Raghuram Rajan recollects fundamental economic lesson a day before he steps down

Outgoing RBI Governor Raghuram Rajan rejected on Saturday the idea of the government taking a special dividend from the central bank for recapitalisation of public sector lenders, saying 'there is no free lunch'. "A fundamental lesson in economics is there is no free lunch. This can be seen in the matter of the RBI dividend: Some commentators seem to suggest that public sector banks could be recapitalised entirely if only the RBI paid a larger dividend to the government. Let me explain why matters are not so simple," he said here.

Explaining the entire ecosystem of earning surplus by the RBI, he said, the central bank earns income out of government assets and printing of currency as well as issuance of deposits to commercial banks. The suggestion of use of dividend of the RBI for recapitalisation of PSU banks was made by Chief Economic Adviser Arvind Subramanian in the latest Economic Survey. "Much of the surplus we make comes from the interest we get on government assets or from the capital gains we make off other market participants. When we pay this to the government as dividends, we are putting back into the system the money we made from it there is no additional money printing or reserve creation involved," he said.

"But when we pay a special dividend to the government, we have to create additional permanent reserves, or more colloquially, print money," he said. "Every year, we have in mind a growth rate of permanent reserves consistent with the economy's cash needs and our inflation goals," he added. Given that budgeted growth rate, he said, to accommodate the special dividend RBI will have to withdraw an equivalent amount of money from the public by selling government bonds in the portfolio or alternatively doing fewer open market purchases than budgeted.

The government can use the special dividend to spend, reducing its public borrowing by that amount, he said, adding, but the RBI will have to sell bonds of exactly that amount to the public in order to stick to its target for money creation. "The overall net sale of government bonds by the government and the RBI combined to the public (that is, the effective public sector borrowing requirement) will not change. But the entire objective of financing government spending with a special RBI dividend is to reduce overall government bond sales to the public. That objective is not achieved," he said.

The bottomline is that the RBI should transfer to the government the entire surplus, retaining just enough buffers that are consistent with good central bank risk management practice, he said. Indeed, Rajan said, this year the board paid out an extra 8,000 crore than was promised to the government around budget time. "Separately, the government can infuse capital into the banks. The two decisions need not be linked. There are no creative ways of extracting more money from the RBI there is no free lunch!," he said.

Instead, the government should acknowledge its substantial equity position in the RBI and subtract it from its outstanding debt when it announces its net debt position, he said, adding, that would satisfy all concerned without monetary damage. He also emphasised that the RBI Board has decided that it wants the RBI to have an international AAA rating so that it can undertake international transactions easily, even when the government is in perceived difficulty in the midst of the 'Taper Tantrum', no bank questioned the ability to deliver on the FCNR(B) swaps, even though the liability could have been tens of thousands of crores.

Based on sophisticated risk analysis by the RBI's staff, the Board has decided in the last three years that the central bank equity position, currently around 10 lakh crore, is enough for the purpose. It therefore has paid out the entire surplus generated to the government, he said, amounting to about Rs 66,000 crore each in the last two years, without holding anything back. "This is of the order of magnitude of the dividends paid by the entire public sector to the government. In my three years at the RBI, we have paid almost as much dividend to the government as in the entire previous decade. Yet some suggest we should pay more, a special dividend over and above the surplus we generate," he said.