Since 2008, there has been a shift in the RBI's asset holding towards domestic assets, after the bank reduced its intervention in the forex market. The RBI has started to earn on liquidity operations by keeping the system in deficit mode.
The Reserve Bank of India (RBI)'s annual report released in the last week of August for the year 2010-11 (ending June 2011) shows that its total income increased by Rs 4,186 crore or 12.7 per cent to Rs 37,070 crore, from Rs 32,884 crore in 2009-10.
This is indeed a heartening development after the Bank's income sharply fell by Rs 27,848 crore or by 45.9 per cent in 2009-10. The two major components of the Bank's income are earnings from foreign sources and earnings from domestic sources.
The report adds that the increase in income from domestic sources by Rs 8,138 crore more than offset the decline in income from foreign sources by Rs 3,953 crore.
As a matter of fact, the income from foreign sources declined over the last three years since 2008-09. It will be of interest to examine how the income of the RBI behaved over the decade beginning 2001-02, distributed as between domestic and foreign sources.
Domestic, Foreign Sources
One factor that determines the income is the asset base. The other factor is the return available from these assets.
While the domestic assets comprise mainly central government securities, the foreign assets comprise foreign currency assets and gold.
The return is mainly a function of the level of domestic and international interest rates. India does not have a fully open capital account and, overall, domestic interest rates were ruling generally higher than international interest rates over the decade. The balance-sheet of the Reserve Bank expanded significantly during 2010-11, mainly reflecting the impact of liquidity management operations undertaken by the Bank.
There was a significant increase in Bank's portfolio of domestic assets in the form of government securities on account of open market purchases, repo purchases and disinvestment of Government of India's surplus balance parked with the Reserve Bank. The increase in foreign currency assets mainly reflected the valuation effect on the portfolio.
The annual report rightly claims that the assets and liabilities reflect the outcome of its operations, guided by the overall policy objectives relating to the economy and the financial system, and not by commercial considerations. Two such important developments in the policy in the recent period affecting the income of the Bank need to be highlighted.
First, the RBI has not been actively intervening in the foreign exchange market and has stopped significantly accumulating foreign currency assets since late 2008. There is, therefore, a perceptible shift in asset holding in favour of domestic assets.
While domestic assets increased by 38 per cent in 2010-11 on top of a 104 per cent increase in 2009-10, the foreign assets depicted an overall decline since 2008-09. As a result, the share of domestic assets increased from 11.2 per cent in 2007-08 to 29.7 per cent in 2010-11.
Second, is the strategic changes that have been introduced in the operating procedures of monetary policy.
One significant element of this policy has been the decision to keep the system generally in deficit mode to achieve a better transmission of policy rate signals of the Bank. This precludes the need of the Bank to absorb enormous surplus liquidity at a cost, and conversely enables the bank to earn on its liquidity management operations.
These two changes in a nutshell would also mean that the sterilisation costs are minimised. In fact, the level of market stabilisation securities has been reduced to zero currently.
The Decadal Trend
The income of the Bank showed volatile movements. On a cumulative basis, since 2001-02, the income increased only by Rs 15,221 crore, the domestic sources contributing Rs 4,156 crore and foreign sources Rs 11,065 crore (Table). For policy reasons and because of the interest rate differential, the return on domestic assets had generally been higher than that of foreign assets, barring two years, 2004-05 and 2005-06. The return on foreign assets touched its lowest in the last two years.
Foreign sources contributed to larger share of income, not because of higher return but because of the predominant share of foreign assets in the RBI's portfolio, touching as much as 89 per cent in 2008-09.
The counter-factual is that, perhaps, in the place of these assets, domestic assets would have earned a higher income.
But, what needs to be kept in mind is that overall policy considerations required the RBI's asset management policy to keep that level of foreign assets during the critical years that helped tide over the crisis situations smoothly. The RBI's operations and policy should, after all, never be viewed from a commercial angle.
The operating procedure of monetary policy in India has witnessed significant changes since the beginning of the 1990s, thanks to developments in the money market and changes in liquidity conditions brought about by financial sector reforms.
In this process, the LAF, introduced in June 2000, emerged as the principal operating procedure of monetary policy, with the repo and the reverse repo rates as the key instruments for signalling the monetary policy stance.
LAF, supported by instruments such as the CRR, OMO and MSS, had served the Indian monetary and financial system well.
Large volatility in capital flows and sharp fluctuations in government cash balances, however, posed several challenges to liquidity management by the Reserve Bank.
(The author is Director, EPW Research Foundation. The views are personal. firstname.lastname@example.org)