Currency gains: Why increasing the risk buffer is a prudent move

The Reserve Bank of India’s (RBI’s) central board last week approved a record surplus transfer of ₹2.69 trillion to the Union government. The government had budgeted for ₹2.56 trillion in receipts from dividend, cumulatively from the RBI and public-sector financial institutions. A higher than budgeted surplus transfer from the RBI will aid the government in achieving the fiscal-deficit target of 4.4 per cent of gross domestic product this financial year. Given that it is still early months of the financial year, it is difficult to envision with certainty how the fiscal situation will evolve over the year. However, additional revenue can partly be used to increase the defence outlay. A higher surplus transfer will also help ease liquidity conditions in the system and aid the RBI’s efforts in this direction. At the time of monetary-policy easing, comfortable liquidity conditions help transmission. 

Although the surplus transfer was higher than what the government had expected, it fell short of market expectations. The RBI board also decided to increase the range for the contingent risk buffer from 5.5-6.5 per cent of the balance sheet to 4.5-7.5 per cent, and keep it at the upper end for the year. The RBI had been increasing the risk buffer over the past years within the range, based on the economic capital framework adopted in 2019. In an uncertain global economic environment, it is prudent to maintain a higher buffer because it will enhance the central bank’s flexibility. The timing is also suitable because the RBI is reporting higher income. Had the RBI not increased the risk buffer, the surplus transfer would have been around ₹3.5 trillion. However, it is to be hoped that the central bank will not go towards the lower end of the new range to help the government meet fiscal targets. 

  The RBI has been generating higher surpluses on account of, among other things, higher interest income and foreign-exchange gains. The central bank holds both domestic and foreign-currency assets. Higher interest rates in the United States, for example, are likely to have aided the RBI’s income. Given economic-policy preferences in the US — higher tariffs and higher Budget deficits — interest rates may remain elevated for some time, which would continue to boost the RBI’s interest income. Further, the RBI sold foreign exchange worth nearly $400 billion at gross level last financial year. Since the historical price of dollar acquisition in rupee terms is much lower than the current price, it would have resulted in higher gains. However, gains on this account will get increasingly limited. With the higher scale of selling and buying foreign exchange, the average holding price would go up, limiting future gains.

  In this context, it is worth noting that the RBI perhaps doesn’t need to intervene excessively in the foreign-exchange market. While a stable currency has its merits, excessive intervention by the central bank can weaken the incentive in the private sector to hedge its exposure. It can further encourage the private sector to raise money from abroad, increasing the burden on the central bank to intervene. The cycle must be avoided. Too much intervention also often leads to currency overvaluation. The central bank can intervene at times of excess volatility, which is also the stated position of the RBI. However, in the normal course, it should allow the private sector to handle currency volatility.