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.
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.
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.
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).
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.
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
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.
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:
● 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
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).
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).
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.
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).
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
3 In 1992, the practice of transferring large sums to the Statutory Developmental Funds out of the surplus income of the Reserve Bank was discontinued, and the unutilised balances were also transferred to the CR from 1998 to strengthen the Reserve Bank’s internal reserves.
4 Hitherto these securities were valued on the basis of lower of book value or market price (LOBOM) prevailing on the last business day of each month wherein depreciation was adjusted against current income and appreciation was ignored. Discount/ premium, if any, was not amortised.
5 If the balances in CGRA account get wiped out due to sharp fluctuations in gold and foreign currency assets, the losses on revaluation will have to be made good by drawing on the CR. In case the CR turns negative, it has to be replenished by drawing from the income for that year which, in turn, can affect the profitability of the central bank.
7 Actual earnings on foreign assets were taken instead of potential returns as a benchmark return on these assets was difficult to arrive at without information on the portfolio of foreign investment of central bank assets which is not disclosed.
9 In the aftermath of the crisis, fresh issuances under the MSS were withheld and part of the government’s market borrowing was financed by de-sequestering the balances under the MSS cash account. Buyback of existing MSS securities was also undertaken to inject liquidity into the system. This essentially resulted in a compositional shift within the head ‘Deposits’ on the liabilities side of the balance sheet. Reflecting these operations, MSS balances declined significantly over the six-month period, from over `1,740 billion at end-September 2008 to around `229 billion by end-June 2009.