Central banking is probably one of the more profitable businesses. The combined Federal Reserve income and expenditure statement shows a net profit margin (surplus before transfer to treasury to total income) of 55% in 2018. In the case of the Bank of England, the banking department had a margin of 16.4% in FY18, while for the issue department it was 54.3%. In 2018, the ECB had a margin of 58.6%, which is in line with the Fed. In case of RBI, for FY19, it has been a very impressive 91%, which wouldn’t change much even if the special provision of `526 billion is excluded.
Central banking is quite a singular business because the organisation has to exist to ensure that currency is in the system, besides conducting other conventional functions like monetary policy, exchange rate management and public debt management. In a way, there are no ‘real’ financial statements like the ones for a commercial entity, where a sale is associated with cost of production or an asset, like a loan associated with a deposit that is created. For a central bank, money is created by the proverbial stroke of the pen, and the rest of the activities are managed accordingly in a seamless manner. At the end of the day, there is a surplus on account of these transactions, and the resulting amount is transferred to the government. But, how does this money get generated?
RBI earned `583 billion as interest in FY19 on holding of government securities. The stock of government securities held was around `9.9 lakh crore, and had increased by `3.6 lakh crore on a point to point basis during the year. These securities yield an interest payment to the holder, which is RBI. Interestingly, RBI had conducted a marathon size of OMOs of `3 lakh crore last year to ensure that liquidity was available to the system.
Add to this the LAF, which supported the virtual continuous deficit to the extent of 1% of NDTL of the banking system in the region of `1-1.5 lakh crore. By buying such securities, the central bank earned interest paid by the government. At even, say, 7% interest rate, the earnings are substantial.
If one follows the trail of these perennial liquidity scarcity episodes, the path is quite fascinating. The government has to borrow to meet its fiscal commitments, and last year, had a gross borrowing programme of `5.71 lakh crore. These are subscribed mostly by banks, which then ran into a problem of liquidity as growth in deposits was tardy. RBI stepped in and provided liquidity on a daily basis through the LAF window, and on a permanent basis through the OMOs. With the latter supporting 53% of the gross borrowing programme, the deficit was monetised adequately.
The government pays interest on these bonds, which adds to the central bank’s profits, and is finally paid back to it as a transfer which supports the fiscal numbers. This ‘circle of money’ is the curious aspect of central banking, where there is a very impactful relationship between monetary policy and the Budget. Ironically, if the bonds are subscribed to by banks and there is no liquidity issue, RBI does not come into the picture, and the interest accrues to them instead of flowing back to the government.
This is not specific to RBI, but to all central banks. In case of quantitative easing, the Fed or ECB bought paper from banks and, hence, received income which would have otherwise gone to the original holders. Such paper was monetised by providing liquidity to the banks and, hence, was a win-win situation, where the system got funding while the central bank earned revenue.
The cost was the liquidity, which is reserve money created by central banks constantly and, hence, does not matter unless it leads to inflation. When economic conditions are depressed, as is the case in India, this possibility does not arise and, hence, the impact is neutral.
There is another `290 billion which comes as forex gains for RBI. Here, too, the central bank has an inherent advantage when there are problems in the currency market. The central bank intervenes in the forex market when there is excess volatility and the rupee depreciates sharply. All the forex reserves reside with the central banks, and can be used during such contingencies. Intervention is by selling dollars in the market to enhance supplies and bring about equilibrium. Other ‘speaking’ operations are pursued by RBI to curb speculative activity in the market.
In FY19, RBI sold $15.4 billion in the market, which resulted in a capital gain. Intuitively, the rupee tends to depreciate over time, and as the sale takes place when the value is declining further, any sale will give a profit to RBI. Therefore, once again, a situation of forex crisis bodes well for central bank revenues and, ultimately, for the government, which also gains when the surpluses are transferred.
This is over and above the interest it earns by investing the forex reserved in securities outside the country. The earnings were `458 billion on holdings of `27,852 billion of forex assets in securities or deposits. In fact, when RBI bought dollars from banks to provide liquidity, it automatically added to its reserves. Here, too, the trail is predictable. As our balance of payments improves and dollars accrue to the system, they move to the central bank which monetises the same through the power given to it. Now, these reserves are invested in overseas assets and earn an income.
The major bonus was `526 billion, which comes under write-back of provisions no longer required. The committee that worked out the complicated route to using RBI’s excess reserves came up with an ideal formula, based on prudent global practices. While the well-executed formula talks of basic tenets to be adhered to, the broader question, which is posed in some quarters, is whether or not there can ever be a risk to a central bank, which has unlimited access to ‘reserve money’ and runs what can be called, at the limit, a notional balance sheet?
This point may be pertinent; while depletion of forex reserves can drive a central bank down, the same never can happen for domestic currency, which can be issued, at will, by the central bank. A fair question is what exactly a contingency reserve is meant for, especially as the balance sheet has real assets—securities, bank deposits, forex—which are mapped notionally to liabilities, where even the ‘real component’ of currency actually has no limits for a central bank.
The argument is similar to whether a government can ever default on its domestic loans for want of money. Does this then mean that, practically speaking, this debate over transfer of reserves is a non-issue?
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