The Big Balance Sheet Conundrum

The Reserve Bank released its annual report yesterday and there was only one thing that dominated the headlines. It read — “RBI’s balance sheet expanded by 30.02 % to ~Rs 53 trillion in FY20”

For context, that’s a quarter of our country’s GDP. So yeah, we need to talk about it

The Story

The premise here is simple. The RBI has been very active in trying to mitigate the impact of COVID-19. Mitigating the impact here almost always involves creating new money. Creating new money means an expansion of the balance sheet. And as the balance sheet expands, RBI’s reserves expand in tandem (in most cases).

Think of it this way. The RBI has a tendency to buy government bonds from the open market every now and then. It's sort of like lending to the government, albeit indirectly. In any case, the RBI can buy these bonds by effectively creating new money and since the government is liable to pay interest on these bonds, the Reserve Bank can make more money from the little money it created earlier. This counts as income and when the RBI sets aside some of this money for future use, the reserves build up.

But pay close attention to the sequence of events here. The RBI was buying government bonds earlier this year in an attempt to foster economic and financial stability (especially after COVID-19). As a consequence of this intervention however, the RBI saw its balance sheet explode in size. So technically, the RBI can create extra reserves without explicitly wanting to do so. This distinction is important because there’s a large debate surrounding what RBI ought to do with these reserves. Some experts contest that the RBI must transfer most of it (if not all) to the government because it’s incumbent on them to do so. The Government has also has been actively promoting this line of thought.

The RBI on the other hand only transfers a portion of the reserves based on what it deems fit. In fact, the last time around, they had to settle the debate with the help of an external committee headed by Bimal Jalan, a former RBI governor. The matter was settled after the RBI transferred ₹1.76 lakh crore to the government.

But the debate continues — Who’s right here? The RBI or the Government?

Well, for starters, consider the RBI’s role in all of this. Its mandate is rather straight forward — To ensure price stability. You dig in a bit deeper, however, and you’ll realise the RBI is trying to ensure price stability in a bid to promote long term economic growth. If the prices of goods and services swing wildly each day, businesses and individuals won’t have the confidence to invest in the future. Which is why it’s imperative that the RBI does its job well.

The government wants to foster economic growth as well. However, they might not be driven by the same compulsions. As Viral Acharya, the former deputy governor notes —

“A government’s horizon of decision-making is rendered short, like the duration of a T20 match (to use a cricketing analogy), by several considerations. There are always upcoming elections of some sort — national, state, mid-term, etc. As elections approach, delivering on proclaimed manifestos of the past acquires urgency; where manifestos cannot be delivered upon, populist alternatives need to be arranged with immediacy.

This myopia or short-termism of governments is best summarized in history by Louis XV when he proclaimed “Apres moi, le deluge!” (After me, the flood!). In contrast, a central bank plays a Test match, trying to win each session but importantly also survive it so as to have a chance to win the next session, and so on. In particular, the central bank is not directly subject to political time pressures and the induced neglect of the future; by virtue of being nominated rather than elected, central bankers have horizons of decision making that tend to be longer than that of governments, spanning election cycles or war periods.

While they clearly have to factor in the immediate consequences of their policy decisions, central bankers can afford to take a pause, reflect, and ask the question as to what would be the long-term consequences of their, as well as government’s policies.”

And that pretty much sums up the argument here. There is absolutely no reason why RBI would simply hoard excess reserves unless it believed such an exercise served a practical reason. In fact, any central bank that can print its own currency can theoretically transfer large sums of money to the government without having to go through the pain of accumulating and apportioning reserves. But they don’t do it because this money has the potential to enter the real economy and wreak havoc. Think Inflation or worse, Hyper Inflation.

And while we are fully aware that price rise hasn’t been a concern for a few years now, I would like to quote the great philosopher George Santayana here — “Those who cannot remember the past are condemned to repeat it.”

Until then…

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In Defence of the RBI

Since today’s topic is about the RBI, we thought we would recommend one of our earliest articles defending the central bank — at a time when the institution was being criticized from all corners.

Also, if you are looking to understand why we always address the RBI as the Dark Knight, this article will explain it all.

Well, kind of…