Moneycontrol Pro Panorama | RBI's profits are a double-edged sword

India’s yield curve has been steepening this year on the back of the RBI’s sizable liquidity infusions, as short-term yields have dropped at a faster pace than their long-tenor counterparts

Dear Reader,

The size of the RBI dividend is the topic du jour. This is nothing but the profit the RBI made through its operations. A large dividend helps the government reduce its fiscal deficit. But while it may seem obvious that the RBI’s profits help the economy by making the fiscal deficit number look good, it is not so simple.

First, let’s understand what the dividend or profit stands for.

The job of a central bank is to print currency notes. Since currency notes are just IOUs with immense trust on them, the bank must keep assets to back up the amount. Usually, the assets are foreign exchange and bonds, denominated in its own currency or the currency printed by another central bank. For instance, the RBI holds rupee denominated government bonds, it holds foreign currency issued by other central banks and US treasury notes denominated in dollars that the US Federal Reserve prints.

Where does it buy the assets? The markets. Open market operations (OMO) are the primary route through which the RBI buys government bonds -- or sells them -- from the bond market and dollars from the foreign exchange market. Here is the tricky part. The RBI is a formidable trader since it has a large balance sheet -- It literally prints money which no other bank can do. Its presence in the market sends out signals and others try to fall in line. Repeated intervention by the RBI distorts prices of assets which otherwise would reflect pure demand and supply.

A more insidious fallout is that markets never learn to wade through crisis and governments become lazy. This is perhaps the crux of the debate on the need and extent of central bank intervention across the globe. The US Federal Reserve’s quantitative easing through incessant bond purchases made it easy for the government to take on additional debt to boost the economy during a recession. But today the US stands at a precipice of unbridled debt which has put a question mark on its ability to pay up.

Emerging markets like India do not have the luxury of the US because the rupee is not a global currency. Simply put, the Fed prints dollars used by almost everyone in the world -- including the RBI -- but the Indian central bank prints money that isn’t used so widely. That puts a cap on how much it can print because there isn’t that much demand.

While the RBI plays the protector, other market players sit back and let the parent take care of them. Foreign investors now know that, beyond a level, the RBI will buy dollars which gives them an easy exit from Indian markets. Domestic traders know that they can extract their pound of profitable flesh directly from the central bank. When there is a crisis, they don’t need to dig for depth or smart choices because the central bank will take care.

An interventionist central bank is the antithesis of free and deep markets. Only free and deep markets can withstand crisis and the job of a central bank is to help develop them. In its bid to protect Indian markets from global whiplashes -- a noble aim, no doubt -- the RBI has now become stuck in a loop of its own interventions. Have a look at our Chart of the Day and see for yourselves.

Past foreign exchange market interventions necessitated today’s bond purchases which in turn would clear the way for exchange rate intervention. In all this, the central bank making a higher profit every year is perhaps making the government too comfortable for its own good.

A central bank is never in the business of making profit. The RBI’s profit is a tax on the general public because it comes at the cost of the true reflection of demand and supply determining the price of an asset. Global uncertainties, emerging market weaknesses, and sudden movements of capital are all good reasons to shield our economy. But the RBI must quickly find its way out of protecting markets beyond what is necessary. Or risk creating vicious loops that undermine the growth of markets.

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