Legislating payments out of RBI’s excess capital could compromise its independence. Critically examine keeping in mind the recent committee established for examining issues of how much equity that RBI should hold. (200 W)




Model Answer:

RBI’s equity sharing works as a fuel cum cushion to its operations and supports against any financial downturn. In simple words, it is the capital set aside to meet the contingency requirement of RBI.

The RBI’s current equity holding is around 27% of its total assets which puts an argument that it is too high in comparison to other countries. Hence, there are views that the RBI should transfer a part of this excess capital to the government as a one-time payment.

The equity sharing of RBI is further categorized as:

  • Paid-up capital, contingency capital, revaluation capital and asset development fund.
  • The two largest components of these are contingency capital (6.6 per cent) and revaluation capital (around 20 per cent). The revaluation capital is an accounting entry that offsets changes in the rupee value of the foreign assets and gold holdings of the RBI due to changes in the exchange rate of the rupee and changes in the dollar price of gold, respectively.

The issue has been in limelight due to recent disputes between centre and RBI regarding transfer of excess capital funds to State as one-time payment.

  • In recent study conducted, it is highlighted that RBI require a 30% overall equity to asset ratio to cover 95% of all shocks it faces. Hence there is no excess capital with RBI to transfer. To substantiate, if instead, one only focuses on non-exchange rate related shocks, then the core equity to asset ratio needed by the RBI to cover 95 % of all such shocks is around 17%. This implies that the RBI’s current core equity level of 6.6 percent needs to be more than doubled.
  • Central Bank should not be treated as Commercial Bank. Instead, Central Bank’s equity should ideally be maintained in safe margins as it upholds political and economic credibility, provides cushion to external and internal shocks.
  • Putting a part of the country’s assets in a protected entity like the central bank builds fiscal credibility of the country as long as the central bank is viewed by markets as being independent of the government. This can improve the country’s international credit rating.
  • It also gives the central bank greater credibility in committing to perform its emergency functions without worrying about the fiscal contingencies of the government.

Mandating payments from the Central Bank: a policy moral hazard:

  • Mandating payments from the capital of the central bank creates a policy moral hazard.
  • For example, a cut in the policy rate raises the value of government securities that the central bank holds.
  • If the resultant rise in the central bank’s equity sparks a payment to the government then there would be greater spending and inflationary pressure in the economy.
  • Anticipating this, the central bank would be tempted to not lower rates as much.
  • A similar argument operates with exchange rate depreciation.
  • More generally, legislating payments out of the central bank’s excess capital will tend to compromise its operational independence in achieving its policy mandate.

What should be done?

Keeping the situation of RBI in mind and the scenario prevailing, the advisable route for the committee currently looking into the RBI’s capital structure is to recommend a formal agreement between the government and the RBI with the agreement stipulating:

  • A target band for the equity level of the RBI based VaR computations;
  • The time frame within which the RBI needs to bring its capital level back within the band every time the bounds of the band are breached, and
  • Explicitly prohibit any payments to the government that is based on the equity level of the RBI.

The mandate of both, the government as well as the RBI is country’s development. Hence, both needs to settle the tussle between growth and inflation with proper arrangement of mechanism and function.