RBI's Dividend Policy: Learn from Dr Raghuram Rajan

First Year Economics: There is no free lunch. RBI Dividend Policy*

A fundamental lesson in economics is there is no free lunch. This can be seen in the matter of the RBI dividend: Some commentators seem to suggest that public sector banks could be recapitalized entirely if only the RBI paid a larger dividend to the Government. Let me explain why matters are not so simple.

If what follows is complicated, trust me, it is. But pay attention, students, especially because it is about your money. I am sure you will understand. How does the RBI generate surplus profits?

We, of course, print the currency held by the public, as well as issue deposits (i.e. reserves) to commercial banks. Those are our fixed liabilities. As we issue these liabilities, we buy financial assets from the

market. We do not pay interest on our liabilities. However the financial

assets we hold, typically domestic and foreign government bonds, do pay interest. So we generate a large net interest income simply because we pay nothing on virtually all our liabilities.

Our total costs, largely for currency printing and banker commissions,

Amount to only about 1/7th of our total net interest income.  So we earn a large surplus profit because of the RBI’s role as the manager of the country’s currency. This belongs entirely to the country’s citizens.

Therefore, after setting aside  what is needed to be retained as equity capital to maintain the creditworthiness of the RBI, the RBI Board pays

Out the remaining surplus to the RBI’s owner, the Government.

The RBI Board has decided it wants the RBI to have an international AAA rating so that RBI can undertake international transactions easily,

even when the Government is in perceived difficulty– in the midst of the Taper Tantrum, no bank questioned our ability to deliver on the FCNR(B) swaps, even though the liability could have been tens of thousands of crores. Based on  sophisticated risk analysis by the RBI’s staff, the Board has decided in the last three years that the RBI’s equity position, currently around 10 lakh crores, is enough for the purpose. It therefore has paid out the entire surplus generated to the Government,

amounting  to about Rs66,000 crores each in the last two years, without holding anything back. This is of the order of magnitude of the dividends paid by the entire public sector to the Government.

In my three years at the RBI, we have paid almost as much dividend to the government as in the entire previous decade. Yet some suggest we

should pay more, a special dividend over and above the surplus we generate. Even if it were legally possible to pay unrealized surplus (it is not), and even if the Board were convinced a higher dividend would not

compromise the creditworthiness of the RBI, there is a more fundamental economic reason why a special dividend would not help the Government with its budgetary constraints.

Here’s why: 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. But** whenwe 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.

If what I have said just now seems complicated, it is, but it is also the correct economic reasoning. Similar detailed rationales lead us to turn

down demands to cut interest rates in the face of high inflation, to depreciate or appreciate the exchange rate depending on the whim of the moment, to use foreign exchange reserves to fund projects, to display forbearance in classifying bad loans or waived farmer loans as

NPAs, and so on...

We have been tasked with a job of maintaining macroeconomic stability, and often that task requires us to refuse seemingly obvious and attractive proposals. The reason why we have to do what we have to do may not be easy for every unspecialized person, even ones with substantial economics training, to grasp quickly.

Of course, we still  must explain to the best of our ability but we also need to create a structure where the public trusts the central bank to do the right thing. This then is why we need a trusted independent central

Bank.

**This  is not  strictly true.  Our earnings on foreign  exchange assets  come from outside the system, so when we pay this to the Government as dividend, we are printing additional money. We do account for this.

*Excerpts from remarks by Raghuram G Rajan, Governor, Reserve Bank of India on September 3, 2016 at St Stephen’s College, New Delhi.