“SURPLUS” made by the Reserve Bank of India (RBI)

Every year Reserve Bank of India transfer surplus amount of money, generated from different activities, is transferred to the Central government. But how does it generate the surplus amount of money?

Activities performed by the RBI:

  • to keep inflation or prices in check
  • manage the borrowings of the Government of India and of state governments
  • supervise or regulate banks and non-banking finance companies
  • manage the currency and payment systems.

Then, how does RBI make profits: While carrying out above functions or operations, it makes the surplus. This surplus is simply the difference of its total income and its expenditure.

Its income sources:

  • The returns it earns on its foreign currency assets — which could be in the form of bonds and treasury bills of other central banks or top-rated securities.
  • Deposits with other central banks.
  • Interest earns on its holdings of local rupee-denominated government bonds or securities
  • While lending to banks for very short tenures, such as overnight.
  • Management commission on handling the borrowings of state governments and the central government.

Its expenditure ways:

  • The printing of currency notes
  • On staff
  • Commission it gives to banks for undertaking transactions on behalf of the government across the country, and to primary dealers, including banks, for underwriting some of these borrowings.

Why it’s called as “surplus” not as “dividend”: The RBI isn’t a commercial organization like the banks or other companies that are owned or controlled by the government — it does not, as such, pay a “dividend” to the owner out of the profits it generates. Following the nationalization of RBI in January 1949, the sovereign i.e. the Central Government has become its “owner”. What the central bank does, therefore, is transfer the “surplus” — that is, the excess of income over expenditure — to the government, in accordance with Section 47 (Allocation of Surplus Profits) of the Reserve Bank of India Act, 1934.

Is there an explicit policy on the distribution of surplus?

No. But a Technical Committee of the RBI Board headed by Y H Malegam, which reviewed the adequacy of reserves and a surplus distribution policy, recommended, in 2013, a higher transfer to the government. Earlier, the RBI transferred part of the surplus to the Contingency Fund, to meet unexpected and unforeseen contingencies, and to the Asset Development Fund, to meet internal capital expenditure and investments in its subsidiaries in keeping with the recommendation of a committee to build contingency reserves of 12% of its balance sheet. But after the Malegam committee made its recommendation, in 2013-14, the RBI’s transfer of surplus to the government as a percentage of gross income (less expenditure) shot up to 99.99% from 53.40% in 2012-13.

Do the RBI and the government agree on this?

The government has held the view that going by global benchmarks, the RBI’s reserves are far in excess of prudential requirements. Chief Economic Advisor Arvind Subramanian has suggested that these funds be utilized to provide capital to government-owned banks. The central bank, on its part, prefer to be more cautious and build its reserves — keeping in mind potential threats from financial shocks, and the need to ensure financial stability and provide confidence to the markets. From the central bank’s perspective, bigger reserves on its balance sheet are crucial to maintaining its autonomy.

Why is the transfer of surplus significant to the government?

The quantum of surplus transferred over the past few years has been large. In 2015-16, the RBI passed on Rs 65,876 crore, which formed a sizeable chunk of the revenue which the government earns under the head of ‘non-tax’, which is mainly dividends. This was much more than the surplus generated by banks and other companies owned by the government. The quantum of RBI transfers has, in fact, been rising progressively, and has helped the government narrow its deficit or borrowings.

How does the government build this surplus into its Budget early in the year?

Well before the annual Budget is unveiled (the exercise was brought forward to February 1 this year), senior RBI and government officials discuss the likely amount which could be transferred. Typically, the government pitches for a higher share of the surplus while the central bank sometimes prefers to set aside funds for contingencies. Based on these talks, and calculations such as likely income and earnings, an indicative figure is given to the government, which it puts under the head ‘non-tax revenue’ in the receipts budget.

The trend of ‘surplus’ transfers for the last couple of years:

Why in 2016-17 surplus transfer was low?

First: The firming up yields on foreign securities is one of the reasons. RBI does not give any details of its foreign assets. It keeps deposits with other central banks, foreign branches of Indian banks, the Bank for International Settlements, special drawing rights acquired from the Government of India, and foreign treasury bills and dated securities.

If we presume that the bulk of its foreign investments are in US papers. The 10-year US paper yield rose from 1.44% in July 2016 to 2.3% in June 2017; similarly, the one-year US Treasury Bill yield rose from 0.44% to 1.23% and that of 3-month US T Bill yield rose from 0.2857% to 1.01% during this period.

The prices and yield of treasury bills and securities move in opposite directions. This means that when the yields rise, prices go down. So, RBI’s foreign investment portfolio is hit as it needs to be marked to market (MTM), an accounting practice whereby an asset is valued at the current market price and not the price at which it was bought. Going by the RBI annual report, foreign securities, other than treasury bills, commercial papers and certain “held to maturity” securities are marked to market on the last business day of the month.

Second: The appreciation of the local currency has also contributed to the erosion of value in RBI’s foreign assets. In fact, it’s a double whammy for the central bank. Since its balance sheet is in rupees, its foreign currency assets have first taken the MTM impact and, at the second stage, lost value while converted into rupee. A dollar fetched Rs67.32 in July 2016; but in June 2017, it fetched less—Rs64.58. This means, there has been a 4.25% value erosion while converting its foreign currency assets into Indian rupees. Since June, the rupee has appreciated further. This piece of data illustrates the impact best: RBI’s foreign exchange reserve of $363 billion was equivalent of Rs24.3 trillion in July 2016; in August 2017, it rose to $393.5 billion but in rupee terms, the rise is marginal—Rs25 trillion.

Third: The printing of new currency notes of Rs500 and Rs2,000 to replace old notes of Rs500 and Rs1,000, distributing them (Indian Air Force helicopters were used to send new currency notes to banks and automated teller machines in Jharkhand, Bihar and parts of North-East), hiring shredding and briquetting machines on lease to scrap old notes and currency verification machines to weed out fake notes have been a costly affair. India imports most of the paper used for printing currency notes, primarily from Italy and Switzerland. Of course, the cost has been shared by RBI and the government as the notes are printed at four presses—two each run by the government-owned Security Printing and Minting Corp. of India Ltd (at Dewas in Madhya Pradesh, and Nashik in Maharashtra), and Bharatiya Reserve Bank Note Mudran Pvt. Ltd, a RBI unit (at Mysuru in Karnataka, and Salboni in West Bengal).

There is no clarity on the exact cost of printing the currency notes. Answering a question in Rajya Sabha, the upper House of Parliament, a minister has said the cost of printing one new Rs500 note is between Rs2.87 and Rs3.09 and that of one Rs2,000 note is between Rs3.54 and Rs3.77. According to former RBI deputy governor R. Gandhi, who was overseeing the entire currency operations of the central bank till he retired in April, the number of notes that were withdrawn could be 23-24 billion of Rs500 and six billion of Rs1,000. We don’t know exactly how many notes of Rs500 and Rs2,000 have been printed to replace the old lot. Nonetheless, this is a direct impact of demonetization.

Fourth, and the last contributing factor to the depletion of RBI’s dividend is the cost that it had incurred to stamp out excess liquidity from the system, an offshoot of demonetization. Money in the banking system, or liquidity, had been tight in April-May 2016, eased in June-July, but in November-December, there was a deluge of money as people rushed to bank branches to deposit old notes. Initially, RBI imposed an incremental cash reserve ratio, or CRR, on banks to soak up all deposits collected between 16 September and 11 November; but it had to use other instruments later—such as reverse repo window and selling securities under the so-called market stabilization scheme, or MSS—to drain liquidity.

There is no cost for CRR as banks are not paid any interest on the money kept with RBI and the cost of MSS is being borne by the government but RBI pays for the money banks keep with it through the reverse repo window. Banks were paid 5.75% and 6% for their surplus kept with RBI for various tenures between overnight and 90 days.

If banks want money from RBI, the central bank gives overnight money at the repo rate against government securities as a collateral. The amount a commercial bank can borrow from the central bank is capped at a quarter percentage point of its net demand and time liability, or NDTL, a loose proxy for deposits. For term repo—when a bank takes money from RBI for seven days and 14 days—the amount is capped at 0.75% of a bank’s NDTL. If banks have excess liquidity (which they continue to have), they park the money at RBI’s reverse repo window. Apart from overnight money, where the rate is fixed, banks can offer money for seven days and more. Unlike the repo, there is no cap on the amount of money that can be parked at the reverse repo window. This means banks can lend as much as they want to but the central bank must have securities to offer as a collateral to absorb the money. The average daily absorption of money through the reverse repo window (net of infusion as some banks need to borrow money from RBI to take care of their temporary asset-liability mismatches) was Rs1.6 trillion in December, Rs2.2 trillion in January, around Rs3.5 trillion in February, Rs4.5 trillion in March, Rs3.8 trillion in April, Rs3.4 trillion in May and Rs3.1 trillion in June. The MSS, too, soaked up Rs3.8 trillion in December, Rs5 trillion in January and Rs2.9 trillion in February, but this cost is borne by the government.