For RBI, May 4 marked a significant event, given the deterioration of its balance sheet, which would impact its day-to-day operations, including currency management. As is known, the issuance department of RBI almost entirely backs up the currency in circulation with foreign investments, which are usually valued at market price on the last business day of the week/month. The theory behind this type of asset/liability management is that it provides flexibility when needed and shares key characteristics with the bullion standard, briefly adopted by India in 1926.
Rising interest rates, however, raise yields on US government bonds, which make up the bulk of foreign securities on RBI’s balance sheet as investments. Since rising yields imply falling bond prices, this has led to losses in market value. As a result, the safeguarding of central bank assets inspired less confidence, especially at a time when increased use of domestic credit was increasing money in circulation faster than expected.
For this reason, with its 0.5% increase in the cash reserve ratio (CRR) announced on May 4, RBI was not only aiming to pull ₹87,000 crore of cash from commercial banks, but also possibly to replenish its foreign investment assets by an equivalent of $11 billion to offset the erosion in asset values. This would conveniently adjust the central bank’s balance sheet without affecting the currency in circulation account.
The revaluation account, which appears on the liability side of RBI’s balance sheet, shows the true impact of rising yields on central bank operations. This account, which includes currency and gold revaluation, investment revaluation as well as its futures valuation account, absorbs any change in the value of domestic and foreign assets held by the RBI.
According to the latest available data, as of April 29, RBI’s revaluation account had contracted by 15% compared to the same period last year. Additionally, the account had lost about a percentage point in value as a proportion of its balance sheet in the first month of 2022-23 alone.
Of course, mark-to-market losses were not the only reason for this contraction. Amid capital outflows, RBI sold a significant amount of foreign assets for dollars which were sold off to give the weakened Indian rupee a soft landing. Therefore, as net domestic assets (AIN) adjust to net foreign assets (NFA) in the reserve currency (RM) function, the proportion of domestic government securities held has increased. This fact created another problem for RBI.
The bank currently holds nearly $190 billion of Indian government securities on its balance sheet. Driven by the banking department, these holdings grew by more than $25 billion in 2021-22 to manage the returns on these securities.
Thanks to record capital inflows until recently, RBI could afford this type of asset strategy. However, that has now turned out to be a bargain, likely giving RBI’s asset management team sleepless nights. Since the start of this fiscal year, domestic assets have seen revaluation losses of around $2 billion to $4 billion amid rising bond yields.
As interest rates rise elsewhere, RBI had to fear even bigger market losses. Since the beginning of the year, the spread between a US and Indian 10-year government bond has often been below the 500 basis point threshold (or 5 percentage points). This has reduced the incentive for 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 withdrawn the equivalent of $20 billion from Indian capital markets.
Raising interest rates was therefore the only alternative left to RBI. It also had to get ahead of the US Fed, as any delay would have exacerbated an already difficult situation.
Nonetheless, in the near term, RBI is sure to witness increased revaluation losses due to rising interest rates. The bond market has already adapted to this new reality and a 10-year government security yielded around 7.46%, as on May 9, 2022. The annualized forward rate for a security of this duration is fixed at 7, 93%, so further erosion in value could be expected.
Going forward, while the value of the RBI’s foreign assets may stabilize somewhat in the near term, the extent of the correction in domestic securities cannot yet be determined. This exposes nearly 25% of RBI’s balance sheet not only to the vagaries of the market, but also to the actions of its own monetary policy committee.
Therefore, with the RBI holding large amounts of government securities, the reduction in the value of national assets is a self-fulfilling prophecy, as its own actions weaken their prices. This not only takes away RBI’s flexibility to modulate assets according to market conditions, but it also ties it into a loop with the government, which wants the central bank to keep its cost of borrowing as low as possible.
If the current situation persists, the central bank’s revaluation account could continue to contract. Beyond a certain point, this account will require a replenishment of the provident fund, which will negatively impact RBI’s risk provisions in these unstable times.
In conclusion, in the interest of its credibility, the RBI must reduce its holdings of Indian government securities at the earliest and increase its foreign holdings. It’s time for RBI to optimize its balance sheet for in-store constraints.
Karan Mehrishi is an economics commentator and author of “The India Collective: What India is Really All About”