Transfer of RBI revaluation reserves can give deflationary shock to economy

Such a transfer can deliver an unintended cataclysmic deflationary shock to the real economy, driving interest rates way too high, and leading to a massive collapse in output and employment

Recent events suggest that the RBI and the government may be going through some trouble in their relationship. At the heart of this tussle is said to be the government's insistence on transferring revaluation reserves worth Rs 3.6 trillion from the RBI to the government.

Let's take a closer look at how such a transfer can affect the economy

The capital and reserves that the RBI holds on its balance sheet consist of two main components, namely, Currency and Gold Revaluation Account (CGRA) and Contingency Fund. These reserves are nothing but only revaluation reserves which represent periodic marked-to-market unrealised gains/losses in the value of foreign currency and gold assets on the RBI’s balance sheet and currently add up to about Rs 7 trillion on RBI’s total assets of about Rs 36 trillion, constituting about 20% of total assets. The other component of RBI’s capital and reserves of Rs 2.5 trillion, constituting about 7% of total assets, comprise equity capital and contingency fund arising from the RBI’s realised net income. Thus the total capital and reserves add up to about Rs 9.5 trillion constituting 27% of total assets on RBI’s balance sheet. Significantly, revaluation reserves in Investment Revaluation Accounts are too insignificant (only Rs 0.165 trillion) to warrant consideration.

It was widely reported in the media that government was seeking transfer of Rs 3.6 trillion of these Rs 7 trillion worth of revaluation reserves. However, it is just as well that only a few days back, government denied the move to seek transfer of Rs 3.6 trillion because the only way that the RBI can transfer such notional unrealised net gains is by actually realising them by selling Rs 14.5 (3.6/7 * 28) trillion worth of its Foreign Currency and Gold assets because this unrealised net gain of Rs 7 trillion is from the revaluation of the Foreign Currency and Gold Assets worth about Rs 28 trillion. But when the RBI actually sells what amounts to 40% of its total assets and 51% of its Foreign Currency and Gold Assets, their value will plummet. Even if, for argument’s sake, we make a strong assumption that this will not happen, the assets sale of this magnitude will result in a massive contraction in RBI's balance sheet of about Rs 11 (14.5-3.6) trillion, that is net of Rs 3.6 trillion transfer to government. As a result, the Reserve Money, or the so-called primary liquidity, will shrink to about Rs 15 (26- 11) trillion from Rs 26 trillion currently.

This contraction of Rs 11 trillion in the Reserve Money will, in turn, lead to the shrinking in Broad Money supply (M3) from the current Rs 145 trillion to about Rs 84 (15*5.6) trillion, assuming the current Money Multiplier of about 5.6. This, in turn, will deliver an entirely unintended cataclysmic deflationary shock to the real economy, driving interest rates way too high, and thus leading to a massive collapse in output and employment. Specifically, on a ballpark basis, GDP will collapse from the current Rs 166 trillion to about Rs 97 (84*1.15) trillion (applying the current GDP/M3 ratio of 1.15 on the reduced M3 of Rs 84 trillion).

And no less, due to this massive contraction in the RBI’s balance sheet assets, there will be a corresponding sharp fall in the RBI's realised income, which ,in turn, will mean so much less future surplus transfer to government. 

Although for the purpose of illustration, the above method of calculation was used for the media-reported transfer of Rs 3.6 trillion worth of revaluation reserves, it can be just as easily used to quantify the impact of revaluation Reserve transfer for any amount. 

The author is a former Executive Director of RBI. He tweets @vksharma52