De-monetisation update – 4: Central bank surplus

I had just read Raghuram Rajan’s last public speech as RBI Governor in St. Stephen’s college. It is a recommended read for all those who are still bloviating about a special dividend. It answers the questions that are still being raised despite my previous post.

Even though his remarks are not linked to the cancellation of monetary liabilities because some folks do not exchange their 500, 1000 rupee notes for other notes, they are still relevant because he reminds us that the central bank will create permanent reserves in line with their estimate of how much cash is needed in an economy of India’s size and expected growth and the central bank’s inflation goals. If some folks destroy their curency notes, the central bank will have to print more of other notes to meet its targeted growth of permanent reserves. Period.

See his remarks here:

Much of the surplus we make comes from the interest we get on government assets or from the capital gains we make off other market participants. When we pay this to the government as dividends, we are putting back into the system the money we made from it – there is no additional money printing or reserve creation involved.2 But when we pay a special dividend to the government, we have to create additional permanent reserves, or more colloquially, print money. Every year, we have in mind a growth rate of permanent reserves consistent with the economy’s cash needs and our inflation goals. Given that budgeted growth rate, to accommodate the special dividend we will have to withdraw an equivalent amount of money from the public by selling government bonds in our portfolio (or alternatively, doing fewer open market purchases than we budgeted).

Of course, the Government can use the special dividend to spend, reducing its public borrowing by that amount. But the RBI will have to sell bonds of exactly that amount to the public in order to stick to its target for money creation. The overall net sale of Government bonds by the Government and the RBI combined to the public (that is, the effective public sector borrowing requirement) will not change. But the entire objective of financing Government spending with a special RBI dividend is to reduce overall Government bond sales to the public. That objective is not achieved!

The bottom line is that the RBI should transfer to the government the entire surplus, retaining just enough buffers that are consistent with good central bank risk management practice. Indeed, this year the Board paid out an extra 8,000 crores than was promised to the Government around budget time. Separately, the government can infuse capital into the banks. The two decisions need not be linked. There are no creative ways of extracting more money from the RBI – there is no free lunch! Instead, the Government should acknowledge its substantial equity position in the RBI and subtract it from its outstanding debt when it announces its net debt position. That would satisfy all concerned without monetary damage.

Indeed, the very idea of a government receiving a surplus from the central bank is somewhat economically vacuous and, if stretched, it is economically costly. In theory, a central bank can create excess reserves, use it to buy government securities or foreign exchange, earn interest and pay the government the surplus. If the government were to feel temporarily happy, they will not when the economic costs of doing so cause the currency and the economy to crater and their tax revenues take a nosedive. Of course, it will not be just the tax revenue that would nosedive. So would popularity and votes while the only thing that would be reaching for the skies would be inflation.

Andy Mukherjee has written a good piece on how such a move – declaring dividend out of demonetisation of currency notes – would stoke fears of expropriation. That is a good angle too.

He told me that someone asked him the cheeky question: if the government wanted a dividend when the liabilities are extinguished, did it pay anything to the RBI when the liabilities were created? Good one.

So, the government should leave the central bank well alone and not take liberties with credibility. Once lost, hard to retrieve.

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