Business and Financial Guide

RBI’s decision of surplus transfer and its impact on investors

Authored by Rishav Ray and Subhadeepa Sen, Students at Christ University, Bangalore

Introduction

Recently, the RBI has notified that it shall be transferring a surplus fund amounting to INR 99,122 crores to the government of India. It has been claimed by economists that the union government’s change in banking policies for forex gains may have partially contributed to this more than expected surplus transfer. In order to understand this more efficiently and how it shall be impacting the fund investors an in-depth study including those of previous surplus transfers is required to be done.

A brief insight on RBI’s Surplus Funds

RBI’s Surplus funds constitute an amount that RBI “transfers” to the government. The financial statements of the RBI have two distinct characteristics. It is exempt from paying income tax and is expected to contribute any surplus to the government upon meeting its own needs.[1]

Another question that might crop in the reader’s mind is how does RBI makes a profit in order to give surplus funds to the government since it is a central bank. It is noteworthy that, RBI is considered a “full-service central bank”, meaning, it is in charge of handling the government of India’s and state governments’ borrowings, as well as monitoring and regulating “banks” and “non-banking finance firms”, and administering the “currency and payment systems”. It makes money when performing these tasks or operations. The interest earned on the central bank’s foreign currency reserves, which include “bonds and treasury bills” approved by other central banks, as well as top-rated securities and deposits with other central banks, is the main source of income. It also earns interest on government bonds denominated in rupees.[2]

It is also pertinent to elucidate the essence of the government’s surplus or profit transfer agreement with the “Reserve Bank of India (RBI)”. The RBI does not pay a “dividend” to its owners because it is not a commercial organisation like banks or other government-owned or controlled businesses. Despite the fact that the Reserve Bank of India (RBI) was established in 1935 as a private shareholders’ bank with a paid-up capital of Rs 5 crore, it was nationalised in January 1949, declaring the “sovereign” its “owner.”

As per “Section 47 (Allocation of Surplus Profits) of the Reserve Bank of India Act”, 1934, the central bank handovers the “surplus”, which constitutes “the excess of income over expenditure” – to the government: After making provision for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation fund [and for all other matters for which] provision is to be made by or under this Act or which are usually provided for by bankers, the balance, of the profits, shall be paid to the Central Government.”[3] The RBI’s Central Board accomplishes this in early August after the July-June accounting year closes.[4]

Understanding the transfers for previous years

Looking at the transfers from the year 2015 to the present, it can be said that the surplus transfer is the largest since the central bank transferred Rs 1.75 lakh crore in 2018-19, which included a one-time payment due to a shift in the RBI’s Economic Capital Framework. The CRB must be maintained at 5.5-6.5% of the balance sheet as per the newly created system. The central bank has decided to keep the smallest buffer possible. It is therefore pertinent to study the August 2019 transfer.

The surplus amount to be transferred to the government was decided to be INR 1.76 lakh by the RBI Board. This was the largest surplus transfer ever made by the RBI and thus gave rise to a huge controversy among economists. Bimal Jalan, the former RBI governor headed a capital transfer committee upon whose advice the government was working. Certain recommendations of the committee are noteworthy to understand the transfer of funds and working of RBI.

The Committee recommendation

The CRB or the Contingent Risk Buffer was the prime focus of the Jalan Committee while suggesting the reforms.“The Contingent Risk Buffer refers to the risk provisioning made from economic resources to cover monetary, fiscal stability, credit, and activity risks (CRB).”[5]

“The RBI should keep CRB in the range of 6.5-5.5 percent of its balance sheet, with 5.5-4.5 percent for monetary and financial stability risks and 1% for credit and operational risks, according to the committee”[6]. It should be noted that the CRB was in the range of 7.05-8.4 percent for the four-year period 2015-2018. After writing back excess provision of 52,637 crores, this came to 5.34 percent in 2019. As of June 30, 2019, economic resources accounted for 23.3 percent of the balance sheet.

The Committee had put forth four major recommendations. It emphasized on the RBI’s economic capital. The Committee suggested a revision of the RBI’s liabilities so as to show the value differences between realized equity, which is a kind of fund in order to tackle the losses stemming from retained earnings and revaluation balances. Now, it is noteworthy that, “unrealized profits, net of losses resulting from the currency exchange rate, price of gold, and interest rate fluctuations,” are accounted for by revaluation balances on the liabilities side of the balance sheet.[7] It is mostly reflective of the benefits achieved as a result of the value of rupees falling against the dollar. It considered the provisions for financial, monetary, external stability risks by the RBI to be the nation’s way of dealing with a financial or monetary crisis situation that may arise. Expected Shortfall methodology was also suggested to be adopted as a tool for measuring RBI’s market risks. This methodology is basically devised in order to calculate the minimum amount of return expected on the “portfolio” keeping in mind, the worst-case scenarios that may come up in the future.  Lastly, it put forth a proposal for a surplus allocation strategy that focuses on the RBI’s realised equity level within the overall level of its economic capital, as opposed to the previous policy that focused solely on total economic capital.

Understanding the present transfer

 Present economic challenges both international, as well as domestic, were taken into consideration by the RBI. Additionally, the recent Reserve Bank policy steps taken to mitigate the negative effect of the second wave of Covid-19 on the economy were also discussed during its meeting. It can be understood that the amount of surplus that the RBI would transfer to the Government of India is significantly higher than what was budgeted. This will provide a cushion to absorb the indirect tax revenue losses expected in May-June 2021 as a result of the effect of the now widespread state lockdowns on discretionary spending and contact-intensive services. Additionally, the higher prices of commodities at a time when demand and pricing power are weakening will eat into corporate profit margins in many sectors, limiting direct tax revenue growth.

The Impact on Investors

It is the interest income earned from foreign and domestic sources which truly make up the revenue of the RBI. These are very prone to market risks and uncertainties as has been shown by the Jalan Committee. Keeping this factor in mind, it is very important for the CB to take care of the balance sheet of RBI rather than supporting the quasi-fiscal deficit of the government.

Since this transfer would essentially be non-tax revenue for the government, there shall be a reduction revenue deficit and fiscal deficit in the budget. Since surplus transfer is essentially a government’s quasi-fiscal deficit, there should be a check on preventing its inflation by accounting arrangements, regardless of how transparent the process is. Although it is the government that owns the RBI, there are two balance sheets at the end of the day. It is always wise to safeguard the balance sheet of the RBI. Else such a practice would go against prudent fiscal management principle. This in turn would give a negative signal to CRAs and international investors and thus, negatively impact the investment outlook for the near future. 

However, this shall bring about a good growth opportunity for private sector investment. It is undeniable that the pandemic has devastated the economy heavily. The pandemic was the worst humanitarian and economic disaster of the century. The economic effect of the pandemic-induced lockdown was huge and it drained the fund reserves of the government. Owing to the lockdowns during the previous year, the goods and services tax revenues were at loss. Therefore it would have been hard for the Government to meet its disinvestment target of $24 billion. Thus, it can be elucidated that this surplus will be used to disinvest in the public sector which is usually run pretty inefficiently and is often loss-making enterprises to the government. Thus, this reflects an overall change in the politico-economic ideology of the government wherein the government is concentrating more on privatizing the economy. Thus, the government is showing signs of making the economy more efficient and capitalistic and less socialistic, welfare-oriented at the moment signaling a great shift with respect to politics in the nation. The surplus can also thus, be used for the planned massive infrastructure push in the economy and increase job creation with the help of both private sectors as well as infrastructure project and reduce the staggering level of unemployment created by the pandemic.

The views of the author(s) in this article are personal and do not constitute a legal/business/financial opinion or advice of the BFTLR.

References

[1] What are RBI’s surplus funds, where do reserves come from? THE TIMES OF INDIA (Aug. 27, 2019, 01:19 PM), https://timesofindia.indiatimes.com/business/india-business/what-are-rbis-surplus-funds-where-do-reserves-come-from/articleshow/70849771.cms

[2] Explained: Why and how does the RBI transfer ‘surplus’ to the government? THE INDIAN EXPRESS (Aug. 27, 2019, 10:04 PM), https://indianexpress.com/article/explained/explained-why-and-how-does-the-rbi-transfer-surplus-to-government-5942031/

[3] Reserve Bank of India Act, 1934, § 47, No. 2, Acts of Parliament, 1934 (India).

[4] Ibid.

[5] Report of the Expert Committee to Review the Extant Economic Capital Framework of the Reserve Bank of India, RESERVE BANK OF INDIA (Aug 27, 2019), https://m.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=939

[6] Ibid

[7] Somesh Jha, Utilising RBI’s revaluation balances a moral hazard: Bimal Jalan panel, BUSINESS STANDARD (Aug. 28, 2019, 09:15 PM), https://www.business-standard.com/article/economy-policy/utilising-rbi-s-revaluation-balances-a-moral-hazard-bimal-jalan-panel-119082801309_1.html

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