Behind The Government-RBI Square-Off Lies A Strained Past

There has never been a Finance Ministry meeting with the Reserve Bank of India (RBI) on dividends that has not been acrimonious. India’s finance ministers, faced with the looming fiscal deficit, have always looked up to the RBI to fill some of that. So to those who track the relations between North Block and Mint Road, the decibel levels of the current dispute seem rather out of place.

To get a sense of what is happening, I intend to wade through some numbers and then tell you about the clash of egos.

First, the numbers: the RBI holds, as part of its other liabilities, five types of reserves. The fattest of those are currency and gold revaluation account and contingency reserves. The government wants a share of those in addition to what the RBI pays out every year as profit from its operations.

Globally, all major central banks reckon their solvency as follows. To the capital they hold, they add their reserves, which they top up by transferring a certain part of their earnings. This comprises their total equity. This equity is measured as a percentage of their total assets to assess how solvent the respective banks are.

There are no given yardsticks unlike those for commercial banks to decide what is an adequate or safe level for the central banks. What do these reserves provide for, since it is commonly understood that the RBI is a sovereign entity with the power to print notes? That is incorrect. In the world of money, a sovereign is only as good as the financial power they hold. Part of that financial power comes from the reserves held as part of the equity of the central bank.

So, the reserves are meant to meet unforeseen contingencies, including depreciation in the value of securities the RBI holds, cover for risks arising out of monetary or exchange rate policy operations, and any other systemic risks. While this is clear, what is not is an agreement on an adequate level of reserves that a central bank should hold. As the Y P Malegam committee, set up by the RBI in 2013, noted, there are variations:

“Thus:

1) The Bundesbank Act requires the Deutsche Bundesbank to build up reserves over the years till such reserves are equal to the Capital.

2) The Banque de France builds up a General Reserve Fund until it reaches twice the size of the Capital.

3) The Swiss National Bank is required to use its profits primarily to set up provisions permitting it to maintain the currency reserves at the level necessary for monetary policy purposes.

4) The statute of the European Central Bank provides that it may transfer to the General Reserve Fund each year an amount not exceeding 20% of the net profits till the Reserve Fund equals the Capital.”

The RBI Act had offered no such explicit instructions. So, the RBI set up successive committees, first under V Subrahmanyam in 1997 and then Usha Thorat in 2004, followed by the Malegam committee in 2013. The former suggested the reserves (since its capital was a puny Rs 5 crore) should reach 12 per cent of the total assets. The Thorat committee pitched it even higher, at 18 per cent. By the time the Malegam committee arrived on the scene, the actual reserves including both currency and gold revaluation account and contingency reserves had reached 30.25 per cent. According to the RBI’s latest balance sheet, this has partly shrunk to 28.92 per cent.

Malegam offered no figure on what he thought was a prudent level, to only say: “The Committee recommends that adequate amount of the profits should continue to be transferred each year to (the reserves). The Committee does not wish to comment on specific amount to be transferred to the CR as it is a policy matter to be decided by the Management”. Based on his recommendation, then RBI governor Raghuram Rajan transferred the entire surplus that year to the government.

Incidentally, a comparison across 18 major central banks made by the same Malegam committee showed that the level of reserves held by the RBI was far more than others. So, there is clearly a justification by the Finance Ministry to ask for more. This is the issue that always comes up for argument between the two agencies, more so in a year like the current one, where the fiscal deficit looks unmanageably wide to bridge.

Now for the story: Under former finance minister Pranab Mukherjee, the Finance Ministry set up an act to reform the finance sector. Known as the Financial Sector Legislative Reforms Commission (FSLRC), the body suggested sweeping changes to the role of the RBI. It broadly suggested divesting the RBI of its entire role of supervision of banks to a Financial Services Authority and retain only the role to decide on the interest rates. The subtext of the entire operation is to clearly establish the Finance Ministry as the principal and the RBI, Securities and Exchange Board of India or Insurance Regulatory and Development Authority as its agents. While the others broadly accept this role, the RBI has made it clear that it is equal in the setting of the monetary policy while the Finance Ministry decides on fiscal policy.

Successive RBI governors have accepted this position and fought to retain this independence. Y V Reddy had publicly disowned the predecessor reports of FSLRC. In the Union budget for 2015-16, the ministry sought to change the RBI’s role accordingly through the Finance Act, which Rajan objected to and was finally able to clip. FSLRC has been a red rag for the RBI, which has no love lost for it. It has shown itself in several skirmishes like the one about setting up of a payments regulator without the control of the RBI. It is still raging.

The current square-off stands on the memories of these battles. The Finance Ministry’s insistence on invoking Section 7 of the RBI Act and RBI’s rejoinders like deputy governor Viral Acharya’s speech take this story forward. Beyond the numbers, it is these differences that sour the relationship between the two. One would suggest setting up of a new committee with a generous representation from the two sides to examine government-RBI relations with a clear mandate to jettison FSLRC; this may help both emerge as winners.