For RBI, 4 May was mark a significant event, given its deteriorating balance sheet, that would impact its daily operations, including currency management. As is well known, RBI’s issuing department backs up currency in circulation almost fully with foreign investments, which are generally marked to market on the last business day of the week/month. The theory behind this kind of asset/liability management is that it offers flexibility in times of need and shares key characteristics with the bullion standard, briefly adopted by India in 1926.
Rising interest rates, however, are increasing yields of US government bonds, which forms the bulk of foreign securities on RBI’s balance sheet as investments. As rising yields imply falling bond prices, this was causing mark-to-market losses. As a result, the central bank’s asset back-up has been inspiring less confidence, especially at a time when rising domestic credit offtake was increasing currency in circulation faster than expected.
For this reason, with its 0.5% increase in the Cash Reserve Ratio (CRR) announced on 4 May, RBI aimed not just to draw out ₹87,000 crore of liquidity from commercial banks, but perhaps also to replenish its foreign investment assets by an equivalent $11 billion odd to compensate for asset value erosion. This would conveniently adjust the central bank’s balance sheet without impacting the currency-in- circulation account.
The revaluation account, which is on the liability side of RBI’s balance sheet, shows the true impact of rising yields on the central bank’s operations. This account, which comprises currency and gold revaluation, investment revaluation and also its forward contracts valuation account, absorbs any changes in the value of both domestic and foreign assets held by RBI.
As per the latest data available, as on 29 April, RBI’s revaluation account had contracted by a huge 15%, as compared to same time last year. Also, the account had lost about a percentage point of value as a proportion of its balance sheet in the first month of 2022-23 alone.
Of course, marked-to-market valuation losses were not the only reason for that contraction. Amid capital outflows, RBI sold a significant amount of foreign assets for dollars that were sold to give the weakening Indian rupee a soft landing. Consequently, since Net Domestic Assets (NDA) adjust for Net Foreign Assets (NFA) in the Reserve Money (RM) function, the proportion of domestic government securities held increased. This fact has spawned yet another problem for RBI.
The bank currently holds nearly $190 billion worth of Indian government securities on its balance sheet. Carried by the banking department, these holdings increased by over $25 billion in 2021-22 to manage the yields of these securities.
Thanks to record capital inflows till recently, RBI could afford this kind of asset strategy. However, this has now turned out to be a barnacle, likely giving RBI’s asset management team sleepless nights. Since the beginning of this fiscal year, domestic assets have seen about $2-4 billion in revaluation losses amid rising bond yields.
As interest rates rise elsewhere, RBI must have feared even bigger mark-to market losses. Since the beginning of the year, the differential between an American and Indian 10-year government bond has often been below the threshold of 500 basis points (that is, 5 percentage points). This has reduced the incentive of foreign investors to stay invested in Indian debt, and the US reversal of quantitative easing will increase the pressure. Since the start of 2022, foreign investors have pulled out an equivalent of $20 billion from Indian capital markets.
Raising interest rates was therefore the only alternative left for RBI. It also had to pre-empt the US Fed, as any delay would have exacerbated an already difficult situation.
Nevertheless, in the short term, RBI is sure to witness heightened revaluation losses on account of increasing interest rates. The bond market has already adjusted to this new reality and a 10-year government security was yielding around 7.46%, as on 9 May 2022. The annualized forward rate for a security of this duration is pegged at 7.93%, so further value erosion may be expected.
Looking ahead, while the value of RBI’s foreign assets might stabilize somewhat in the near term, the extent of the correction in domestic securities cannot be ascertained yet. This exposes almost 25% of RBI’s balance sheet to not only the vagaries of the market, but also to the actions of its own monetary policy committee.
Therefore, with RBI holding large quantities of government securities, domestic asset value reduction is a self-fulfilling prophecy as its own actions weaken their prices. This not only takes away RBI’s flexibility to modulate assets as per market conditions, but it also binds it in a loop with the government, which wants the central bank to keep its cost of borrowing as low as possible.
If the current circumstance persist, the central bank’s revaluation account may continue to contract. Beyond a point, this account will require replenishment from the contingency fund, which will negatively impact RBI’s risk provisions in these volatile times.
In conclusion, for the sake of its credibility, RBI must reduce its Indian government security holdings at the earliest and increase its foreign asset holdings. It is about time RBI optimizes its balance sheet for the stresses in store.
Karan Mehrishi is an economics commentator and author of ‘The India Collective: What India is Really All About’
