How much money should RBI create?

It may sound amazing, but the fact is, it is hard to discern what the Reserve Bank of India’s monetary policy and reserve management objectives are. Sample this quote from the RBI’s 2014-15 annual report. “The balance sheet of the Reserve Bank of India is a reflection of the activities carried out in pursuance of its currency issue function as well as monetary policy and reserve management objectives”. It doesn’t tell us very much, does it?

When the RBI is continually expanding its balance sheet, it perhaps doesn’t have a template to go by. The economic consequences of such an approach are too serious to be wished away.

Indeed, no less a person than former governor C Rangarajan, in a recent interview, said that the objectives of the RBI have not been clear in the 80 years of its existence. He points out that the recent tensions between the political establishment and the RBI have arisen because the objectives of the central bank have not been clearly spelt out. He approves of the recent changes, formalising a quantitative objective for the RBI.

Though the RBI’s role and objectives have not been clear till very recently, that has not prevented the central bank from saying its balance sheet reflected its monetary policy objectives!

The size and composition of the RBI’s balance sheet has a significant bearing on the daily lives of people for the impact on prices. These economic consequences have a greater effect, the longer the balance sheet continues to grow without specific objectives. As Rangarajan says, it’s been 80 years. Therefore, one can imagine how profound the economic consequences of the RBI’s balance sheet management have been.

In this context, when an otherwise acceptable technical recommendation is made on the presentation of the RBI’s balance sheet, one is constrained to see what the economic consequences of any such move will be.

An article in BusinessLine , ‘RBI’s frozen assets’ by D Sampathkumar (August 9), makes such a technical recommendation. The crux of the recommendation is that reserves created by periodical revaluation of the RBI’s portfolio of foreign exchange and gold assets over the last 25 years are lying idle. And, if the “fair value” accounting principle is not applied to these revaluation reserves, they will continue to remain idle — hence they are frozen.

The article points out, that on a “fair value” basis there will result an excess of reserves because the odds are very low that the foreign exchange/gold assets will lose value in rupee terms (to the extent of 25 per cent, since the revaluation account is approximately one-fourth the assets account as of June 2015).

The “excess” reserves can then be ploughed back to the Government’s account, the article points out.

Given the amorphous background to the RBI’s balance sheet in the last 80 years, any fresh move that can potentially alter its make-up does ring a warning bell.

Adopting “fair value” with respect to the revaluation reserves — though from an accounting perspective it ticks all the correct boxes — will potentially be a minefield as far as the economic consequences go. It very likely will accentuate the trends we have seen over the past 80 years — a balance sheet existing and growing without any concrete objective.

So, what have been the consequences of an objective-less balance sheet of the last 80 years?

When the RBI buys domestic bonds and/or foreign exchange, the money it creates gets multiplied manifold in the financial system. That is, the base or reserve money created by the central bank is converted into broad money in the system, through the operation of the money multiplier. This is how the fractional reserve system works.

But when there is no formula or even rules or principles based on which the central bank can create reserve money — which is what is explicit in Rangarajan’s “no objectives” statement — then we are shooting in the dark.

The long-term implications of this kind of balance sheet expansion are not benign. And we are talking about 80 years! Though we are all dead in the long run, the implications will apply to each successive generation. For structurally supply-constrained economies such as India, one can reasonably say that large central bank balance sheet expansion will be inherently inflationary. It will just keep adding to demand in the economy for all kinds of assets, goods and services. It will not be incorrect to say that India’s inflation experience in the past 25 years and the strain this has imposed on the common man has been amongst the worst in emerging economies.

On top of this effect, if the revaluation reserves also were to be credited to government account , that will be like money out of thin air. One cannot but be concerned about the consequences of enhanced government spending power.

Of course, the counter-argument could be that inflation is necessary to stimulate the real economy. This is a repeat of the famous Phillips curve argument made in the 1950s,1960s and early 1970s in the western world, when a statistically inverse relationship between inflation and unemployment was sought to be exploited by deliberately loose monetary and fiscal policy. It ended in despair and tears and it required a Paul Volcker in 1979-80 to do the surgery and set right the situation. At a more fundamental level, crediting the revaluation reserves to government would completely obliterate (if it has not already) the firewall that has to be maintained between the power to create money (with the central bank) and the power to spend money (with the Government) in a fiat money system.

An alternative course of action could be to not revalue the assets at all. Another alternative: Do not acquire the assets at all in the first place — but that goes to the very heart of the country’s exchange rate policy and how India can deal with what is called the “impossible trinity” in international economics. Unfortunately, there’s been no fresh thinking here in all these years from either the RBI or government. The axiom seems to be: Keep buying foreign exchange or domestic assets.

The central bank balance sheets can arguably be treated differently from other entities. The question therefore is: Why revalue assets and put an inflated value on them and create a fresh source of trouble?

The writer is a Chennai-based financial consultant