Podcast | Digging Deeper - RBI's Annual Report for 2017-18

Last week, the Reserve Bank of India (RBI) released its annual report for fiscal year 2017-18. The report contained forecasts about the current financial year, updates on demonetisation and the state of the central bank’s finances. It also addressed issues like asset quality in the banking system, the value of the Indian rupee, and other macros with regard to India’s economy.

The one point that made headlines was obviously that demonetisation may well have been an exercise in futility. Let’s dig deeper into the heart of all that the central bank said in its annual report.

Demonetisation

Let’s look at the main points that the central bank addressed. First off, demonetisation. The RBI said that nearly 99.3 percent of the old Rs 500 and Rs 1,000 notes, that were in circulation as on November 8, 2016, have returned to the banking system.

In all, Rs 15.31 lakh crore has been returned, a small rise over the interim number of Rs 15.28 lakh crore that the RBI revealed in last year’s report. That means old notes worth approximately Rs 10,000 crore has not been returned. That statistic could indicate that tax evaders might have managed to legalize their ill-gotten gains or ‘black money’. But the jury is still out - investigations are still underway into several large deposits, and these probes are likely to meet resistance in the form of litigation.

Speaking about the new currency notes, the report mentions that they too are susceptible to counterfeiting. There was a jump in the number of counterfeit notes detected for the new Rs 50, Rs 500, and Rs 2,000 notes. The report observed that it detected an increase of 35 percent in counterfeit Rs 100 notes. There was also a 154.3 percent rise in counterfeit Rs 50 rupee notes.

However, the report also says the overall number of counterfeit notes detected fell by 31.4 percent to 5,22,783 pieces in 2017-18, compared to 7,62,072 pieces in the previous year. That’s around Rs 23 crore of counterfeit notes in 2017-18, half of what was detected last earlier. The central bank attributes this reduction to the introduction of high-security feature notes that, it claims, makes counterfeiting difficult.

Economic Affairs Secretary S C Garg claimed demonetisation had virtually weeded out fake notes in the system. He added that in the 22 months since the event, there has not been a single case of a high-quality fake note due to the introduction of high-security feature notes. From all the Fake Indian Currency Notes, or FICNs, detected, the notes detected at the RBI rose to 36.1% as compared to 4.3% in the previous year. This was due to the processing of large volume of SBNs, or Specified Bank Notes, withdrawn from circulation.

After the note ban, the RBI allowed SBNs to be deposited in banks, with unusual deposits inviting income tax scrutiny. The central bank said, “the humongous task of processing and verification of specified bank notes (SBNs) was successfully achieved." Yes, the Reserve Bank of India used the word humongous in official communication. The SBNs were verified, counted and processed in the high-speed currency verification and processing system, or CVPS, for accuracy and genuineness, after which they were shredded.

The RBI report also noted that the institution spent Rs 7,965 crores in 2016-17 on the printing of new currency notes. That’s more than double the Rs 3,421 crore spent in the previous year. In 2017-18 (July 2017 to June 2018), it spent another Rs 4,912 crore on printing of currency, the annual report said.

There was some collateral damage as a result of the rise in printing and other costs - the dividend paid by the RBI to the government. The RBI paid Rs 50,000 crore as dividend to the government in 2017-18, up 63 percent from Rs. 30,600 crore a year ago. That included an interim dividend of Rs 10,000 crore earlier in 2018.

The central bank set aside Rs 14,190 crores towards its contingency fund, which is used for contingencies like depreciation in the value of securities, risks arising out of monetary/exchange rate policy operations, systemic risks etc. The Economic Times noted that the 10,000 crores may have helped the government rein in fiscal deficit for FY’18. However, the central bank drew criticism for the transfer of surplus to the government before the end of its financial year.

The government is pressing the RBI for more dividends and has reportedly questioned high allocations to the contingency fund. However, the bank’s annual report shows that contingency and asset development funds are only seven percent of the RBI’s current balance sheet compared to 9.2% in 2014.

The RBI, for its part, has defended the dividend distribution policy in the annual report. It adopted a staggered surplus distribution policy in transferring profits to the government. The bank claims this is a prudent measure since capital levels that determine the surplus have shown a cyclical trend.

The bank said, “With a view...towards reducing the impact of cyclicality, while putting in place a rule-based methodology for determining the provisioning requirements and consequently, the available transferable surplus to the Government of India, an alternative rule based approach, the Staggered Surplus Distribution Policy has been put in place.”

An Economic Times column states that the surplus distribution policy adopted by a central bank is one of the key elements that determines its financial strength. Such policies depend on political and economic environments as well as the levels of risk exposure under which they operate. What did the markets think of this?

A report by Bank of America Merrill Lynch said, “RBI contingency reserves is coming off. We remain concerned about the steady erosion in the RBI's contingency reserves to 7 percent of the balance sheet this year from 7.6 percent last year and 11.9 percent in 2009.”

Further, demonetisation doesn’t seem to have succeeded in pushing people away from cash transactions. The report shows that in 2017-18, households added currency worth 2.8 percent of gross national disposable income, or GNDI. The reason? Dis-saving, or excess expenditure, of cash by as much as 2% in the previous year.

Household savings in financial instruments also rose to 11.1 percent of GNDI. A Moneycontrol report noted that these are provisional estimates and should be taken with a pinch of salt. For FY17, the RBI had estimated household financial savings at 11.8 percent of GNDI. That number has now been revised to 9.1 percent.

The annual report also seems to indicate that despite increased cash holding and the rise in currency in circulation, demonetisation had boosted digital payments. In 2017-18, non-cash transactions rose 45 percent in volume and 29 percent in value. The volume rate of growth, while lower than that in 2016-17, is higher than the average 25 percent seen in the two fiscals prior to demonetisation. The trend is similar for value growth too.

Finance minister Arun Jaitley posted on his Facebook account that the larger purpose of demonetisation was to move India from a tax non-compliant society to a compliant one.

He wrote, “This necessarily involved the formalisation of the Economy and a blow to black money...the positive impact of the Demonetisation… (is) more formalisation of the economy, more money in the system, higher tax revenue, higher expenditure, higher growth after the first two quarters.”

Even NITI Aayog Vice-Chairman Rajiv Kumar weighed in on the issue last week. He said demonetisation of high-value currency helped reduce cash transaction and encouraged digital payments. “Demonetisation has impacted the markets and market psychology. How many transactions used to take place in cash (before the note ban), and what is the position now?” remarked Kumar.

NPAs

 The report also addressed the issue of NPAs. The RBI said banks will witness further deterioration in their non-performing assets due to the economic situation prevailing in the current fiscal.

After the Punjab National Bank debacle, the value of frauds in the Indian banking system has, not surprisingly, risen to approximately Rs 41,000 crore in 2017-18. The number of such cases has jumped to 5,835 in FY18 from an average of 4,500 over the last decade.

State-owned banks accounted for 93 percent of the frauds. The annual report noted that by end-March 2018, Rs 12 out of every Rs 100 lent by Indian banks had turned sour. It said this number is only expected to rise by the end of the current fiscal. That said, I doubt anyone is surprised given how the NPA situation unraveled. NPAs in public sector banks increased by about Rs 6.2 lakh crore between March 2015 and March 2018.

The power sector, too, is in a mess. Estimates suggest the power sector could add as much as Rs 1.7 lakh crore (about 1.7 percent of bank credit) to the bad loans tally. The industry fears more loan losses as it prepares to take stressed power assets for resolution under the insolvency and bankruptcy code following an Allahabad High Court judgement that declined interim relief to power companies from escaping insolvency proceedings.

Around 34 coal-based thermal power plants, with an exposure of about Rs 1.77 lakh crore, are under stress as per a government Standing Committee report. State Bank of India has referred 16 assets to insolvency courts while about another eight accounts worth Rs 17,000 crores are in the process of a resolution.

Gold reserves

The Reserve Bank purchased 8.46 tonne of gold in the 2017-18, the first purchase of the yellow metal by the apex bank in almost nine years, its report said. The bank held 566.23 tonnes of gold on June 30, 2018, compared with 557.77 tonnes on June 30, 2017. 292.30 tonnes of this gold are held as backing for notes and are shown as an asset of the Issue Department.

The other 273.93 tonne is treated as an asset of the Banking Department. The total value of gold held by the Banking Department rose to Rs 69,674 crore on 30 June, 2018. The last time the central bank purchased gold was in November 2009, when it had bought 200 tonnes from the International Monetary Fund (IMF). Meanwhile, the rupee’s value has taken a beating. It is currently hovering around the Rs 71 mark against a strong dollar.

There was an increase in the flow of financial resources from banking to the commercial sector in 2017-18. Banks accounted for 43 percent of all fund flows to the commercial sector compared to 26.7 percent a year earlier. The report said credit growth follows economic growth and there is scope for credit absorption, but the bad loan problem has to be tackled and public sector banks sufficiently recapitalised.

GDP growth and FDI

Speaking about growth, the RBI’s annual report projected GDP growth of 7.4 percent for 2019-20. That is consistent with the August monetary policy statement. The report said this growth will be driven by consumption (both rural and urban), investment, and exports. It added that India remains a preferred destination for foreign direct investment (FDI) as domestic consumption remains strong.

The bank observed that manufacturing activity is gathering momentum thanks to new business, both domestic and export orders, rising capacity utilisation and drawdown of inventories.

Helped by the services and agriculture sectors, consumption demand was robust in the country, making India an attractive investment destination.

The report said, “Early indicators suggest that consumption demand remains robust. Aggregate domestic demand is also being supported by steadily strengthening investment - with a renewal of the capex cycle underway- and a strong pick-up in exports in Q1. India remains a preferred destination for FDI.”

India received $37.3 billion capital inflow last fiscal compared to $36.3 billion in the previous financial year. In 2015-16, this investment stood at $36.06 billion. The increase in foreign capital flow was mainly due to higher flows into the communication services, retail and wholesale trade, financial services and computer services.

According to the UNCTAD’s Investment Trends Monitor for 2018, India was the 10th largest recipient of global FDI in 2017 and remained the topmost destination for greenfield capital investment.

The central bank also said, “There are country-specific factors that could distinguish the Indian experience going forward. In the real sector, a normal monsoon for the third consecutive year should lift agricultural output.”

The bank also had a good word for ease of doing business. Its report noted that with the policy reforms being undertaken in sectors like single brand retail trading, civil aviation, real estate broking service, and simplification of legal and regulatory systems, India has moved into the top 100 countries in the World Bank’s Ease of Doing Business global rankings.

Inflation

The RBI’s inflation outlook remains unchanged. In its August 1 monetary policy statement, the bank projected retail inflation of 4.6 percent from July to September 2018, and 4.8 percent for the period from October to March. It predicted retail inflation of 5 percent in the first quarter of the next financial year.