Ajit Ranade: RBI’s increasing fiscal support deserves a closer look

This monetary reform has stood India in good stead. To be fair, India’s inflation management was much better than that of most developing countries, especially in Latin America and Africa, even before the formal inflation-targeting regime was put in place. There have been no episodes of runaway inflation or sustained bouts of hyperinflation. Credit for this should go largely to RBI and also to the political system, which has been sensitive and responsive in taking corrective action against rising price levels.

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Even as RBI manages monetary policy within the inflation-targeting framework, it is not a central bank with a single mandate. Among other things, it has to ensure adequate availability of credit, manage foreign exchange rates and reserves and exercise a vigil on financial sector stability. How much weightage each of these objectives is assigned and the trade-offs involved in RBI policies are matters of conjecture.

Beyond central banking, RBI is also a regulator of banks and non-bank financial institutions, an enabler of innovation in digital payments and currencies, and increasingly a repository of data on the Indian economy. It also serves as the government’s merchant banker, conducting bond sales to raise fiscal resources. This role is often at odds with its role as a money tightener, since the former calls for lowering the cost of borrowing while the latter requires the opposite. Because of this potential conflict, there have been calls to separate the debt management office of the government and move it fully to New Delhi.

One de facto role of RBI that is not quite captured in its set of responsibilities is that of a fiscal provider. The central bank is not a tax revenue earner, but has become a significant source of funds. The bad old practice of its automatic monetization of the Centre’s fiscal deficit was discontinued as part of the 1990s’ reforms. The price of government bonds since then has been market determined and RBI may stock up on this paper by buying bonds in the secondary market.

Sometimes, this has led to indirect monetization. For instance, in 2020-21, nearly 80% of new government bond issuances ended up in RBI’s possession. This has thankfully been much lower in the past two years, but a case in point is RBI’s upcoming bond-purchase programme of ₹1.25 trillion over the next fortnight. This is part of its liquidity injection measures that have been underway for several weeks, intended as a corrective step after its tight monetary stance of the previous two years.

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RBI was aggressively selling dollars till then, an estimated $250 billion worth of them over 18 months, and was thereby mopping up rupee liquidity. This was done to protect the rupee from sliding precipitously. The rupee fell nearly 10% anyway and has recovered somewhat. 

The sale of dollars at higher levels immediately created profits for RBI, since those dollars were purchased at a much lower price. Its aggressive dollar sales were both in spot and forward forex markets, and about $80 billion will soon be due for delivery as per last year’s forward contracts. But the silver lining is that last year’s rupee depreciation has created handsome profits for RBI. The rupee is now strengthening on the back of recent dollar inflows into India’s stock market and RBI can make up for some dollar shortage (for forward market contract deliveries) if needed by buying dollars cheaply.

The net result is that RBI is expected to deliver a whopping dividend of ₹2.5 trillion to the Indian government, representing the excess income it made in 2024-25. This is nothing short of a fiscal bonanza, much larger than what was anticipated in the Union budget presented on 1 February. 

Thanks to such profiteering, RBI has given about ₹8 trillion to the government since 2017. This year’s dividend—to be paid out in 2025 but attributed to last fiscal year—will be about 10% of the government’s net tax revenues, more than its customs duty mop-up and one-fourth of its personal income tax collections. By next year, RBI’s dividend might climb to ₹3.5 trillion.

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RBI’s balance sheet since 2017 has grown by 113%, whereas India’s GDP is up 61% in nominal dollar terms. This pace of balance sheet expansion does not seem commensurate with economic activity. It is also pertinent to ask whether the rupee kept artificially strong for two years, which resulted in the handsome RBI dividend, came at the expense of stagnant exports.

Exchange rate management is tricky and entails a trade-off between the economic insurance benefits of adequate reserves and the opportunity cost of holding such large reserves. If the size of reserves exceeds the insurance coverage needed and then that excess is used to book profits on dollar sales to generate dividends, it calls for scrutiny. Is there not a conflict between aiding exports and fortifying the government’s treasury? 

This question will be even harder to answer as recessionary winds blow over the US, requiring Indian policymakers to rev up drivers of growth beyond the exhaustible sums pushed out by fiscal pump priming.

The author is senior fellow with Pune International Centre.