Mint Explainer: The Deep Links Between the RBI Balance Sheet and the Economy

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What makes central bank balance sheets unique?

The balance sheets of central banks, including that of the RBI, are unique. What makes them unique is that central banks do not need capital to carry out their operations, as they can replenish their capital at any time simply by printing money. However, that doesn’t mean they are, or can be, indifferent to the health of their balance sheets. Indeed, there is an important link between the financial resilience of central banks and the effectiveness of their policies.

Thus, according to RBI, central banks need “financial resilience to absorb the risks that arise from their operations and the execution of their public policy mandate to protect the economy from monetary shocks and headwinds to financial stability. “. Central banks in emerging market economies have an additional role in managing external stability in the face of volatility in capital flows and the ripple effects of monetary policy changes by central banks in advanced economies – which we are seeing happening today as dollar outflows due to US Fed policy tightening sees the rupee fall to historic lows against the dollar day after day, even as the RBI uses its foreign exchange reserves (a just under $600 billion but falling day by day) to smooth out volatility.

How does the central bank’s balance sheet affect the money supply in an economy?

A central bank’s balance sheet is not just a statement of accounts; it is central to the money supply process. At the cost of oversimplification, a simple relationship links broad money (M3), i.e. money to the public, demand and time deposits with banks, and other deposits to the RBI , to the reserve currency (RM), i.e. M3 = m * RM, where m is the money multiplier. The components of reserve money are primarily currency with the public, cash reserves with banks, and bank balances held with the central bank. The sources of reserve money are net domestic assets (NDA) (comprising central bank credit to the government, commercial sector and banks) and net foreign exchange assets (NFA). When RBI acquires one of these assets, it injects money into the system, thereby increasing the money supply. Changes in central bank liabilities and assets therefore lead to changes in the money supply (M3).

What is the relationship between the balance sheet of the central bank and the balance sheet of a commercial bank?

Through changes in the cash reserve ratio, policy rates (repo and reverse repo) and open market operations, the central bank influences banks’ reserves and, therefore, the money supply. While changes in the cash reserve ratio and open market operations have a direct impact on the volume of commercial bank resources, changes in key interest rates influence the cost of funds.

Why are central bank balance sheets making headlines?

Central bank balance sheets, more specifically the balance sheet of the US Federal Reserve, are in the news as the Fed begins to shrink its balance sheet as part of its two-pronged approach – the other being to raise the rate of the Fed – to tighten political monetary policy in response to rising inflation (8.6% in May 2022).

In the wake of the covid-19 pandemic, the Fed expanded its balance sheet – some would say it ballooned – as it tried to stave off an economic meltdown by pumping money into the system – buying obligations and giving money. In the process, the Fed’s balance sheet has grown from $4.7 trillion in March 2020 to over $8 trillion at the end of 2021. Now that the Fed needs to withdraw this extra money, it can do so in two ways: sell securities or stop reinvesting in maturing securities. securities.

However, a sudden or outright reduction in the size of its balance sheet can only shake the financial markets. Thus, he would prefer to reduce the pace of bond buying first, thereby reducing the pace of balance sheet expansion, a process known as tapering, a gradual reduction such that it does not shock the recovery process.

How are central bank profits treated?

Different countries treat the profits of their central banks differently. In India, the profits of the RBI are credited to reserves and appear as liabilities of the RBI. When these are transferred to the central government, the reserves are reduced to that extent on the liability side. On the asset side, the RBI’s net credit to the central government is reduced by the amount of the RBI’s profits transferred. If RBI suffers a loss and the loss is compensated by the reserves created for this purpose, the amount of the monetary reserve will remain the same.

If RBI transfers all of its profits to the government and no reserve is maintained for possible losses in the future, then in case of future losses, RBI will have to transfer the loss to the government through an increase of the RBI net credit to the central government. As a result, the reserve currency would increase to that extent.

In India, RBI transfers have often come to the aid of a beleaguered government seeking resources to overcome a fiscal crisis. A few years ago, the tussle between the government and the RBI over the amount of reserves to be transferred led not only to the ousting of then RBI Governor Urjit Patel but also to the establishment of a committee of experts to “examine the existing economic situation”. capital of RBI” under the chairmanship of former RBI Governor, Bimal Jalan.

The committee’s recommendations were accepted by the government and subsequent transfers to the government were governed by them. In May 2022, RBI transferred a sum of 30,307 crores to the government as a surplus for 2021-22, significantly lower than the 99,126 crores transferred in the previous year, after keeping the emergency risk buffer at 5.50% of its balance sheet.

In a nutshell, central bank balance sheets are important for a host of reasons and should be viewed with caution.

What are the main balance sheet items of the RBI?

The RBI balance sheet separately lists the assets and liabilities of the banking and issuing departments. Under the RBI Act, the sole responsibility of the issuing service is “notes in circulation”. The assets of the Issuing Department basically include gold coins and bars, rupee coins, rupee securities and foreign securities.

The Banking Department’s balance sheet consists of assets and liabilities arising from the banking business of the RBI. Deposits come into the RBI from three major sources, namely government, banks and others. “Other liabilities” is a residual item and includes reserves and provisions, the most important of which is the contingency reserve (CR).

What is RBI’s main source of income?

The main sources of income are interest on domestic foreign securities and foreign deposits; discount and rediscount charges; and public debt management commission. The largest part of the expenditure relates to staff costs and interest payments.

(Taken from the RBI Balance Sheet Management Lecture by YV Reddy, Former RBI Governor, November 1997)

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