Does the RBI need any reserves at all even during times of economic stress?  Going by a recent research paper entitled “Paranoia or Prudence: How much capital is enough for the RBI?” by four well-known economists, the answer seems to be a resounding no. These economists—Abhishek Ananad, Josh Felman, Navneeraj Sharma and Arvind Subramanian—give out three reasons for arguing that central banks can run with negative capital. They point to examples of central banks which actually have negative capital like those of Israel, Chile, Mexico and the Czech Republic.

Since central banks can always print unlimited amounts of currency, they can always take care of their domestic obligations or debt payments–rupee liabilities—without any problems, irrespective of their networths. Secondly, since central banks form a part of the government, it is the broader government balance sheet that is important, and not those of any of its constituents. So it is far more important for the government to have a healthy balance sheet than the central bank. Thirdly, it is their unique ability to generate revenue through seigniorage—profits made by the RBI by issuing currency, especially the difference between the value of the currency and its production cost—that ensures that the central banks will always be profitable. They will continue to generate net income as long as the assets they hold promise some return. That stream of profits will come to an end only when the world turns cashless. Moreover, unlike commercial banks, the RBI does not undertake any risky lending, which has the propensity to turn into NPAs.

Others, however, argue that if the government’s own finances are fragile, it is highly unlikely that they will be capable of recapitalising the central bank as and when the need arises. Or that they may have to toe the government’s line in terms of setting interest rates in case they do not have enough surpluses with them. But fortunately such a situation has never emerged, at least till date. In the past 20 year there has not been a single year when the RBI has made losses. “In short, the RBI has not experienced any serious threats to its balance sheets in the past 20 years despite several bouts of intense economic stress in 1998, 2008-09 and 2013,’’ says the report.

More importantly, the RBI actually makes profits during periods of stress. The reason is simple enough. During the stress years, there is a tendency on the part of the national currency like the rupee to depreciate against the dollar or other foreign currencies.  The central bank books profits on its foreign exchange sales because it earns more rupees on every dollar sold. Moreover, it enjoys large valuation gains on the remaining reserves since they are now worth more in dollars.

But that does not mean that the RBI does not have reserves because many of its assets are subject to a host of risks. For instance, the central bank’s foreign currency assets are affected during time of an appreciating rupee or when foreign interest rates rise, as higher interest rates reduce the price of bonds. So the RBI maintains certain internal reserves like the Currency and Gold Revaluation Account, Investment Revaluation Account, Contingency Fund etc.

So how does the RBI’s reserves stack up against other countries. After studying the reserves of central banks of 51 countries—developed and developing countries--, the authors conclude that the RBI is an outlier in this case.  It holds about 27% of its capital in reserves which is the fifth largest amongst all central banks, while the median reserves is around 8.4%. So a huge amount of money is lying unused. This unused amount could be used profitably like paying off the government’s debts or recapitalising loss-making public sector banks.

Even if all the market risks associated with the RBI assets—foreign currency assets, domestic securities and gold-- are taken into account using the value-at-risk model, the authors argue that the RBI is holding Rs 4.5 lakh excess in its kitty. More importantly, the paper suggests that if an alternative cross-country econometric analysis is deployed, the excess capital is even greater between Rs 5.7 lakh crore and Rs 7.9 lakh crore. Points for the Bimal Jalan committee to ponder over.

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