RBI's balance-sheet: Mirroring global change

Ashoak Upadhyay

A little over a month after the new Budget, concerns about the pressures on liquidity have prompted the Finance Minister, Mr P. Chidambaram, to ask the Reserve Bank of India to find ways to ease those pressures in the banking system and, while at it, devise ways to channel credit to the farm sector at 7 per cent, as the Budget had promised. As far as the former problem is concerned, a small cut in the CRR (cash reserve ratio) should release funds into the system.

CREDIT TO FARM SECTOR

Chief executives of banks who gathered in New Delhi a fortnight ago also know that the RBI has enough market instruments, such as the Market Stabilisation Scheme (MSS), to regulate the liquidity according to supply and demand, much like the locks on a canal that moderate the flow of water. Fluctuations in liquidity are now part of the financial system, responding to robust credit demand.

The Minister's signal to channel greater credit to the farm sector at concessional rates sounds like faint echoes of directional lending that the RBI authored till the 1990s with such dedication as to colour its own profitability and the overall balance-sheet.

The Finance Minister knows that the RBI, like the economy, has come a long way from those days of `social control' when the banking system's resources were directed to priority sectors through the central bank's refinance facilities. The extent to which it has travelled in the last 15 years from that phase is graphically evident in the dramatic shifts in its assets and sources of income.

SHIFT IN BALANCE-SHEET

In a fundamental way, these changes mirror and, in some cases, may have even led to the transformation in the rest of the organised economy and financial system. The most striking of these is the shift in the RBI's balance-sheet from domestic to foreign currency assets (FCA). Fifteen years ago, they accounted for 1.9 per cent of the total assets; by June 2005, FCA accounted for 87 per cent and climbing. As an asset backing currency expansion, its proportion to notes was a meagre 0.4 per cent in 1991; now, the ratio of FCA to notes is a staggering 157.3 per cent.

Over the last 15 years, the RBI has, on this count, soaked in the effects of globalisation with the attendant risks, since such a portfolio exposes its balance-sheet to interest and exchange rate fluctuations. But, by the same token, it has joined the world's leading central banks that have been redefining their role as the guardian of their countries' monetary policy. That role entwined with the burden of devising the right polices for funding economic growth would have placed a greater burden on the RBI while breaking from its key operating functions of the past four decades. The latest

Report on Currency and Finance 2004-05

gives a fascinating account of how the balance-sheet morphed into its present shape; every moment of change is also a milestone at which the real economy was confronted with new challenges.

PLAYING BANKER

All through the two decades till 1991, the RBI's predominant role was playing banker to the government and its balance-sheet reflected that role. Funding the fiscal deficit through monetisation provided the RBI its assets in terms of ad hoc Treasury Bills; its income came from interest on those bills with a rate of 4.6 per cent fixed in and unaltered since 1974.

To neutralise the inflationary potential of deficit financing, the RBI wore its other hat and raised successively, reserve ratio requirements in the form of the CRR and the statutory liquidity ratio (SLR). In the 1980s, the net RBI credit to the government accounted for 90 per cent of reserve money. That favourite phrase of the 1990s, "crowding out the private sector" had its origins in the mushrooming fiscal deficit underwritten by the RBI.

Another aspect of its `developmental role' was priority lending to agriculture and industrial and housing sectors through three National Funds and refinance facilities for development finance institutions (DFIs). But the overall strategy of neutralising government borrowings by spiking reserve requirements worked to shore up the RBI's balance-sheet; by the end of 1981, the resources, thus impounded, amounted to nearly 10 per cent of the RBI's balance-sheet. As for the foreign currency assets, the less said the better. An unplanned and hesitant attempt at externalising the economy led to sliding forex reserves, deteriorating balance of payments mid-1980s onwards till the mud hit the ceiling in 1991 with just a billion in the forex kitty.

Among other things, the impact of the reforms was felt in the RBI's relative freedom to exercise discretion in acquiring domestic assets. Which meant that gradually, and rather reluctantly, the Government began to ease up on its borrowings from the RBI; for its part, the central bank put in place operating structures to cope with the flow of capital that steadily mounted through the late 1990s and into the new century. Once directional lending was abandoned, reserve requirements were eased with the SLR being put to rest and the CRR being reduced in phases.

MARKET INSTRUMENTS

The fact that the RBI now uses market instruments such as the MSS and the LAF (liquidity adjustment facility) and the repo windows to coordinate liquidity reflects the extent of its own liberalisation. But it is the predominance of foreign currency assets in its balance-sheet that is most striking; as of March 2004, the ratio of net FCA to reserve money mounted to 111 per cent compared to 7.6 per cent in 1990.

Using indirect monetary control procedures has reduced the share of bank reserves in the RBI's liabilities to 13.1 per cent of overall liabilities in 2004 from 30 per cent of overall liabilities in June 1995, according to an RBI study.

As of now, the share of FCA in the central bank's income has risen to 90 per cent, clearly a dramatic example of the changes wrought by the economy's introduction to globalisation. By the same token, that income has been subject to fluctuations on account of the RBI's market operations and its vulnerability to interest and exchange rate changes. While the income from such assets is substantial, just how much more foreign assets contribute compared to domestic assets will depend on the global and domestic interest rate differentials.

At $146 billion, the forex reserves are on way to posing a problem of plenty. That level is one precondition more than sufficient for full convertibility. During the 1990s, the build-up of forex reserves represented three times the additional external debt incurred; much of the capital flow has been debt-free.

Exchange guarantees provided by the RBI to encourage capital inflows, for example in the FCNR(A) schemes, the India Development Bonds of 1990 were removed in the case of the 1998 India Development Bonds and IMD of 2000 recently redeemed.

Yet, the flows did not ease. The RBI's transformed balance-sheet represents more than the changes wrought so far. It provides a road map for further changes; like full convertibility perhaps.