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What does the RBI's MRI say? - Outside View by S.S. TARAPORE

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What does the RBI's MRI say?
Sep 4, 2015

Studying the balance sheet tells us why the RBI needs to be ultra conservative in its accounting practices

The Reserve Bank of India Annual Report always bears the stamp of excellence. Scribes invariably skip the arcane RBI accounts and concentrate on the review of the economy. This is unfortunate as the RBI balance sheet is a magnetic resonance image (MRI) of the economy, and therefore deserves close attention.

This is all the more important when the RBI undertakes major changes in the way the balance sheet is constructed.

With their exclusive power to create money, central bank accounts cannot follow standard balance sheets. The hallmark of a central bank's balance sheet is that it should follow ultra conservative accounting policies. The central bank balance sheet is not driven by profits but by the wider interests of the economy. Low profits of the central bank, under certain conditions, reflect improved performance of the economy. Per contra, large profits may reflect the poor state of the economy.

Foreign and domestic assets

The RBI's balance sheet in 2014-15 grew by 10 per cent. As on June 30, 2015, domestic assets constituted 26 per cent of the total as compared with 33 per cent the previous year. Again, foreign currency assets accounted for 74 per cent of the total, against 67 per cent the previous year. The increase in share of foreign assets reflects a strengthening of the balance sheet. By and large, in the emerging market economies (EMEs), the return on domestic assets is much higher than on foreign assets. Prudent central banks do not relentlessly pursue higher total income. Rather, they welcome the increase in the proportion of foreign assets.

In the case of some central banks, notably the one in Germany, the legislative framework makes it mandatory for the government to pick up all the losses of the central bank. In the case of countries such as India there is no such legislative safeguard. Thus, the RBI must be ultra conservative in its accounting practices.

Changes in the balance sheet

In the recent period, the RBI has moved towards standard corporate accounting principles. In the case of prices of foreign securities, once they are written down they were not written back when prices rise. Again, on domestic securities these were valued on the lower of book value or market price.

Now these are being altered to fair price. Such changes may bring the RBI closer to standard accounting norms but the move away from ultra conservative practices will create problems in the future. The RBI's securities transactions are determined not by a profit motive but by the need to adjust liquidity in the economy. Hence, its absorption or unloading of securities is not governed by a profit motive. There was great merit in the earlier valuation practices followed by the RBI all these years.

The RBI all along had a Contingency Reserve (renamed Contingency Fund) and for over 15 years an Asset Development Reserve (renamed Asset Development Fund). Many years ago, it was the objective of the RBI to raise the CF and ADF to 12 per cent of total assets. For the last two years there has been no accrual to the CF. As a result the total of the CF and the ADF as a percentage of total assets has fallen from 10.1 per cent in June 2013 to 8.4 per cent in June 2015.

The absolute amount of these funds is now Rs. 2.43 lakh crore but compared with the size of the RBI balance sheet this amount is puny.

During the 1980s and up to 1991, the RBI was required, at government's behest, to give unlimited exchange rate guarantees under the Foreign Currency Non-Resident Accounts Scheme (FCNRA) as also for the funds parked with the RBI of flagship foreign borrowing by Indian financial institutions. There was a real danger of the RBI going bust as it would have been stripped off all its reserves and yet would have had liabilities to clear in June 1993.

The RBI has to make provision on an accrual basis while the government follows a cash basis. On a brilliant resolution worked out by Governor Rangarajan and Deputy Governor Janakiraman and Finance Secretary Montek Singh Ahluwalia, all FCNRA liabilities were transferred to the government with a written assurance that the RBI would, each year, meet the loss incurred by the government. The RBI's institutional memory should have reminded today's policymakers of the 1993 episode.

Income-expenditure

Table XI.2 on page 142 of the report shows a memorandum item,'Transfer of surplus to government as percentage of gross income less expenditure'. This presentation is erroneous. The surplus to be transferred is after allocation to various funds.

The overzealous presentation in the Annual Report to show that 99.99 per cent of the gross income minus expenditure is being transferred to government is bound to embarrass the RBI in future. It is best that the RBI drops this memorandum item in future.

It is now going to be difficult for the RBI to indicate that in future that there would be sizeable allocations to the Contingency Fund. But the sooner the RBI bites the bullet, the better. From June 2016 onwards, the RBI must restart building up the CR and the ADF by the same percentage growth as the total assets. Thereafter, the RBI should increase the size of the two funds to reach the earlier target of 12 per cent of total assets and thereafter gradually increase this ratio.

The decision to make no allocations to the CR for two years is a serious lapse by the RBI and the RBI will pay dearly for this faux pas.

Please Note: This article was published in the Business Line print edition dated September 4, 2015

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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