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All about the RBI's contingency fund

The centre and the RBI seem to have finally thrashed out a solution over the contingency fund tussle. But is the government justified in asking a share of it in the first place?

A recent public spat between the RBI and the centre over the former’s contingency fund had us all hooked.

Having overspent already and in serious need for funds to get the economic machine roaring before the general elections in 2019, the ruling BJP government turned its gaze towards the contingency fund. But being its hard-earned money, the apex bank naturally refused.

The deadlock persisted for days with a desperate government threatening to invoke section 7 (it allows the government to give directions to the apex bank on matters of public interest) to get the money. And under severe pressure, it was widely speculated that the RBI governor Urijit Patel would tender his resignation in the next board meeting of the central bank on 19th November.

Matters however have cooled to an extent after that with both parties agreeing to soften their stance on different issues, including the one on contingency funds.

But with things getting so heated, it does warrant a closer look at what the contingency fund is, why it is the bone of contention and how justified the warring parties are in their respective stances.

Scroll down to learn more…

What is the contingency fund?

This is not to be mistaken for the contingency funds under the disposal of the president of the nation and meant to meet unforeseen expenditures of the government resulting from natural or manmade disasters and other things.

This fund belongs to the central bank. As the name suggests, it is for unexpected, unforeseen expenditures too, but those faced by the bank.

Those could arise from the rapid depreciation of the value of its domestic bond holdings, exchange rate depreciation on its foreign exchange assets and losses from open market operations involving the tweaking of the repo and reverse repo rates for managing the supply of money in the economy.

Or it could be because of the collapse of a commercial bank which can rattle the economy and thus needs to be bailed out.

There could be “black swan” event too such as the sudden note ban two years back. It costed the RBI considerably in shredding of accumulated redundant notes and printing new ones. As per data released by it, the price of printing notes doubled to Rs 7,965 crore in fiscal year 2017 from fiscal year 2016.

The contingency fund alongside other reserves such as asset development fund, foreign currency and gold reserves are a crucial part of the RBIs balance sheet. They enable the RBI to tackle unexpected disruptions, and in this manner serve to instil faith in global investors.

Where does the RBI make money to put into its contingency fund?

There are various sources. Foremost among them is the interest earnings on foreign currency assets such as bonds. It could also be from interest earned from loans and advances to central and state government. Interest from deposits held with foreign banks is another source of income for the apex bank.

Net interest earned from liquidity operations is a source of income too. This includes the difference between repo rate (interest charged by the RBI to commercial banks while lending money to the latter) and reverse repo rate (interest paid by the RBI to borrow money from commercial banks).

A part of the earnings of the central bank from all these sources go into printing currencies and supporting its operations. The remaining amount is transferred to the government as a dividend.

And sometimes, the RBI also sets aside a part of its income for contingency funds. This leads to reduced dividend transfer to the government.

Why did the centre demand a part of the contingency fund?

With campaigning for the general elections set to start in six months’ time, the ruling BJP government is hard pressed to deliver. And economic growth, which suffered a serious setback owing to the toxic mix of demonetisation and haphazard implementation of the GST, is topmost on its agenda.

To revive it, the government first needs to recapitalise the bankrupt banks and NBFCs (non-banking finance companies) mostly barred from lending till they correct their balance sheets by recovering their loans. The lending restrictions placed on them has stifled business growth in the nation, particularly in the MSME (micro, small, and medium enterprises) sector which has bore the main brunt of demonetisation and GST implementation.

The massive funds needed for bank recapitalisation, for large social welfare schemes and for materialising other tall promises such as the quick Rs.1 crore loan to the MSMEs is expected to put a severe strain on the government’s fiscal deficit going forward.

Hence the finance minister Arun Jaitley demanded a whopping Rs.3.6 lakh crore from it. This has been calculated to be around 2 percent of the GDP of the nation.

Why has the RBI put its foot down on parting with a part of its contingency fund?

The centre has been dissatisfied with the RBI putting money into its contingency fund, reason being it reduces the government’s share of dividends.

It feels that the RBI’s contingency fund is already the second largest in the world after Norway. Besides, being at 26.5 percent of total assets, it is greater than the median of 10 percent.

Under such circumstances, why was the RBI reluctant?

The biggest reason is that with the money gone from its coffers, RBI would stand to lose its credibility; it would destroy the trust of the global investors and other nations on the Indian apex bank to meet various contingencies.

Besides, it would also gradually lower the earnings of the central bank. This is because it holds the contingency fund in the form of gold reserves, forex exchange reserves, consisting of foreign currency assets along with foreign currencies, and government of India bonds. With a substantial part of the contingency fund depleted, its interest income would also come down.

But most importantly, drawing the staggering amount at one shot would generate a systemic risk as it would force the central bank to sell the government bonds or its foreign exchange reserves.

As per experts, it is simply imprudent to use up all the funds accumulated over several years at one go. The fund is meant to be used sparingly, only when there is an extreme emergency.