For the RBI, May 4 was a significant event, given its deteriorating balance sheet, which would affect its day-to-day operations, including currency management. As is well known, the issuing department of RBI almost completely backs up the currency in circulation with foreign investment, which is usually marked on the last trading day of the week/month in the market. The principle behind this type of asset/liability management is that it provides flexibility in times of need and shares key features with the bullion standard, which was briefly adopted by India in 1926.
Rising interest rates, however, are increasing yields on US government bonds, which make foreign securities in large numbers on the RBI’s balance sheet as investments. Since rising yields meant a fall in bond prices, it was causing a mark-to-market loss. As a result, central bank asset back-ups are motivating low confidence, especially at a time when the currency in circulation was rising faster than expected due to increased domestic credit offtake.
For this reason, with the 0.5% increase in the cash reserve ratio (CRR) announced on May 4, the RBI aimed to not only withdraw 87,000 crore liquidity from commercial banks, but perhaps to replenish its foreign investment assets equivalent to $11 billion to offset asset value erosion. This will easily adjust the balance sheet of the central bank without affecting the currency-in-circulation account.
The revaluation account, which is on the liability side of the RBI’s balance sheet, reflects the true impact of rising returns on the operations of the central bank. This account, which includes currency and gold revaluation, investment revaluation and its forward contract valuation accounts, absorbs any changes in the value of assets, both domestic and foreign, held by the RBI.
As per the latest data available, as on April 29, the RBI’s revaluation account had seen a steep decline of 15% as compared to the same period last year. Further, the account had lost nearly one percentage point of value as a proportion of its balance sheet in the first month of 2022-23 alone.
Of course, the mark-to-market valuation loss wasn’t the only reason for that contraction. Amid the capital outflow, the RBI sold a significant amount of foreign assets for dollar to give a soft landing to the weakening Indian rupee. Consequently, as the Net Domestic Assets (NDA) gets adjusted for Net Foreign Assets (NFA) in the Reserve Money (RM) function, the proportion of domestic government securities has increased. This fact has created another problem for the RBI.
The bank currently has about $190 billion in Government of India securities on its balance sheet. Moved by the Department of Banking, these holdings increased by more than $25 billion in 2021-22 to manage the yields of these securities.
Thanks to record capital inflows until recently, the RBI could afford such an asset strategy. However, it has now turned into a barnacle, possibly giving sleepless nights to the asset management team of RBI. Since the start of this fiscal year, there has been a revaluation loss of about $2-4 billion in household assets amid rising bond yields.
As interest rates rise elsewhere, the RBI anticipates even bigger mark-to-market losses. Since the beginning of the year, the gap between an American and an Indian 10-year government bond has often been below the threshold of 500 basis points (i.e. 5 percentage points). This has reduced the incentive for foreign investors to stay invested in Indian debt, and the US reversal of quantitative easing will add to the pressure. Since the beginning of 2022, foreign investors have pulled out the equivalent of $20 billion from the Indian capital market.
So raising the interest rates was the only option left with the RBI. It also had to be pre-empted by the US Fed, as any delay would have exacerbated an already difficult situation.
Nevertheless, in the short term, the RBI is sure to widen the revaluation deficit due to increase in interest rates. The bond market has already adjusted to this new reality and as of 9 May 2022, a 10-year government security was yielding around 7.46% returns. The annual advance rate for this term security is estimated at 7.93%, so further price erosion is expected.
Looking ahead, while the value of RBI’s overseas assets may remain somewhat stable in the near term, the extent of correction in domestic securities is yet to be ascertained. This exposes about 25% of the RBI’s balance sheet not only to market uncertainties, but also to the actions of its own Monetary Policy Committee.
Therefore, with RBI holding a large amount of government securities, the reduction in domestic asset value is a self-fulfilling prophecy as its own actions weaken their prices. Not only does this take away the RBI’s flexibility to modify assets according to market conditions, but it also binds it in a loop with the government, which wants the central bank to keep its cost of borrowing as low as possible.
If the current situation persists, the central bank’s revaluation account may continue to contract. More than a point, this account would need to be replenished from the contingency fund, which would negatively impact RBI’s risk provisions in these volatile times.
Finally, for the sake of its credibility, the RBI should reduce its Government of India security holdings and increase its foreign asset holdings at the earliest. The time has come for the RBI to adapt its balance sheet to account for the stress in store.
Karan Mehrishi is an economics commentator and author of The India Collective: What India is Really All About.