Quasi-fiscal costs

Business Standard, 17 September 2003

Last week the RBI added USD 1.1 billion to foreign exchange reserves. There are reports that schemes are being formulated to encourage the Resurgent India Bond (RIB) funds to stay with India. Finance minster Jaswant Singh has said that India will hold USD 100 billion in reserves by the end of the year.

There may or may not be merit in holding extremely large reserves. This article is about one element of the cost of building these reserves. Clarity on the costs will help us think more clearly about the choices involved. Though the RBI mentions that the policy has costs in the latest Annual Report, no attempt is made to measure them. In a recent paper The costs of currency intervention in India (see http://openlib.org/home/ila/currency.html), I explore some of these issues.

We begin with a look at RBI's earnings for the year 2002-03.

The RBI has reported that for the year 2002-03 the surplus it transfered to the Government of India was Rs.8,834 crore. This was lower than the sum of Rs.10,324 crore transfered in 2001-02. A lower transfer from RBI to GOI resulted in an addition to the fiscal deficit of the center. This reduction in income took place even though RBI's total assets (domestic plus foreign) increased. So what caused this fall in income?

Since an addition to foreign exchange reserves has an impact on the monetary base, the RBI sterilised its purchase of dollars by reducing its domestic assets through open market operations of marketable government securities. Foreign currency assets of the RBI increased from Rs.2.67 lakh crore on June 30, 2002 to Rs.3.65 lakh crore on June 30, 2003. Domestic assets fell from Rs.1.86 lakh crore to Rs.1.54 lakh crore. Gross interest income fell from approximately Rs.25,478 crore to Rs.22,890 crore.

This reduction in gross interest income by Rs. 2,580 crore contributed to the reduction in the surplus transfered to the government. This was partly the result of lower foreign and domestic interest rates. It was also the result of the policy of sterilised intervention by the RBI and is popularly known in the literature as quasi-fiscal costs. The concept can be found in a 1991 IMF Staff Paper by Guillermo Calvo titled "The perils of sterilisation". `Quasi-fiscal costs' ensue when central banks exchange high-yielding domestic government debt for foreign securities typically paying lower nominal yields when they undertake sterilised intervention. The term 'quasi-fiscal' indicates that the accounts of parastatal enterprises such as the central bank are included.

When GOI issues a bond that RBI buys, the consolidated balance sheet of GOI plus RBI is unaffected. It is only when the RBI sells that government bond, that the consolidated balance sheet of the government and RBI now shows a liability and involves an interest outgo.

India is not the first country to witness such costs. Surges in capital inflows in a number of countries, such as those in the Pacific Basin in the 1980s and early 1990s, led to concerns about the implications of capital inflows for the exchange rate. If the exchange rate was floating, these inflows could lead to an appreciation of the currency, and loss of competitiveness. Many central banks resorted to sterilised intervention, in order to try to have a currency policy without simultaneously subordinating monetary policy. Studies indicate that these costs may be 0.25 to 0.5 per cent of GDP. During periods of surges in capital inflows quasi-fiscal costs have been seen to rise up to over one percent of GDP.

It is interesting to note that researchers find that if quasi-fiscal costs represent a significant cost to government, it may play a role in the timing of the abandonment of a sterilisation program. Since the sterilisation program represents an effort to maintain a downward peg on a nominal exchange rate while maintaining a monetary policy objective, a government that decides that these costs have become too high will rationally choose to abandon such a program, either by allowing its exchange rate to appreciate or its money supply to rise.

The response to rising quasi-fiscal costs has varied across countries. Ken Kletzer and Mark Spiegel find that in response to rising QFC, Philippines, Mexico and Taiwan reduced the extent of sterilisation. While the increase in domestic credit was still contained, it no longer fully offset the impact of capital inflows. Other countries, such as Indonesia, Korea and Singapore maintained their sterilisation programs in the face of quasi-fiscal cost surges. In these countries domestic credit growth did not expand.

Another response to rising QFC has been to give up the erstwhile currency policy. In Singapore, after the sudden rise in inflows, the central bank reduced its intervention in the forex market. Consequently, the nominal and real exchange rate appreciated significantly. Similarly, Chile and Spain widened their exchange rate band and allowed some appreciation.

In India, quasi-fiscal costs were about 0.56 percent of GDP in both 2001-02 and 2002-03. If reserves were to rise to USD 100 billion next year, quasi-fiscal costs could rise to 0.67 per cent of GDP or roughly 11 per cent of the interest expenses of GOI.

If USD 25 billion are added to reserves in 2003-04, then with an average interest differential over the year of 4 percent, there will be an additional cost of Rs.4,500 crore to the RBI.

It is another matter that the RBI does not hold enough government securities to sterilise USD 25 billion to its reserves, if it chooses to add them. During 2002-03, to ensure that the RBI has a sufficient stock of marketable securities, the GOI converted large amounts of Special Securities issued earlier to RBI into marketable securities.

The RBI has set up a working group to look into the issue of RBI bonds that can be used to sterilise the monetary impact of reserve accumulation. Currently this is prohibited by RBI Act, 1935. Even if the Act is amended and RBI is allowed to issue bonds against its dollar reserves, the interest it would pay is likely to be higher than what it receives on US T-bills and the quasi-fiscal costs would not be reduced.

If there was fiscal transparency in the Indian system and next year's budget earmarked a sum of Rs.4,500 crore of taxpayers money for adding USD 25 billion to reserves, the government would have to clearly indicate the benefits from this additional accumulation. However, as it is in the case of defence expenditure, the government can impose these costs on the public and get away by appealing to nationalist sentiments.

The author is at ICRIER. These are her personal views.

Ila Patnaik

Ila Patnaik
ila at icrier dot res dot in