The biggest kerfuffle going around on the demonetisation debate is on the use of currency that is expected to be "extinguished", ie, those old 500/1000 rupee notes that are never tendered back to the banking system. There is a general consensus that around 3-3.5 lac crores is the number.
The big question is whether this is money that is income for RBI that can be repatriated to the government as a special dividend, resulting in a fiscal bounty. Opinion is sharply divided on this. While there is a strong (financial market participant) view that it can be done, there are others like ex-governors D.Subbarao and C Rangarajan as well as perceptive columnists like Bloomberg's Andy Mukherjee (who wrote a strong column on the issue, though basis a seeming non-sequitur) who think otherwise.
In terms of global precedent, the situation is equally murky. Previous instances in Germany and Israel (partly covered in this KPMG report) involved scales much smaller than what is being talked about here (3 lac crores would be just short of ~10% of RBI's balance sheet).
There's also the point on prudential accounting - typically large gains on balance sheet net worth arising out of revaluation isnt taken as "Income" in P&L (while losses usually are). And this effectively, is a gain arising out of revaluation of RBI's liabilities.
Is there a solution? Can the "money" be put to use? There is perhaps an answer, though it would raise a few hackles with purists. First, lets examine the RBI Balance Sheet (RBI annual report 2015-16)
As can be seen, the 2 biggest items on the Liability side are 1) notes issued and 2) Revaluation account. On the Asset side, the two biggest items are Foreign Currency Assets (FCA) and Domestic Investments (primarily G-secs held by RBI to facilitate Open Market Operations).
The Reval Accounts, comprising of a number of different accounts (Currency and Gold Reval Account-CGRA, Investment Reval Account-IRA etc) essentially capture Mark-to-Market (MTM) movements in the various Assets (and Liabilities) positions of RBI. Effectively, this reserve acts as the valuations buffer for RBI while carrying out market interventions (both foreign currency and domestic money market).
So, what happens if the total currency extinguished is (say) 3 lac crores? One, Notes issued goes down by the same amount. Two, the Reval a/c (RBI could create a special, different a/c to teat this) gets bumped up by the same amount. Note that the Reval a/c would now be ~30% of the size of RBI's balance sheet.
Now, given that a dividend cheque to the government is ruled out, what next? A simple exercise would be the following:
1. Out of the ~7 lac crores of G-Sec holdings, RBI takes out (say) 2.5 lac crores and swaps it with a bunch of PSU banks for a special equity issuance.
2. Technically, it effectively means RBI sells 2.5 lac crores of G-Secs in the market to raise cash and uses it to buy equity in PSU Banks.
3. Normally, this could mean a fair amount of market impact. However, done as a straight swap with banks, and accounting for the very high level of liquidity available to banks (estimated to be 6-7 lac crores incremental deposits as a result of demonetisation), market disruption would be minimal.
4. From a balance sheet perspective, RBI will now have 2.5 lac crore of equity on the Asset side, against a 3 lac crore increase in Reval a/c on the Liability side, effectively providing a MTM cushion of 50k crores for the equity exposure.
This, effectively would obviate the need for RBI to pay a dividend to the government, while achieving the aim of recapitalising banks. 2.5 lac crores of additional equity, plus incremental revenues out of system liquidity going up will likely cover 50-60% of incremental capital required by banks today for Basel III.
Issues? Biggest one is of moral hazard of the regulator owning equity in banks. While this is valid, the fact is RBI held the sovereign stake in State Bank of India till very recently. The government can in unison also start work on a series of legislative actions to facilitate a transfer of this equity from RBI to government in a reasonable amount of time.
Is this the best solution? Given the circumstances, and given the enormous disruption to the economy due to demonetisation, it would be a shame if this opportunity was not taken to clean up banks and make the financial system ready for a fresh trajectory of growth.
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