivalent legislative or parliamentary
scrutiny compared to budgetary operations. Another
rationale for some QFAs is that it may be more convenient to administer them relative to budgetary
operations. However, as they are not a charge on
the budget, they show up in the balance sheet of the
central bank. QFAs led to huge losses for the central
bank of Chile in the late 1980s.
III. The Reserve Bank’s Balance Sheet and
Fiscal Operations
Evolution of the Reserve Bank’s Balance Sheet
4.22 The Reserve Bank’s balance sheet has
undergone substantial transformation over the years
in line with the shifts in the regimes of monetary
policy operations and different phases of fiscal-monetary
co-ordination. Three distinct phases can
be discerned during the post- independence period
− the formative phase (1951-1967), social control
phase (1968-1990) and the financial liberalisation
phase (1991 onwards) (RBI, 2006). While these
phases have been documented extensively, for the
present chapter, a quick rundown of the broad trend
is presented so as to appreciate the context and
evolution of fiscal operations in the balance sheet of
the Reserve Bank (Chart IV.1).
4.23 During the formative phase, the Reserve
Bank adopted a strategy of ‘development central banking’ that involved developing an institutional
framework for industrial financing, extending rural
credit and designing concessional financial schemes
for economic development (Singh et. al., 1982). The
expanded role of the Reserve Bank in the nationbuilding
process was reflected in the asset side
of its balance sheet in the form of subscription to
the share capital of several development financial
institutions and contributions to various sector-specific dedicated development funds. To meet the
growing needs of the fisc in a planned economy
framework, the Reserve Bank undertook certain
measures, such as dispensation of the ceiling on its
investment in government securities, an increase in
its advances to state governments and the automatic
monetisation of government deficit through the
creation of ad hoc treasury bills. There was a sharp
draw-down of foreign exchange reserves to finance
large-scale capital imports to cater to the Plan-led
industrialisation process that was underway. Thus,
the composition of the Reserve Bank’s balance
sheet witnessed a dramatic transformation, with
domestic assets assuming dominance. With the
depletion of foreign securities to back the currency
expansion, the proportional reserve system, which
required 40 per cent foreign asset backing for note
issuance, was gradually replaced by a minimum
reserve requirement of `2 billion in gold and foreign
securities. The size of the Reserve Bank’s balance
sheet, however, declined during this phase, reflecting
the gradual shift from a cash-based system to the
banking channel, in keeping with the expansion of
the banking network in the country.
|
4.24 During the social control phase, which was
characterised by bank nationalisation, directed credit
and concessional financing, the entire financial
system was geared to meet the objectives of the fiscal
policy. The size of the Reserve Bank balance sheet
increased significantly during this phase, reflecting
the Reserve Bank’s growing accommodation to the
government to meet the latter’s Plan needs as well
as to face the macroeconomic challenges posed
by the war and oil shocks and the use of monetary
policy instruments to curb attendant inflation. With
the Reserve Bank’s net credit to the government increasing to 90 per cent of the monetary base in
the 1980s, the ratio of monetised deficit to GDP
doubled over the previous decade. To contain
the growing inflationary pressures exerted by the
expansion of reserve money, the Reserve Bank
had to take increasing recourse to hikes of reserve
requirements, which led to an increase in bank
deposits on the liability side of its balance sheet.
The resultant expansion in the Reserve Bank’s
balance sheet was only partially offset by a sharp
reduction in the currency-deposit ratio, reflecting the
acceleration of financial deepening in the economy
(Table 4.3).
4.25 The financial liberalisation phase, which
began in the aftermath of the balance of payments
crisis of 1991, was characterised by wide-ranging
reforms in the financial sector. The Reserve Bank’s
balance sheet reflected the shift in the conduct of
monetary policy and the growing integration of the
economy with the rest of the world. The sizeable
balance sheet expansion during the pre-reforms
period continued in the first half of the 1990s. The
expansion in the Reserve Bank’s balance sheet on
the asset side was driven by accretions to net foreign
assets through its foreign exchange intervention
operations to prevent the destabilising effects of large capital inflows. This was in contrast to the domestic
asset-driven expansion in the earlier two phases
on account of substantial increases in net Reserve
Bank credit to the government. On the liability side,
the expansion continued to be driven by increases
in bank reserves in line with continued hikes in the
CRR, as open market operations (OMOs) could
only partially sterilise the surplus capital flows. With
the discontinuance of ad hoc treasury bills and the
parallel development of the government securities
market, the Reserve Bank’s balance sheet could
be insulated from the switches in capital flows by
trading the surpluses on the external account with
the deficits in government account. This allowed the
Reserve Bank to progressively bring down the CRR,
which in turn resulted in a contraction in the size
of the balance sheet during the second half of the
1990s.
Table 4.3: Evolution of the Reserve Bank’s Balance Sheet - Select Indicators |
(per cent) |
Indicators |
1970s |
1980s |
1990s |
2000s |
2010-12 |
1 |
2 |
3 |
4 |
5 |
6 |
1. Balance sheet size to GDP |
14.6 |
19.6 |
19.6 |
22.5 |
23.9 |
2. Capital account* to total balance sheet size |
NA |
NA |
13.7 |
20.4 |
26.5 |
3. Size of Issue Department to Banking Department balance sheet |
2.0 |
1.0 |
1.1 |
1.1 |
1.1 |
4. Foreign Currency Assets to Domestic Assets |
25.6 |
22.8 |
43.2 |
466.8 |
213.8 |
5. Surplus transferred to the government (per cent of balance sheet size) |
1.4 |
0.4 |
1.4 |
1.8 |
0.8 |
6. Currency to M3 |
33.2 |
22.8 |
19.4 |
15.7 |
14.5 |
7. CRR |
6.0 |
15.0 |
9.0 |
6.0 |
4.75 |
*: Includes capital, reserves, provisions and revaluation accounts.
NA: Not available.
Note: Figures given in this table are end-year averages for the periods mentioned. |
4.26 The Reserve Bank’s balance sheet,
however, again increased between 2001 and 2007,
reflecting the Reserve Bank’s efforts to prevent
the destabilising effects of large capital inflows on
the domestic economy, through intervention in the
foreign exchange market. The monetary impact of
large-scale foreign exchange accretion was offset
by its sterilisation operations. Unlike central banks
in several advanced economies, which witnessed
significant expansion in their balance sheets as
a result of their policy responses to the crisis, the
Reserve Bank’s balance sheet shrank during 2008-
09. Measures to increase liquidity in the system
through a reduction in the CRR and the unwinding of
the government’s MSS balances led to a contraction
of the Reserve Bank’s liabilities. There was a
contraction on the asset side as well, as a result
of a decline in foreign assets in keeping with the
capital outflows. However, the size of the Reserve
Bank’s balance sheet increased significantly in the
next three years – 2009-10, 2010-11 and 2011-
12 – in response to its policy actions and liquidity
management operations. On the assets side, there
was an increase in the Reserve Bank’s holding of
both domestic securities, on account of open market
purchases of government securities for injection of liquidity, and foreign currency assets, due to valuation
effects. On the liabilities side, the expansion of the
balance sheet is explained by the rise in currency
in circulation and deposits in 2009-10 and 2010-
11 and currency in circulation and accretion to the
Currency and Gold Revaluation Account (CGRA) in
2011-12.
Trends in the Government Account with the
Reserve Bank
Government Deposits
4.27 Under Sections 20 and 21 of the Reserve
Bank of India Act, 1934, the central government
deposits all its cash balances with the Reserve
Bank, free of interest, subject to a mutually agreed
minimum. State governments also maintain
minimum cash balances that are linked to the
volume of budgetary transactions in accordance
with mutual agreements. These balances are
reflected as government deposits on the liability
side of the Reserve Bank balance sheet. Surplus
balances over and above the minimum balances
are reinvested in central government securities with the Reserve Bank up to a pre-agreed ceiling, which
reduces the investment portfolio of the Reserve
Bank on the asset side. Excess balances beyond
the ceiling for re-investment continue to be reflected
under government deposits. During the post-reforms
period up to 2001-02, government finances,
in general remained in deficit, with only brief spells
of surplus, mostly towards the end of the financial
year. There was a transition in the pattern of central
government cash balances from 2002-03, with the
emergence of large surpluses (Box IV.1).
4.28 Since the 2003-04 balance sheet, government
deposits also reflected the balances under the MSS
account. As the funds in this account were maintained
for the specific purpose of redeeming the MSS, they
were not available to the government for its
transactions. During 2008-09 and 2009-10, however,
a part of the balances in this account were
de-sequestered and transferred to the government
in order to reduce the reliance on government market
borrowing in the aftermath of the global crisis. Large
intra-year variations in government deposits have
complicated liquidity management for the Reserve
Bank.
Box IV.1
Emergence of Large Surpluses in Government Cash Balances
The government balances with the Reserve Bank have
witnessed large and prolonged periods of surplus since
2002-03. The main factors contributing to the surpluses
were:
● Introduction of the Debt Swap Scheme (DSS) for States,
which enabled them to pay their high-cost liabilities to
the Centre.
● Increase in the notified amounts of treasury bill auctions
between 2002-04 in order to build up government
surpluses to sterilise the Reserve Bank’s foreign
exchange interventions.
● Surpluses of the state government, which are reflected
in their investment in eligible central government
treasury bills. These surpluses, in turn, are a result of:
-
Fiscal consolidation at the State level under the
fiscal responsibility framework effected mainly through buoyancy in States’ own tax revenues and
containment of expenditures;
-
A sharp increase in the volume of devolution and
transfer of resources from the Centre following the
award of the Twelfth Finance Commission;
-
Buoyancy in small savings collections;
-
A shift in the sharing arrangement of the National
Small Savings Fund (NSSF) proceeds between the
States and the Centre from 80:20 to 100:0 between
2002-03 and 2006-07.1
● Improvement in government finances in 2008 prior to
the onset of the crisis.
● Proceeds from the 3G and broadband auctions of the
central government, during Q1 of 2010-11, in excess of
the budgeted amounts.
Source: Reserve Bank Annual Reports, various issues.
Loans and Advances
4.29 The Reserve Bank also extends loans and
advances in the form of ‘ways and means advances’
(WMA) and overdrafts (OD), both to the central and
state governments to meet their short-term liquidity
mismatches.
Reserve Bank Investment in central government
securities
4.30 During the post-reforms period, particularly
since the second half of the 1990s, the Reserve
Bank’s investment in central government securities
has been governed more by the conduct of its
monetary policy operations than by the need to meet
the borrowing requirements of the government. With
the discontinuation of the Reserve Bank’s primary
subscription to the government securities auctions
since April 2006, changes in the Reserve Bank’s
holding of government securities are brought about
by open market purchases/sales in the secondary
market, repo/reverse repo operations and
reinvestment/disinvestment by the government in
its own securities from cash surpluses in its account
(Table 4.4).
Role of the Capital Account
4.31 The Reserve Bank’s capital base consists of
an initial paid-up capital of `50 million as prescribed
by Section 4 of the Reserve Bank of India Act, 1934
and a Reserve Fund as prescribed under Section
46 of the RBI Act. The original Reserve Fund of `50
million was created as a contribution from the central
government for its currency liability. Thereafter,
`64.95 billion was credited to this Fund by way of
gain on periodic revaluation of gold up to October
1990, thus taking it to a total of `65 billion.
4.32 With a switch to indirect monetary policy operations since 1998-99 and rising capital flows
since 2003-04, it was felt that the Reserve Bank’s
balance sheet needs to be sufficiently strong in order
to enable it to independently undertake monetary
policy actions without being constrained by balance sheet considerations. Therefore, besides the capital
account and the Reserve Fund, the Reserve Bank
has created certain reserves and revaluation
accounts under the enabling provisions of Section
47 of the Reserve Bank of India Act, 1934 to meet
unforeseen contingencies arising from market risks,
even though there are no explicit provisions for
maintaining such reserves. There are two reserves
in the nature of provisions, viz., contingency reserve
(CR) and asset development reserve (ADR)2. The
CR is maintained to strengthen the provisions meant
for meeting depreciation on securities, exchange
guarantees and risks arising out of monetary/
exchange rate policy operations. After being
substantially eroded in the early 1990s to meet the
exchange losses arising from the Foreign Currency Non-resident Account (FCNR(A)) scheme, the CR
has been rebuilt since 1993 through the transfer of
funds from the gross income and from the National
Development Funds.3
Table 4.4: Government Transactions in Reserve Bank’s Balance Sheet |
(Percent of Total Liabilities/Assets) |
Years |
Liabilities |
Assets |
Government Deposits |
Loans and Advances |
Investments |
Cash |
MSS |
Total |
1 |
2 |
3 |
4 |
5 |
6 |
Average for: |
|
|
|
|
|
1990s |
0.1 |
– |
0.1 |
0.9 |
56.0 |
2000s |
4.6 |
– |
4.2 |
1.2 |
14.1 |
2010-12 |
0.0 |
0.0 |
6.1 |
0.0 |
24.1 |
2004 |
0.0 |
6.2 |
6.2 |
1.2 |
12.0 |
2005 |
0.1 |
10.5 |
10.6 |
0.1 |
10.0 |
2006 |
0.0 |
4.1 |
4.1 |
0.0 |
4.8 |
2007 |
0.0 |
8.1 |
8.1 |
2.0 |
8.9 |
2008 |
1.2 |
11.9 |
13.1 |
0.0 |
6.6 |
2009 |
0.0 |
1.6 |
1.6 |
0.0 |
7.6 |
2010 |
2.3 |
0.0 |
2.4 |
0.0 |
17.7 |
2011 |
0.0 |
0.0 |
0.0 |
0.0 |
22.3 |
2012 |
0.0 |
0.0 |
0.0 |
0.0 |
25.9 |
‘–’ : Not available.
Note: 1. Data are as on June 30
2. MSS account was created in 2004 to sterilise capital
flows.
3. Government cash surpluses above the minimum balance
and up to certain prescribed ceilings are re-invested in
Government Securities and thus reduce RBI’s investment
in the same. |
4.33 Against the backdrop of the changing
composition of the Reserve Bank’s balance sheet and
the evolving domestic and international environment,
an informal Group set up by the Reserve Bank
(Chairman: V. Subramanyam) in 1996-97 proposed
a cover of 5 per cent of total assets for volatility in
prices of domestic and foreign securities because of
monetary/ exchange rate policy compulsions; 5 per
cent for revaluation of foreign assets and gold; and 2
per cent for systemic risks and requirements relating
to central bank development functions, internal
frauds, unforeseen losses, etc. In pursuance of the
recommendations of the Group, a medium-term
target was set for achieving a CR of 12 per cent of
assets by June 2005, with a sub-target of one per
cent of assets for the ADR within the overall target.
4.34 The Reserve Bank set up the ADR in 1998
to meet internal capital expenditure and investments
in subsidiaries and associate institutions. With a
view to separating the central bank’s function as the
owner of banks/institutions from its role as regulator,
as recommended by the Narasimham Committee,
the Reserve Bank has progressively divested its
holding in subsidiaries that it regulates. Accordingly,
the Reserve Bank transferred its entire stake in the
State Bank of India and 99 per cent of its stake in
NABARD to the Government of India in 2007 and
2010, respectively. In line with these developments,
the transfer to the ADR from the gross income is now
mainly done to meet the Bank’s capital expenditure.
The target of 12 per cent was almost achieved in
2009 but there has been a fallback since then.
4.35 The Reserve Bank also maintains
revaluation accounts to insulate the balance sheet
from prevailing market trends. From October 1990, the valuation gain/loss on gold has been booked in
the Exchange Fluctuation Reserve (EFR), renamed
the Currency and Gold Revaluation Account
(CGRA), which also includes gains/losses on
valuation of foreign currency assets. The EFR was
also used to replenish the Exchange Equalisation
Account (EEA), to meet, inter alia, the exchange
losses on an accrual basis in respect of liabilities
under schemes involving exchange guarantees
provided by the Reserve Bank. With the Reserve
Bank no longer giving exchange guarantees and
winding up schemes that enjoyed such guarantees,
the balances in the EEA have come down over
the years. At present, balances in EEA represent
provision for exchange losses arising from forward
commitments.
4.36 In 2009-10, Reserve Bank effected a change
in its accounting policy for valuation of foreign dated
securities which has implications for the size of the
Reserve Bank’s profits. Accordingly, foreign dated
securities other than treasury bills are being valued
at the market price prevailing on the last business
day of each month and the net appreciation/
depreciation, as the case may be, is being transferred
to a newly created Investment Revaluation Account
(IRA). Further, discount/premium, if any, is now
being amortised on a daily basis over the remaining
period till maturity.4 As depreciation is not adjusted
against current income under the new accounting
policy as was done earlier, the profits of the Reserve
Bank, and by extension, the surplus transferred to
the government, would be higher than in the pre-accounting
change scenario.
4.37 While the share of capital and reserves in the
total liabilities has been declining over the years, the
share of provisions and revaluations has been rising
in line with the increased risks in the operations of
the central bank in a market-oriented and globalised
environment (Table 4.5).
Table 4.5: Reserve Bank’s Capital Base |
(Per cent to Total Assets) |
Year |
Capital Account |
Provisions |
Revaluation Accounts |
Total |
Capital |
Reserves |
Contingency Reserves |
Asset Development Reserves |
Currency and Gold Revaluation Account |
Exchange Equalisation Account |
Investment Revaluation Account |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
1935 |
2.1 |
2.1 |
– |
– |
– |
– |
– |
4.2 |
1951 |
0.3 |
0.3 |
– |
– |
– |
– |
– |
0.6 |
1971 |
0.1 |
2.6 |
– |
– |
– |
– |
– |
2.7 |
1991 |
.. |
5.3 |
4.5 |
– |
2.9 |
4.4 |
– |
17.1 |
1995 |
.. |
3.0 |
1.9 |
0 |
3.4 |
1.2 |
– |
9.5 |
2002 |
.. |
1.4 |
10.7 |
1.0 |
11.2 |
.. |
– |
24.3 |
2008 |
.. |
0.4 |
8.7 |
0.9 |
11.2 |
.. |
– |
21.2 |
2009 |
.. |
0.5 |
10.9 |
1.0 |
14.1 |
.. |
– |
26.5 |
2010 |
.. |
0.4 |
10.2 |
0.9 |
7.7 |
.. |
0.6 |
19.8 |
2011 |
.. |
0.4 |
9.4 |
0.9 |
10.1 |
.. |
0.2 |
21.0 |
2012 |
.. |
0.3 |
8.8 |
0.8 |
21.4 |
0.1 |
0.6 |
32.0 |
‘–’: Not available / applicable. .. : Negligible
Source: Reserve Bank Annual Reports, various issues. |
4.38 Although the recent crisis did not lead to
erosion in the capital base of the Reserve Bank,
given the stable build-up of provisions to safeguard against growing risks, several central banks around
the world faced problems on their capital front
(Box IV.2).
Box IV.2
Central Bank Capital: Issues and Perspectives
Though central banks, with their special status, do not
require large amounts of capital, they generally prefer to
have at least positive capital on their balance sheet. Views
differ on the issue of financial soundness (in terms of
capital held) of central banks. Some argue that adequacy
of capital base of central banks is immaterial as central
banks have the ability to print money to recapitalise them
through seigniorage. Ultimately what matters are the
institutional arrangements in place (i.e., recapitalisation
agreements with the Treasury) and the consolidated fiscal
position (i.e., fiscal ability to recapitalise the central bank).
Many central banks have operated with negative capital for
years. The central bank of Chile, despite carrying negative
capital for several years, was considered highly credible
and successful in maintaining inflation under control. What
is required is a healthy consolidated government fiscal
position. However, this argument has generally been
contested on two fronts. First, even though central bank
losses can be offset by future seigniorage, this would
conflict with the goal of domestic price stability. Second,
and more important, political economy reasons reinforce
the need for central banks to be cautious about the health
of their balance sheets. To minimize the need for transfers
from the Treasury, governments may exercise greater
oversight, which undermines central bank independence.
Empirical evidence also supports the fact that central bank
financial strength matters for the conduct of monetary policy. Large interest rate deviations from optimal policy
can be explained to some extent by central bank balance
sheet weaknesses (Adler, 2012). The dependence on
the government for funding support could undermine the
credibility and goal of independence of a central bank.
Central bank capital assumes importance on the back
of several cases of losses incurred by central banks and
the absence of specific legal provisions for the treatment
of losses or rules to cover these losses. Sweidan (2011)
identifies the reasons for central bank losses in 17 countries
including Brazil, Chile, Indonesia, Philippines, South Korea,
Thailand, and Uruguay. He holds open market operations
using central bank securities as the dominant cause of
central bank losses in these countries, though exchange
rate fluctuations, foreign exchange revaluation and the
interest differential between domestic liabilities and foreign
assets also emerge as important reasons for central bank
losses.
The latest global economic crisis has brought to the fore the
issue of central bank capital and reserves in the backdrop
of the ‘lender of last resort’ function played by central banks
in advanced economies (Horakova, 2011). Keeping in view
the risk factor associated with the role of central banks as
‘lender of last resort’, the losses that central banks may
face from their unconventional policy measures and the financial stability responsibility, there is a re-thinking on the
issue of capital buffers for central banks.
For example, the Swedish government changed its policy
stance after the crisis. Unlike its pre-crisis stance that a
central bank does not need a lot of capital, after the crisis
the capital level of the Riksbank was increased vis-a-vis
the pre-crisis levels. The reason was that the central bank
has to hold more dollar-denominated instruments than
before to perform its lender of last resort function and fund
these holdings.
Recognising the increasing risks due to volatility in foreign
exchange rates, interest rates and gold prices, as well
as credit risk, the European Central Bank (ECB) almost
doubled its subscribed capital since December 2010, from
€5.76 billion to €10.76 billion. Market participants viewed
this as an attempt to create a buffer to cover potential losses
from its euro area sovereign bond purchase programme,
and interpreted this as a signal of the strengthened
credibility of the ECB. The ECB does not have the option of
going to a single European fiscal authority and the capital
of the ECB comes from the national central banks of all
European Union member states.
Although there is little consensus on the appropriate level
of central bank capital, yet some qualitative distinction
needs to be made between capital losses arising on
account of revaluation of foreign-exchange holdings when
the domestic currency strengthens and those which can be
attributed to quasi-fiscal activities (QFAs). QFAs are defined
as activities carried out by a central bank with an effect that
can, in principle, be duplicated by budgetary measures in
the form of an explicit tax, subsidy, or direct expenditure
The experience of the Czech National Bank (CNB) falls in the first category. The erosion of capital of the CNB,
particularly around the mid-2000s, stemmed mainly from
the strengthening in the market value of its own currency
liabilities. However, the central bank’s seigniorage income
remained sufficient, providing confidence that its capital
would be rebuilt over time. BIS has also been supporting
the CNB’s position. The ECB with its eurozone bonds
purchase programme belongs to the second category.
The latter is relevant to central bank’s role as lender of last
resort. The capital requirements are expected to be larger
for central banks entrusted with quasi-fiscal activities to
ensure that any potential loss arising from such activities
does not interfere with their monetary policy objectives.
Such quasi-fiscal crisis measures also highlight the need
for a rethink and discussion with the government on capital
buffers or loss-sharing arrangements. If allocations take
place when gains are recorded but there is no transfer from
the government when the central bank posts losses, then
this could entail the risk of running down the central bank’s
capital.
References
Adler Gustavo, Pedro Vastro and Camilo E.Tovar (2012),
“Does central bank capital matter for monetary policy?”,
IMF Working Paper, February.
Horakova, Martina (2011), “Central Bank Capital Levels:
Do They matter and What can be done?” Central Banking
Journal, June 10.
European Central Bank (2010), Convergence Report 2011,
available at http://www.ecb.int/
Sweidan, Osama D. (2011), “Central bank losses: causes
and consequences”, Asian-Pacific Economic Literature,
Volume 25, May.
IV. Fiscal-Monetary Interface and the Reserve
Bank’s Balance Sheet: Some Issues
4.39 Chapter 3 has provided in detail the fiscal-monetary
interactions since Independence and its
impact on the effective operations of any central
bank. It may be noted that the fiscal-monetary
interface also has a direct bearing on the central
bank balance sheet. During the pre-reforms period,
the strategy of neutralising the monetary impact of
deficit financing on the asset side with higher CRR on
the liability side began to expand the Reserve Bank’s
balance sheet as a proportion to GDP from the mid-
1970s. The Reserve Bank’s accommodation to the
government increased significantly, with the net RBI
credit to the government accounting for over 90 per cent of reserve money in the 1980s. The Reserve
Bank often expressed concern about fiscal deficit
and its impact in terms of excess liquidity creation
and reserve money. This concern was reflected in
the Chakravarty Committee Report (1985), which
prompted the government to modify the definition of
budget deficit so as to better reflect the monetisation
of the budgetary deficit. Post reforms, the move from
adhoc treasury bills to WMA and finally to a Fiscal
Responsibility and Budget Management (FRBM)
framework in 2003 has freed the monetary policy
and hence, the central bank balance sheet from
fiscal deficit’s straitjacket. Notwithstanding this,
there are issues linked to fiscal-monetary interface
in the post-reforms period, particularly linked to the Reserve Bank’s role of being a banker and debt
manager of the government, that have a direct/
indirect bearing on the Reserve Bank’s balance
sheet. Some of these aspects are analysed below.
Performance of the Monetary Targeting Framework
4.40 Following the Chakravarty Committee’s
recommendations, Indian monetary policy adopted
the framework of monetary targeting with feedback.
This, coupled with other policy decisions relating
to the financing arrangements for the central
government, eased the impact of fiscal pressures
on the Reserve Bank’s balance sheet. The share
of net RBI credit to the central government in the overall monetary base, which had declined from
about 95 per cent in the 1980s to 65 per cent in the
1990s, declined further to only 12 per cent in the
2000s. It may be noted here that even though the
monetary targeting framework could not accomplish
the targets per se on most occasions, it succeeded
in generating consciousness to undertake fiscal
consolidation. This was in sharp contrast to the earlier
situation characterised by automatic monetisation
when deviations from the target had remained
significant. In the 2000s, while the dominant role of
fiscal expansion in monetary expansion gradually
faded, capital flows took centre-stage, keeping the
deviations significant, albeit lower than that of the
monetary targeting regime. (Box IV.3).
Box IV.3
Performance of Monetary Targets (pre-1998) and Indicative Projections (post-1998) during the
Multiple Indicator Approach Period
The link between fiscal deficit and reserve money creation,
and accordingly the RBI balance sheet, was more prominent
in the 1980s and the 1990s. Despite the adoption of formal
monetary targeting in 1985, no specific monetary targets
were set during the period 1985-90, except for fixing a
ceiling linked to the average growth of broad money (M3)
in previous year(s). This was because there continued
to be a large overhang of excess liquidity due to primary
money creation. The Reserve Bank had no control over its
credit to the central government, which accounted for the
major chunk of incremental reserve money. The Reserve
Bank could at best set limits on the secondary expansion of
money through instruments, such as the cash reserve ratio
(CRR), statutory liquidity ratio (SLR) and selective credit
controls. Despite these measures, money supply growth
remained high, which contributed to inflation.
M3 growth during 1991-92 to 1994-95 was off the target on
average by more than 5 percentage points. Along with fiscal
expansion, this was attributed to larger-than-projected
foreign exchange accruals and statistical factors due to
year-end and fortnight-end bulges. The years of success
were immediately preceded by years of sharp increases in
money supply. The first few years of successful monetary
targeting in the 1980s (1985-86, 1987-88 and 1990-91)
were accompanied by a lower rate of expansion in both
net RBI credit to the central government and net foreign
exchange assets of the banking sector. In spite of the higher
expansion in net RBI credit to the central government, the
next year of success (1995-96) was rendered possible due
to substantially lower expansion in the net foreign exchange assets of the banking sector. During 1997-99, the increase
was due to a substantial expansion of domestic credit to
both, the government and commercial sectors, and an
increase in the net foreign exchange assets of the banking
system.
The pressures on monetary expansion that emanated from
the monetisation of fiscal deficit during the 1980s and early
1990s gradually gave way to the increasingly important role
of capital flows in determining reserve money expansion in
the 2000s. In the absence of restraint over capital inflows,
the success of monetary targeting became contingent
on fiscal adjustment. While in the early part of the 2000s
(2001-02 and 2002-03), broad money slowed down in
consonance with real GDP growth, money supply rose
above indicative projections persistently through 2005-07
on the back of sizeable accretions to the Reserve Bank’s
foreign exchange assets and a cyclical acceleration in credit
and deposit growth, particularly the latter, in 2007-08. Since
2006-07, when the Reserve Bank stopped subscribing
to primary issuance of government securities, the fiscal
impact on reserve money expansion has been limited. In
the crisis year of 2008-09, there was a significant increase
in the fiscal deficit due to fiscal stimulus measures that led
to periodic upward revisions in the M3 target. Though M3
growth increased during the year, it ended the year close to
the indicative projection of January 2009.
Looking at the degree of accuracy of the M3 growth
projections as quantified using Root Mean Square Error (RMSE) and normalising it by the average actual M3 growth
for the monetary targeting period and post 1998-99 period
(see table), it is observed that the gap between the target
and actual M3 growth remained high at above 20 per cent.
There has been a reduction in the gap between the M3 indicative projection and the actual in the post-1999 period,
particularly after the quarterly assessments started in 2005-06. Thus, while large-scale monetisation of the government deficit and, to some extent, capital flows explained the large
deviations observed in the monetary targeting regime, it is
these deviations that underscored the importance of and
urgent need for fiscal consolidation. In the 2000s, while the
dominant role of fiscal expansion in monetary expansion
gradually faded, capital flows took centre-stage, keeping
the deviations significant, albeit lower than that of the
monetary targeting regime.
Table: Growth in M3 – Actual vs Projection |
Period |
Average actual M3 growth
(per cent) |
RMSE of M3 growth projection
(per cent) |
RMSE/Average Actual
M3 growth
(per cent) |
1985-86 to 1998-99 |
|
17.5 |
3.7 |
21.1 |
1999-2000 to 2011-12 |
Using April Projection |
16.5 |
2.7 |
16.4 |
|
Using January projection* |
16.5 |
2.3 |
13.9 |
* The Reserve Bank started making quarterly projections since 2005-06.
Note: 1. Where the projection is a range, the average of the range has been used.
2. Deviations between actual and projected could also be due to financial innovations and instability in the presumed relationship that
underpins current M3 projection. |
References
Mohanty, Deepak and A. K. Mitra (1999), “Experience
with Monetary Targeting in India”, Economic and Political
Weekly, January 16-23.
Mohanty, Deepak (2010), “Monetary Policy Framework in
India: Experience with Multiple Indicators Approach”, RBI
Bulletin, February.
Net Market Borrowings of Central Government
4.41 Following the enactment of the Fiscal
Responsibility and Budget Management (FRBM)
legislation, 2003, the Reserve Bank ceased to act
as an underwriter of last resort in the government’s
issuances. From April 2006, as stipulated by the
FRBM Act, the Reserve Bank’s withdrawal from the
primary market was operationalised. As the Reserve
Bank continued to intervene in the secondary market,
OMOs became a key instrument for monetary and
public debt management, thereby necessitating a
re-orientation through a review of processes and
technological infrastructure consistent with market
advancements.
4.42 In performing the role of banker to the
government, the Reserve Bank manages the
market borrowing programme of the government in
tune with the liquidity requirements of the economy.
Under this arrangement, the overall bank credit to
the government is decided a priori in line with the
overall monetary and macroeconomic scenario. Of
course, how best the government adheres to the borrowing requirements is critical in determining
the credit availability for the commercial sector in
a growing economy. Given the SLR commitment
on the part of banks, this also determines the net
RBI credit to the government through investment in
government securities, in turn impacting the reserve
money and the Reserve Bank balance sheet.
4.43 Looking at the net market borrowing of
the government during the post-FRBM period, it
is observed that prior to the crisis the net market
borrowings of the central government had generally
remained in line with what was indicated by
the Reserve Bank in the backdrop of monetary
projections and as projected in the Budget (Table
4.6). During 2008-09, the actual market borrowings
substantially exceeded the projected levels (both
the Reserve Bank’s indicative projections and the
budgeted amounts) because of the fiscal stimulus
measures that had to be undertaken in the wake
of the financial crisis. The budgeted and actual net
market borrowings were substantially higher than
the Reserve Bank’s projection in 2009-10 due to
the continuation of the fiscal stimulus measures.
Although the budgeted net market borrowings for
2010-11 was close to that projected by the Reserve
Bank, the actual borrowings were substantially
lower due to the accumulation of large cash
balances in the wake of one-off receipts from 3G
spectrum auctions. During 2011-12, the net market
borrowings presented in the Budget was broadly in
line with that projected by the Reserve Bank, but
the actual borrowings far exceeded the estimates
due to large fiscal slippages due to the economic
slowdown and overshooting of subsidies. This
indicates that although there has been significant
improvement in effective co-ordination between
the Reserve Bank and the government, global and
domestic uncertainties have impacted the outcome
as reflected in the actual net market borrowings.
Table 4.6: Net Market Borrowings of Central
Government* - Projected versus Actual |
(` billion) |
Year |
Net Market Borrowings
(indicated by the
Reserve Bank) |
Net Market
Borrowings
(indicated in the Budget) |
Actual Net Market Borrowings |
1 |
2 |
3 |
4 |
2006-07 |
1,100 |
1,138
460 (MSS borrowing) |
1,104 |
2007-08 |
1,230 |
1,096
100 (MSS borrowing) |
1,318 |
2008-09 |
1,130
1,500 (MSS borrowing) |
1,006
298 (MSS borrowing) |
2,336# |
2009-10 |
1,404 (if MSS is rolled over)
2,004 (if there is no MSS rollover)
(Difference = 600=MSS) |
3,980# |
3,984# |
2010-11 |
3,004 |
3,450 |
3,254 |
2011-12 |
3,580 |
3,430 |
4,364 |
* : Net market borrowings through dated securities.
# : Including MSS de-sequestering.
Source: Budget documents and RBI. |
Transfer of Surplus from the Reserve Bank to the
Central Government: Strengthening of Reserve
Bank Balance Sheet
4.44 The transfer of surplus by the Reserve Bank
to the government is determined by the magnitude of surplus generated by the Reserve Bank and the
proportion that would be retained in its balance
sheet. During the pre-reforms period, the Reserve
Bank’s surplus transfer to the government steadily
declined, reflecting the impact of the social control
of banking. During the post-reforms period, the
Reserve Bank’s surplus fluctuated in response to
the shift in the monetary policy regime. Factors,
such as substantial reduction in allocations to
national funds from 1992 onwards (a token annual
contribution of `10 million for each fund), acquisition
of government securities at market-related interest
rates, which were much higher than the earlier low-yielding
ad hoc treasury bills, and transfer of quasi-fiscal cost (arising from exchange rate guarantees)
to the government, played an important role in profit
transfer during this period. However, the Reserve
Bank’s surplus transfer since the second half of
the 1990s was negatively impacted by the decline
in interest rates on government securities and
depreciation in the investment portfolio following
the turnaround in the interest rate cycle in 2004-05.
Besides, surplus transfer was also affected by the
sharp increase in the share of foreign assets in the
total assets of the Reserve Bank and the resultant
impact on interest income due to lower earnings on
these assets on the one hand, and higher allocations
to the contingency and asset development reserves
in order to strengthen the balance sheet on the
other. The decline in the surpluses on account of
the above factors was partially offset by (a) higher
interest earnings from the conversion of the 4.6 per
cent special securities (created earlier from ad hoc
and tap treasury bills) into marketable securities
carrying higher interest rates and (b) a decline
in interest payments on CRR balances due to a
sustained cut in CRR rates up to 2003, delinking of
interest payments on eligible CRR balances from the
Bank Rate from 2004 and a progressive reduction
in the interest on CRR balances before its ultimate
discontinuation from March 2007.
4.45 Surplus transfer from the Reserve Bank has
emerged as an important source of non-tax revenue
for the central government, contributing as much as
21.5 per cent of the total non-tax revenue of the
central government in 2009-10. The share of the Reserve Bank’s surplus transfer to the government
in total non-tax revenue increased from 3.8 per cent
in the 1980s to 8.5 per cent in the 1990s and further
to 16.2 per cent in the 2000s. It constituted 12.1 per
cent of the centre’s non-tax revenue in 2011-12. The
issue of retaining or transferring central bank
surpluses has not been settled. As discussed earlier,
the Reserve Bank has set a target of 12 per cent of
total assets for the CR and ADRs, and has been
pursuing a pro-active policy of strengthening the CR,
particularly after the latter was depleted in the early
1990s. Transfers to the CR as a proportion of gross
income were higher than the surplus transfer to the
government in 8 out of the 19 years since 1993-94 (Chart IV.2). Since the enactment and implementation
of the FRBM Act, transfers to the reserves have been
generally higher than the transfers to the government
even during some of the years when revenue deficit
had increased. However, given the expansion of the
balance sheet and the increased risks from the
compositional shift to foreign assets, the need to
strengthen the balance sheet cannot be over-emphasised.
The currency and gold revaluation
account as a proportion to foreign currency assets
and gold has exhibited considerable volatility,
particularly in recent years. Sharp fluctuations in gold
and foreign currency assets have implications for the
profitability of the central bank and hence the surplus transfers to the government.5 The CR would,
therefore, have to be sufficient to make good any
losses the central bank may suffer due to volatility in
international markets. Thus, there may be a need to
revisit the 12 per cent target in light of the growing
size of the balance sheet and dominance of foreign
currency assets.
|
Seigniorage
4.46 The role of seigniorage in the central
bank balance sheet has engaged the attention of researchers over the years (Box IV.4). Seigniorage
refers to the profit from money creation and, thus, is
a way for governments to generate revenue without
levying conventional taxes. Three concepts of
seigniorage are generally employed in the literature:
(i) the opportunity cost concept (also called fiscal
seigniorage), which is measured in terms of the
net interest earned on the central bank’s reserves,
(ii) monetary seigniorage, which is measured in
terms of change in the monetary base over a
year after deducting the costs that arise from the creation of the monetary base, and (iii) the inflation
tax concept which is measured as the product of
the inflation rate and the monetary base. Each of
these three approaches has its limitations. While the
‘tax base’ for seigniorage in all three approaches is
the stock of monetary base, the assumed ‘tax rate’
differs in each case. The opportunity cost approach
ignores the effects on seigniorage due to changes in
base velocity. The monetary approach ignores the
effects due to the fact that the real rate of interest
and the rate of growth of GDP may differ from each
other, and the inflation tax approach ignores both the
value of the real rate of interest and the effects due
to changes in base velocity (Hochreiter and Rovelli,
2002). Thus, in practice, each of these approaches
to seigniorage would yield a different result.
Box IV.4
Seigniorage and Central Bank Profits
Seigniorage is the profit that accrues to central banks by
virtue of their unique position of paying little or no interest
on two of their major liabilities, viz., notes in circulation and
banks’ deposits with them. In other words, seigniorage is
the revenue from the interest-free credit the central bank
obtains through the creation of the monetary base minus
the cost of supplying the monetary base. It is also defined
as the opportunity cost the government has to pay if it
exchanged the monetary base against interest-bearing debt
(Baltensperger and Jordan,1998). Drazen (1985) defines
seigniorage as the total revenues associated with money
creation, which is measured as the sum of the revenue from
assets purchased due to money creation (after netting out
that part of revenue used to keep assets constant) and the
revenue from current expansion of money supply in real
per capita terms. In other words, seigniorage according to
this definition refers to the interest earned on central bank
reserves minus losses (gains) due to an increase in the
GDP velocity of the monetary base.
Seigniorage arising from note issuance is calculated as the
notes in circulation (less the cost of printing and distributing
them) multiplied by the market interest rate, which is the
potential rate of return on central bank assets. Seigniorage
accruing from bank balances with central banks arises
from funds banks have to hold with the central banks to
meet their reserve requirements, either as interest-free
balances or at below market interest rates. A study done
in the early 2000s shows that currency seigniorage has
declined in several emerging market economies in line with
the prevalent inflation rate (Hawkins, 2003).
A central bank functioning in a closed economy has
complete monopoly over the creation of liquidity and money, and hence would need no liquidity reserves. It can then hold
its entire portfolio in government debt, which has neither
the default risk nor the currency risk. Interest rates on
government debt provide a useful benchmark for measuring
seigniorage. In reality, central banks face competition from
substitute sources of liquidity and money, which would lead
to shifts in the demand for domestic currency. Central banks
would, therefore, have to hold reserve assets in the form of
international reserves and gold to ensure the credibility and
reliability of its money. Central bank profits, thus, depend
on the investment profile of the central bank assets. These
assets can have varying degrees of risk, such as currency
risk (in the case of investments in foreign assets), market
risk (for both domestic and foreign assets) and default risk
(for lending to private sector and foreign countries). Apart
from foreign assets and non-interest bearing gold, other
factors could lead to a deviation in the central bank profits
from the benchmark seigniorage measured in terms of its
investments only in domestic sovereign debt. These include
operating costs, which reduce profits; subsidised lending
to domestic firms; interest-free credit to governments and
interest rate fluctuations on long-term investment.
References
Baltensperger, Ernst and Thomas J. Jordan (1998),
“Seigniorage and the Transfer of Central Bank Profits to the
Government”, Kyklos, Vol. 51, 73-88.
Drazen A. (1985), “A General Measure of Inflation Tax
Revenues”, Economics Letters, Vol. 17, 327-330.
Hawkins, John (2003), “Central Bank Balance Sheet and
Fiscal Operations”, BIS Papers No. 20, October.
4.47 The choice of an appropriate measure
of seigniorage would depend on the purpose for
which it is used and the nature of the economy it is
computed for. The concept of inflation tax is more
applicable for use in economies where hyperinflation
is an issue and where the central bank is a major
financier of government deficit. Since both monetary
seigniorage and the inflation tax approach neglect
the role of real interest rates in the generation of
seigniorage, it would be more useful to employ the
opportunity cost concept in computing seigniorage
for a country like India as this concept is similar to
the accounting definition of seigniorage, viz., the net
interest accrued to central bank reserves.
4.48 Using the methodology adopted by Hawkins
(2003), which employs the opportunity cost concept
for separately measuring currency seigniorage and
seigniorage from bank reserves, the seigniorage for
India has been computed as follows:
Currency seigniorage, C = (c-g)*r - p;
where c = notes in circulation, g = gold holdings of the
central bank, p = cost of printing notes6, i.e., security
printing and r = potential rate of return earned on currency weighted by the share of domestic assets
and foreign assets of the issue department in total
assets of the issue department, i.e., r = sDAid*iDA
+ sFAid*iFA. Here sDAid = share of domestic assets
of the issue department (net of gold) in total assets
of the issue department, iDA = weighted average
yield on central government securities (on financial
year basis), sFAid = share of foreign securities held
in issue department to total assets of the issue
department and iFA = earnings on foreign assets as
given by the Reserve Bank.7
4.49 As notes in circulation are the liability of the
central bank, this has been taken into account instead
of currency in circulation, which also includes coins
that are the liability of the government. Gold holdings
(as reflected in the issue department balance sheet
of the Reserve Bank) have been netted out because
it yields no return.
Seigniorage on bank reserves, B, is calculated as
b*(r’-i’);
where b = bank reserves, r’ is the potential rate of
return earned on bank reserves weighted by the
share of domestic assets and foreign assets of the
banking department in total assets of the banking
department, i.e., r’ = sDAbd*iDA + sFAbd*iFA, where
sDAbd = share of domestic assets of the banking
department in total assets of the banking department
and sFAbd = share of foreign assets in the banking
department to total assets of the banking department.
i’ = effective interest rate paid by Reserve Bank (up to
March 20078) on deposits of scheduled commercial
banks (which account for over 98 per cent of the
total deposits).
4.50 Both currency seigniorage and seigniorage
on bank reserves, relative to GDP, declined during
the 1990s, due to the decline in domestic and foreign
interest rates. The increase in seigniorage revenue
during 2000-01 is attributable to the sharp increase in earnings from foreign assets, reflecting the
significant rise in international interest rates during
the first half of the year coupled with the increasing
share of foreign assets in the total assets of the
Reserve Bank. Seigniorage revenue from currency
and bank reserves again increased sharply between
2004 and 2008 (Chart IV.3). Currency demand
increased during this period, reflecting increased
transaction demand in the face of high growth.
The seigniorage from bank reserves increased on
account of the combined effect of an increase in the
aggregate deposits with banks as well as counter-cyclical
hikes in reserve requirements.
4.51 The sharp fall in international interest rates
since the onset of the crisis in 2008 and its impact on
earnings from foreign assets affected seigniorage
revenue. Thus, the currency seigniorage-GDP ratio
continued to decline despite an increase in currency
demand. The reduction in CRR from the peak of 9
per cent in August 2008, as a policy response to the
global crisis, resulted in a fall in seigniorage on bank
balances, which had started rising again following
the hikes in CRR since February 2010. Seigniorage
revenue from bank reserves marginally increased
in 2010-11 due to the increase in the share of and
returns on domestic assets but declined in 2011-12
due to cut in CRR.
Capital Flows, Sterilisation and the Reserve
Bank Balance Sheet
4.52 Since the introduction of the reform process
in the early 1990s, India has witnessed a significant
increase in cross-border capital flows, a trend that
represents a clear break from the previous two
decades. The large excess of capital flows over
and above that required to finance the current
account deficit has resulted in the accumulation
of foreign currency assets, which are reflected in
the Reserve Bank’s balance sheet. Central banks,
when confronted with a surge of capital flows, may
intervene in the foreign exchange (forex) market
to dampen disorderly movements of the exchange
rate. The management of capital flows through
market intervention and sterilisation operations,
however, is associated with quasi-fiscal costs if the
domestic assets yield higher returns than the foreign
currency assets. The large-scale use of intervention
measures also leads to changes in the size and
composition of the central bank’s balance sheet.
4.53 Barring the few years of strong remittances
and non-resident deposit inflows in the mid-1970s
and early 1980s, the Reserve Bank’s asset base
was almost entirely dominated by domestic assets,
either in the form of its net credit to the government
or sector-specific refinance facilities. Following the
Reserve Bank’s active intervention in the forex
market in the backdrop of large capital flows,
particularly in the mid-2000s, the composition of the
balance sheet underwent a transformation in favour
of a larger net foreign assets (NFA) in relation to
the net domestic assets (NDA) (Chart IV.4). The
movements in the NFA in the balance sheet of
the Reserve Bank reflect its foreign currency
operations, aid receipts by the government and
income generated by foreign currency assets. While
the accumulation of foreign exchange reserves was
reflected in terms of a steady increase in NFA in the
Reserve Bank’s balance sheet, the Reserve Bank’s
holdings of domestic assets declined on account of
sterilisation operations carried out through OMOs.
Accordingly, the ratio of foreign assets to domestic
assets in the Reserve Bank balance sheet increased
dramatically, from 22.8 per cent in the 1980s to
182.4 per cent during the period 1997-2004.
|
4.54 In the face of large capital flows coupled
with the declining stock of government securities,
the Reserve Bank of India introduced a new
instrument of sterilisation, viz., the MSS to sustain
market operations. Since the introduction of MSS
in April 2004, the government has mopped up the
Rupee liquidity released by the Reserve Bank’s
purchases in the foreign exchange market through
the issue of securities and parking these proceeds
with the central bank. The MSS, thus, immobilises
the rupee liquidity released by the Reserve Bank’s
operations in the foreign exchange market within
the Reserve Bank balance sheet, in contrast to the
parallel offloading of domestic assets in the case of
conventional open market operations.
4.55 Large-scale sterilisation operations are
associated with both fiscal and monetary costs.
To conduct a sterilised forex market intervention,
the issuance of government securities (e.g., MSS
bonds in India) in an attempt to mop up the excess
liquidity often places a debt-service burden on the
government. For a central bank, operating losses
can occur when the accumulated foreign exchange
reserves are invested in foreign assets, which earn
interest rates prevailing in the major world currencies
that are often lower than the rates the central bank
earns on the domestic securities it has sold. The magnitude of the cost varies with the extent of
sterilisation and the yield differentials. These are
termed as “quasi-fiscal” costs since the costs to the
central bank are passed on to the sovereign through
a lower transfer of profits (RBI, 2004). An estimate
of the cost of sterilisation operations in India shows
that such costs have been significant for the Reserve
Bank during period of high capital flows (Box IV.5).
Quasi-fiscal Activities and their Impact
4.56 Central banks around the world often
undertake quasi-fiscal operations in the nature
of forced lending to unqualified borrowers, bank
bailouts and provision of exchange guarantees,
which affect their profitability. The Reserve Bank
too had extended such quasi-fiscal support to the
government in the past in the form of exchange
guarantees for certain schemes in order to shore up
the balance of payments of the country. As a result,
the profitability of the Reserve Bank came under
severe pressure during the early 1990s as the Bank
had to make large provisions to cover the exchange
risk in respect of foreign currencies borrowed under
(i) the foreign currency non-resident (accounts)
(FCNR(A)) and foreign currencies deposited under
similar schemes by foreign banks in India, (ii) funds
mobilised under India Development Bond and
(iii) foreign currency loans obtained by financial institutions and deposited with the Reserve Bank
pending utilisation under a Parking Fund Scheme.
The burden devolving on the Reserve Bank on
account of the exchange risk borne on FCNR(A)
withdrawals/renewals aggregated to `106.15 billion
during the period 1990-93. This burden was borne
by the EFR, which was replenished by depleting the
CR, which fell to a low of `8.59 billion in June 1993.
The Government of India took over the exchange
risk liabilities related to FCNR(A) deposits on
annual outflows from July 1, 1993 onwards, with the
understanding that the Reserve Bank would transfer additional funds over and above the normal transfers
in order to meet these losses. The government also
met a small fraction of the losses from its budget
during 1993-94 and 1994-95. Over the period
1993-98, the Reserve Bank transferred an additional
sum of `128.47 billion from its profit to meet the
FCNR(A) losses (Table 4.7). With an objective of
withdrawing exchange rate guarantees on various
deposits, the FCNR(A) scheme was phased out
in the late 1990s and the FCNR(B) scheme was
introduced under which foreign exchange risk is
borne by banks based on their risk perception.
Box IV.5
Costs of Sterilisation in India
The Reserve Bank undertakes sterilisation operations
through three means – the MSS, OMOs/LAF and CRR
increase. MSS involves a cost for the government as it
has to bear the interest costs. Any OMO sale to absorb
liquidity or LAF reverse repo operation implies a cost for the
Reserve Bank, as securities parted with under OMO sales
generally earn higher interest than that on foreign securities
acquired by the central bank. The net cost incurred by the
central bank, termed quasi-fiscal costs, at times turn out
to be substantial, with implications for the central bank
balance sheets per se and the conduct of future monetary
policy. For certain Latin American countries, these quasi-fiscal costs are estimated to be between 0.25–0.5 per cent
of GDP. Further, the quasi-fiscal costs increase during
periods of surges in capital flows. In such situations, central
banks have used sterilisation operations through OMOs
in conjunction with other measures like increases in cash
reserve requirements, exchange rate appreciation and
also imposition of capital controls. The increase of CRR
for sterilisation purposes imposes a burden on the banking
system as it leads to the impounding of reserves by such
amount that otherwise would have been available to banks
for lending and earning a return. The Table attempts to
quantify the cost of sterilisation for the central bank, the
government and the banking system in India for the pre-crisis
period when capital flows were high. As can be
noticed, during periods of high capital inflows particularly
2004-05 to 2006-07, the maximum cost of sterilisation was
borne by the Reserve Bank.
It may be noted that the Reserve Bank could intervene to
sell securities either because domestic money supply is
higher than projected or because there are excess capital
flows. The Reserve Bank publishes in its policy statements
the projected M3 growth, which is consistent with the
prevailing growth, inflation and external sector dynamics
and takes into account the market borrowing requirements
of the government and the likely growth in demand for credit from the private sector. Accordingly, the desirable/
threshold level of reserve money beyond which it would
be considered as excess could be computed as the level
consistent with the projected M3 growth, given the money
multiplier. It is observed that while sterilisation kept the
actual reserve money after adjusting for CRR changes
close to projected levels for most of these years, for some of
these years, despite sterilisation activity, the actual reserve
money remained above the desirable/threshold level,
indicating that sterilisation fell short of the requirement.
Further, considering that net RBI credit to the Centre was
low during the period of high capital inflows from 2004-05 to
2007-08, expansion in reserve money and the consequent
sterilisation undertaken was due to expansion in the net
foreign exchange assets of the Reserve Bank.
Table: Cost of Sterilisation for the Reserve Bank, Government and Banks |
(as percentage to GDP) |
Year |
RBI |
Government |
Commercial Banks |
2004-05 |
1.7 |
0.1 |
0.2 |
2005-06 |
0.4 |
0.1 |
0.3 |
2006-07 |
0.6 |
0.1 |
0.3 |
2007-08 |
0.1 |
0.2 |
0.5 |
2008-09 |
0.0 |
0.2 |
0.4 |
Note: 1. Cost for the Reserve Bank has been calculated by taking the
difference between the interest that the Reserve Bank has to pay
on OMO/LAF sales and the return that it earns on forex. It may
be noted that the return on forex in rupee terms, after taking into
account exchange rate changes, could be different.
2. Interest payments on MSS have been taken as the cost for the
government.
3. Cost for banks is taken as the return that banks would have
earned on the amount that is impounded due to CRR. Except
during the first half of 2008-09 when inflation was in double
digits, the period being considered was generally a low inflation
period and CRR was generally raised for liquidity management
purposes. Otherwise, given that the entire CRR is not only for
sterilisation purposes, the actual cost for banks would have been
lower. |
Table 4.7: Quasi-fiscal Costs arising from Exchange Guarantee for FCNR(A) Scheme |
(` billion) |
Year |
Losses on
account of
FCNR(A)
Guarantee |
Losses
borne by the
Reserve Bank
by drawing
down its
reserves |
Amount
transferred
from Reserve
Bank surplus
to cover
losses |
Losses
borne by the
government
from its
budget |
1 |
2 |
3 |
4 |
5 |
1991 |
25.14 |
25.14 |
- |
- |
1992 |
55.32 |
55.32 |
- |
- |
1993 |
25.70 |
25.70 |
- |
- |
1994 |
56.86 |
- |
55.87 |
0.99 |
1995 |
25.95 |
- |
23.28* |
2.66 |
1996 |
24.38 |
- |
24.38 |
- |
1997 |
27.63 |
- |
27.63 |
- |
1998 |
18.27 |
- |
18.27 |
- |
‘–’: Not applicable.
*: Includes gains of `2.7 billion at the time of closure of the scheme
in August 1994. |
V. Global Financial Crisis and the Reserve
Bank’s Balance Sheet
4.57 Monetary authorities all over the world took
recourse to a number of unconventional policy
measures to address the liquidity shock generated
by the global financial crisis. Monetary authorities
in the advanced economies first responded through aggressive monetary easing, followed by the use
of unconventional measures to augment liquidity.
With the financial crisis spreading to the real sector
and raising concerns about an economic recession,
credit and quantitative easing acquired policy
priority in most central banks (Mohanty, 2011).
These liquidity-augmenting measures resulted in
unprecedented expansion as well as changes in the
composition of the balance sheets of several central
banks (Box IV.6).
4.58 The policy measures adopted by the central
banks of the advanced countries and the emerging
market and developing economies (EMDEs)
differed significantly. The central banks in advanced
countries extensively used credit and quantitative
easing measures, while they were barely used in the
EMDEs (Subbarao, 2011). To combat the contagion
effects of the global financial crisis, the EMDEs first
took recourse to liquidity augmenting measures
through instruments like currency swaps and CRR
before activating policy rate cuts, albeit from a much
higher level compared to the advanced economies.
Most of the emerging market central banks conducted
outright sales of foreign exchange reserves to meet
the demand for foreign funding in the domestic
market and to ease the pressure on the exchange rate. The central banks of Brazil, Korea, Mexico
and Singapore had dollar swap arrangements with
the Federal Reserve. However, the use of credit
easing and quantitative easing measures was more
limited for the emerging economy central banks
compared to their advanced economy counterparts.
Accordingly, the impact of the liquidity augmenting
measures on the central bank balance sheets was
less severe in the case of EMDEs.
Box IV.6
Unconventional Monetary Policy Measures and Central Bank Balance Sheets in Advanced Economies
Central banks the world over resorted to unconventional,
widespread and aggressive use of their balance sheets
during the recent global financial crisis in order to tackle
liquidity problems arising from intense market stress and
also to overcome the policy impasse arising from policy
rates approaching the ‘zero lower band’ to interest rates,
which impeded the monetary transmission mechanism. To
start with, central banks in advanced economies extended
conventional liquidity easing measures by expanding
the pool of securities as well as the number of counter-parties
eligible for their central banking operations, and
also extended the maturity of those liquidity-providing
operations. As the crisis deepened and the interest
rate channel became ineffective, central banks in these
countries were forced to go for quantitative easing.
Country-wise measures have been enumerated in detail in
Chapter 2.
As a result of the extensive use of credit and quantitative
easing, the balance sheets of central banks in advanced economies have expanded sharply. The ratio of total
assets to GDP of the Federal Reserve and the Bank of
England (BoE) increased from less than 10 per cent to
over 15 per cent of GDP, while the increase in the case of
the eurosystem was from 13 per cent to more than 20 per
cent of the euro area GDP (Chart). The size of the balance
sheet of the Bank of Japan (BoJ) was even larger at around
30 per cent of GDP, though it was more on account of
quantitative easing undertaken in the early 2000s. In the
emerging market economies, the size of the central banks’
balance sheets had already expanded considerably before
the crisis on the back of accumulation of reserves by central
banks. The combined foreign exchange reserves of major
emerging market economies stood at US$ 5 trillion in mid-
2008 (Hannoun, 2010).
The large-scale economic slowdown that accompanied
the crisis evoked counter-cyclical fiscal policy measures of unprecedented magnitude leading to the Keynesian
resurrection (also refer to Chapter 2). Reflecting such
fiscal stimulus measures, some of the leading advanced
economies witnessed significant deterioration in their
fiscal position in terms of a rise in the share of government
debt to GDP (IMF, 2011) and high government borrowing
programme with concomitant implications for monetary
transmission and liquidity management by central banks.
|
While the large-scale asset purchases by central banks
in advanced economies seem to have stabilised financial
markets, the resultant expansion in balance sheets along
with their compositional shifts has, however, increased their vulnerability to interest rate, exchange rate and credit risk
factors. While the interest and credit risks have assumed
significance in the balance sheets of central banks in the
advanced economies, as they have acquired private sector
assets as part of the central bank asset purchases during
the global financial crisis, the central banks in emerging
market economies, which hold large foreign currency
assets, face the exchange rate risk (revaluation risk) and
the risk of return on foreign assets falling short of the cost of
short-term sterilisation bonds, if issued by the central bank
or the interest income foregone on domestic assets.
References
Subbarao, Duvvuri (2011), “Implications of the expansion
of central bank balance sheets”, Comments by Governor
of the Reserve Bank of India, at the Special Governors’
Meeting, Kyoto, January 31.
Mohanty, Deepak (2011), “Lessons for Monetary Policy
from the Global Financial Crisis: An Emerging Market
Perspective”, Paper presented in the Central Banks
Conference of the Bank of Israel, Jerusalem on April 1.
Hannoun, H. (2010), “The expanding role of central banks
since the crisis: what are the limits?” BIS Speech.
IMF (2011), Fiscal Monitor Update, June 17.
RBI (2010), Report on Currency and Finance, 2008-09.
4.59 Unlike the experience of several foreign
central banks whose balance sheets have grown
in size due to the granting of loans and advances
and the extension of refinance facilities to various
institutions, the Reserve Bank’s balance sheet
shrank during 2008-09, despite the Reserve
Bank’s extensive use of both conventional and
unconventional measures to meet the domestic and foreign exchange liquidity needs of the increasingly
liberalised Indian financial markets. This contraction
in the balance sheet size was brought about by
specific liquidity injecting measures undertaken
during the crisis. On the liability side, the reduction
in the CRR by 400 basis points and the unwinding
of the government’s MSS balances served to reduce
the overall liabilities of the Reserve Bank. Since CRR
balances are a part of reserve money, a reduction in
the CRR shows up as reduction in reserve money
and vice versa. In addition, the MSS was another
instrument that came handy for the Reserve Bank
to expand liquidity in the system by unwinding of the
securities held under MSS. The amount sterilised
through MSS remained immobilised in the central
government’s account with the Reserve Bank9. The
unwinding of MSS balances gave adequate space for the Reserve Bank to embark on necessary
liquidity expansion without resorting to expansion in
its balance sheet by any significant measure.
4.60 On the asset side, one major factor that
led to the contraction in the balance sheet of the
Reserve Bank was the reversal in capital flows as
the crisis deepened and global macro-economic
conditions deteriorated. Consequent to the capital
outflows, the balance of payments position of India
came under pressure during the third quarter of
2008-09. As a corollary, the Reserve Bank was
required to drawdown the reserves to make up for
the shortfall in order to ensure orderly conditions
in the foreign exchange market. The drawdown of
reserves led to a corresponding contraction in the
base (reserve) money. Therefore, on the asset side,
reduction in foreign assets to stabilise the exchange
rates served to reduce the overall assets.
4.61 Although domestic assets expanded through
OMOs and the accommodation of the liquidity needs
of select Indian financial institutions, the net effect
was a contraction in the balance sheet size resulting
from the large and sustained reverse repo operations
due to the dampened credit environment. As a result,
the size of Reserve Bank’s balance sheet declined
to `14,082 billion as on June 30, 2009 from `14,630
billion on June 30, 2008. Thus, the release of earlier
sterilised liquidity back into the system stabilised
the markets and also prevented the Reserve Bank’s
balance sheet from showing any unusual increase,
unlike the global trend.
4.62 There are some key differences between
the actions taken by the Reserve Bank and the
central banks in many advanced economies to
combat the crisis (Mohanty, 2011). First, in the case
of injection of liquidity in the market by the Reserve
Bank, the counter-parties were banks, unlike non-banks
in the case of the advanced economies.
Even liquidity measures for other financial
institutions, such as mutual funds, non-bank finance
companies and housing finance companies were channelled through the banks. Due to restrictions
in the statutory provision of the RBI Act, 1934 for
lending to non-bank financial companies (NBFCs),
an innovative arrangement was put in place by the
central government for providing liquidity support
for meeting the temporary liquidity mismatches for
eligible Non-Banking Financial Companies-Non-
Deposit Taking-Systemically Important (NBFC-NDSI)
companies through a special purpose vehicle
(SPV). Under this arrangement, the Reserve Bank
was to purchase government guaranteed securities
issued by the SPV and the latter, in turn, was to invest
the funds received from the Reserve Bank in short
term instruments10. Although the availment of this
facility was limited, it was an example of effective cooperation
between the government and the Reserve
Bank to manage the liquidity crisis. Second, unlike
the mortgage securities and commercial papers
in the advanced economies, in India the range of
collaterals was not expanded beyond government
securities, which kept the collateral standards intact.
Third, despite large liquidity expansion, the Reserve
Bank’s balance sheet did not show unusual increase
because of the release of earlier sterilised liquidity.
4.63 The size of the Reserve Bank’s balance
sheet increased significantly in the next three
years. It expanded to `15,531 billion by June
2010, `18,047 billion by June 2011 and further to
`22,089 billion by June 2012 in response to the
policy actions and liquidity management operations
aimed at strengthening the recovery process while
containing inflation. On the assets side, there was
an increase in the Reserve Bank’s holding of both
domestic securities on account of open market
purchases of government securities for injection of
liquidity and foreign currency assets due to valuation
effects. On the liabilities side, the expansion of the
balance sheet is explained by the rise in currency
in circulation and deposits in 2009-10 and 2010-11
and accretion to the CGRA along with increase in
currency in circulation in 2011-12.
VI. Concluding Observations
4.64 The central bank’s balance sheet echoes its
relationship with two key economic agents to whom
it acts as a banker, viz., banks and governments.
While the relationship of the central bank with
banks in some sense is the core area of interest of
monetary policy transmission, the interface between
the fiscal and monetary authorities gets reflected in
the central bank’s balance sheet. This could assume
significance, as has been the case in the recent
global economic crisis when central banks adopted
unconventional monetary policy measures including
purchases of government bonds to provide liquidity
and stability to financial markets. Thus, having
analysed the connection between the central bank’s
balance sheet and monetary dynamics in an earlier
issue of this Report, the present chapter analysed
the developments in the Reserve Bank’s balance
sheet as a mirror of the evolving relationship
between the government and the Reserve Bank
of India, particularly in the post-reforms period. As
discussed in the chapter, the link between the two
authorities from the Reserve Bank’s balance sheet
perspective can come through three sources, viz.,
government deposits with the central bank, the
central bank’s loans to the government through WMA
and overdrafts and its investment in government
securities.
4.65 Historically, fiscal dominance was evident
during the period of social control (1968–1990).
The initiation of monetary targeting approach since
the mid-1980s underlined the need to overcome
operational constraints and rigidities, arising on
account of fiscal dominance, in monetary policy
operations. The emergence of a market-based
government borrowing programme, cessation of the
Reserve Bank’s involvement in primary government
securities issuances and the substantial reduction in
its contribution to various long-term funds ushered
in a new era in the interface between the central
bank’s balance sheet and fiscal policies. The share
of net RBI credit to the central government in the
overall monetary base has progressively declined
over the last three decades.
4.66 In the 2000s, while the dominant role of
fiscal expansion in monetary expansion gradually
faded, capital flows took centre-stage and added a
new dimension to the balance sheet of the Reserve
Bank, as the net foreign assets were accumulated
simultaneously with a reduction in net domestic
assets on the Reserve Bank’s balance sheet. As a
result, deviations between the projected and actual
M3 growth remained significant, albeit lower than that
of the monetary targeting regime of the 1980s and
the 1990s. The introduction of the MSS under which
government securities were issued for sterilisation
purposes was an important milestone in the interface
between the fiscal and monetary authorities, with
the fisc also sharing the cost of sterilisation.
4.67 It is important to note that the adoption of
unconventional monetary policies and quantitative
easing measures during the global financial crisis
have expanded the balance sheets of several central
banks. In contrast, in India, the intervention by the
Reserve Bank was structured such that its balance
sheet contracted in 2008-09. The Reserve Bank’s
balance sheet has expanded significantly since
then reflecting its liquidity management operations,
aimed at strengthening the recovery process while
supporting the government borrowing programme
and containing inflation. In light of the increasing
valuation and systemic risks in today’s market
oriented and globalised environment, particularly
in the post-crisis scenario that saw several central
banks facing problems on the capital front, a need is
being felt to strengthen the balance sheet, which has
implications for the surplus transfer from the Reserve
Bank. Revenue on account of seigniorage that
essentially refers to the profit from money creation
has also generally moderated post-crisis reflecting
the fall in international interest rates coupled with a
decline in CRR.
4.68 As already indicated, the central bank’s
balance sheet captures the spirit of the relationship
of the central bank with commercial banks and
the government. This relationship is not static, but
undergoes significant transformation over a period
of time. The Indian experience is no exception to
this general trend.
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