RBI Revaluation Reserves: A Dispassionate Look 

On 19 November, the board of directors of the Reserve Bank of India (RBI) met and agreed to constitute an expert committee to determine the appropriate level of economic capital that the central bank must hold. So, now, all of us have the time to evaluate the issue more objectively.

Niranjan Rajadhyaksha (former senior editor at MINT and a good friend) wrote a column in MINT which basically gave the following message:

- The equity plus contingency reserves have hardly increased revaluation reserves have reflected growing FX holdings
- Comparisons with other countries are really not useful unless we understand the specific institutional arrangements.
- The government has really not given us a solid argument other than RBI has more capital as a proportion of BS than other CBs.

Few days later, just on the day of the RBI board meeting, MINT published an excellent interview with economist Indira Rajaraman.

She said the following:

I think in a lot of what RBI does, there is this sense—I am not attributing it to the present governor—an institutional sense that there are things that have to be done in public interest which the public cannot quite comprehend. That has to go. I think there has to be a sense that the public can understand if they are made to understand.

The questions that North Block is raising exhibit a fairly nuanced understanding of a number of issues. Let’s say the 12 issues that were raised by the government in the three letters to RBI. I was quite surprised at the depth of understanding in North Block of the various issues and in particular on the reserves issue. I think it was time the question was asked and RBI was made to defend its particular level of reserves.

Mr. Malegam, who is considered a high priest on the reserves issue as he has been on the board for so many years and has chaired a couple of committees on it, has said that under Article 58 of the RBI Act, there is no provision for transfer of reserves to the government. I do not agree with him there.

Yes; of course, in Article 58, there is no explicit provision for transfer of reserves, but then again, there is no provision that reserves must not be transferred. There are a lot of things unsaid in the legislation and for the government to have identified that hole and to say that there is possibility of transfer and tell us why you cannot transfer.

In addition, there have been many regulatory lapses during the last year which have led to a sense among the ministry of finance and educated watchers that the regulatory plumbing needs to be overhauled.

For instance, the RBI annual report is a submission of the board of RBI to the ministry of finance and not of the RBI management to the ministry of finance as was the general impression.

The annual report used to be placed in the draft form for a 15-minute examination by the board before it was pulled away for finalization. I used to speak up and tell my board members that this is going from us and we should read this. In the four years, I was probably the only one who insisted on a draft and having a video link with RBI in Mumbai with my comments on every page of the draft.

I am sure I was considered a nuisance but I took my responsibilities seriously as a board member of RBI and wanted that the annual report should be accurate portrayal of RBI’s functioning.

The board for a long time was not aware of its powers. In a certain sense, this confrontation has brought to the fore the role of the board, its powers and responsibilities and made the management more aware that they are accountable.

RBI has to engage as its actions impinge on everyone in the country. There has to be more transparency and more willingness to talk to people who do not understand the intricacies but are still in need of an explanation.

I don’t think they are just motivated by the fiscal concern. There is the liquidity concern also which could be termed as in the public interest.

The important thing is that RBI has to look into each issue on its merit.

For instance, on the liquidity issue, the government asking for a calculation of the liquidity squeeze, or asking why does the central bank think that liquidity is adequate; I think the ministry of finance is perfectly justified in it.

Given her intellectual depth and breadth of experience, her own previous association with RBI and her final wish for this institution to be nourished and cherished lend her criticism of RBI a far greater authenticity and credibility than that of the many unthinking, reflexive defences of RBI.

Revaluation Reserves

Revaluation Reserves are gains accruing from the rise in the value of the foreign currencies and gold against the Indian rupee. That is why it has swelled to about 25 per cent of the forex and gold reserves.

In general, for India, the revaluation reserve will only keep rising. The rupee has a history of depreciation and for the right reasons. India is productivity and scale challenged. Hence, it is export-challenged and hence, it is current-account challenged.

Therefore, the risk that a sharp appreciation of the rupee will erode the value of the foreign currency assets that RBI holds and hence, it should be adjusted against the revaluation reserves is rather remote for the foreseeable future.

Revaluation reserves have reflected growing FX holdings – that is factually correct. Revaluation profits will keep occurring with a currency that is a ‘depreciating unit by default’. India’s revaluation reserves at about 26 per cent of RBI’s foreign currency and gold reserves are too high.

Bank of Brazil’s revaluation reserves are a very tiny portion of its foreign exchange reserves. Indeed, Bank of Brazil’s overall equity (capital + reserves) is rather modest.

In contrast, Bank of Russia’s capital is nearly 37 per cent of its balance sheet size! Bank of Russia does not give breakdown of its capital into capital and reserves.

People’s Bank of China Balance sheet for 2017 shows that the bank has far too tiny a capital base and no revaluation reserves. The Chinese yuan does appreciate more often and in greater magnitude than the Indian rupee does. It has a huge cache of foreign exchange reserves which loses value whenever the yuan appreciates. Yet, they do not have revaluation reserves. See here.

So, the question arises as to why India has such a large revaluation reserve of around 26.2 per cent of its total foreign assets (Rs 6916.41 billion against total foreign securities of Rs 7983.89 billion + Rs 18366.85 billion as of 30 June 2018). On top of this, there is a contingency reserve of Rs 2321.08 billion.

There is an interesting article in India Express (ht Usha Thorat, former RBI deputy governor) published on 19 November 2018, written by P Vaidyanatha Iyer:

In June 1994, while finalising its balance sheet, the RBI realised it was unable to provide for the exchange loss liability on account of a foreign currency deposit scheme offered by banks since 1975. …

The scheme was called the Foreign Currency Non-Repatriable Deposit Scheme, or FCNR-A, and was introduced to attract capital inflows and help finance deficit in the current account. Prodded by the government, banks offered interest rates higher than what they offered on local deposits. These deposits ballooned in the 1980s.

The RBI had agreed to provide exchange guarantee on these deposits. It didn’t think too much into the future then, and had a simple rationale: the dollars were added to foreign currency assets, these were revalued when the rupee depreciated, and so the revaluation gains would be available for meeting losses during repayment of principal. The interest to be paid on the FCNR-A deposits would be met through earnings on the dollars invested abroad.

But then, India was hit by a Balance of Payments crisis in the late 1980s. According to sources familiar with the developments then, the forex assets depleted fast and even the $1.1 billion of assets in 1991 represented dollars sold forward under a separate swap arrangement with State Bank of India. The losses from 1991 till 1994 were met by drawing from the Exchange Equalisation Account and the Contingency Reserve of the RBI. By 1994, both these reserves were fully depleted, and there was no source for providing for exchange losses on $10-billion worth dollar liabilities under the FCNR-A scheme.

The FCNR-A liabilities comprised $5 billion in principal and $5 billion in accrued interest. The average rate at which these dollars were bought was about Rs 16 a dollar. In 1994, the exchange rate was almost double at Rs 31.37, meaning the RBI had to bear a loss of Rs 15 more on every dollar. The total loss added up to Rs 1,500 crore.

Now, we understand the situations for which the revaluation reserves and contingency reserves were put to use, earlier. But, since then, RBI does not offer exchange rate guarantees. Commercial banks bear the risk when they attract dollar deposits.

The ‘Usha Thorat Committee’ had recommended a total of 18 per cent of assets for both revaluation reserves and contingency reserves. Actually, the denominators are slightly different. The ‘Currency and Gold Revaluation Reserve Account’ of 12-13 per cent is calculated against foreign currency assets and gold holdings whereas the Contingency Reserve of 5 per cent is on overall assets. Foreign currency assets constituted roughly 73 per cent of total RBI assets as of 30 June 2018.

I understand from reliable sources that contingency reserves are held by the Reserve Bank of India for the following reasons:

- when market intervention operations cost more than the anticipated;

- for shortage in deposit insurance fund;

- for any cyber security risk;

- for ‘lender of last resort’ function and

- if there is no transfer to GoI because of above contingencies, then it could affect fiscal math - hence some minimum profit transfer to GoI had to be assumed by RBI each year for better fiscal management by the government

The Economic Survey of 2015-16 had recommended that total reserves be 16 per cent of RBI assets, reduced from 32 per cent (Box 1.6, Chapter 1, p. 19, Economic Survey 2015-16) and wanted the ‘excess reserve’ be used for bank recapitalisation.

So, even if the government fiscal math was behind the recent clamour for RBI’s ‘excess’ reserves, it is not unreasonable because the fiscal math was not undone by any reckless spending on the part of the government but because of the introduction of Goods and Services Tax, because of the failure of investment cycle to kick in, leading to higher economic activity and tax revenues, etc. Further, although bank recapitalisation charges were not reckoned with for fiscal deficit calculations, interest paid on the amounts would be added to the government expenditure.

Indian newspapers today have flagged a recent Bank of America – Merrill Lynch report which mentions the excess reserves that RBI could potentially transfer to the Government of India. The report puts the figure between Rs 1,00,000 crore and Rs 3,00,000 crore (Rs 1.0 trillion to Rs 3.0 trillion). See here.

So, there is a case for cooler heads and some transfer of excess reserves from the Reserve Bank of India to the Government of India.

How Does RBI Pay This To GoI? My Proposal Is This

Let a certain portion of the revaluation reserves be written back to the income statement every year, over three to five years. Then, it can be paid along with the profits for the year to GoI. To be sure, during this period, the revaluation reserves may increase if the rupee depreciates. Then, the duration may get lengthened. So, be it. Amortizing the payment to GoI over a period is the least-disruptive way to reduce the revaluation reserves from its current ‘excessive’ level to a comfortable level and also avoid the accusation that it is a short-term expedient for the present government.

What About The Other Demands Of The Government Of India?

Ananth Narayan has neatly listed the government demands in his latest article in Economic Times:

- The government wants the RBI to relax lending restrictions on the notionally weak banks that are under RBI’s Prompt Corrective Action (PCA) framework.

- It wants RBI to provide forbearance (in other words, to close its eyes) on stressed loans, particularly to the power and micro, small and medium enterprise (MSME) sectors.

- It wants to access the capital on RBI’s balance sheet.

- Finally, it wants the RBI to provide relief to stressed non-banking financial institutions (NBFIs).

We have dealt with no 3 in the list in this blog post.

On the other three demands, my suggestion is that the government should bite its lips and not interfere with the central bank’s current stances. After all, they are the extension of the structural reforms that the government itself had undertaken – willingly or otherwise.

It did demonetisation; it introduced the Goods and Services Tax; it enacted the Insolvency and Bankruptcy code and it passed the Real Estate Regulation Act. All these mean discontinuity with the status quo that had prevailed for the previous 67 years. Similarly, regulatory forbearance has been the practice of the previous 67 years. In these areas, RBI is wanting to signal a change. It is welcome. It is painful in the short-term. The government has to bite its lips and face the short-term growth disruption and the complaints of its core constituencies who might be affected.

To offset the political damage, the government must take the case to the people, as it did in the case of demonetisation. It must market itself as the champion of long-term structural reforms for the good of the nation, sacrificing its own personal and political interests in the short-term for the good of the nation.

Not easy but do-able.

What Should RBI Do On Its Part?

It must come off its high horse and admit to failings in its regulatory architecture and practice. It should listen to Indira Rajaraman. As Dr Y V Reddy said in a speech in February, it must come out with a white paper on non-performing assets, detailing its own failings. It must accept to regulatory shortcomings with respect to detecting frauds such as the one that happened in Punjab National Bank. The case of IL&FS highlighted failures in the regulation of non-banking finance corporations. It must be candid; admit to its inadequacies and failures, resolve to address them and outline steps it will be taking to do so, with clear timelines. It must report to the public on the progress of the redressal measures and close them within a reasonable time-frame.

As importantly, it must use the opportunity to address consumer issues as highlighted by Debashis Basu in this article in Business Standard recently.

This piece was first published on the writer’s blog and has been republished here with permission.