RBI’s dependence on forex intervention gain needs a closer look

For the financial year 2022-23, the RBI paid a dividend of Rs. 87,420 crore to the government vis-a-vis Rs. 30,311 crore for the previous year, which was a six-year low. The higher payout was on the back of a 47 per cent jump in both income and surplus before appropriation.

Central banks like the RBI are also financial institutions, albeit of a unique kind. And the year 2022-23 was a difficult one for the finances of central banks with large forex reserves, as in the wake of rising inflation and tightening of liquidity and policy rates in most OECD countries, bond yield rose and equity markets fell. For example, the Swiss National Bank (SNB), the country’s central bank with forex reserves of around US$ 800 billion, posted a record loss of CHF 132.5 billion (US$ 143 billion) in 2022 caused by a sharp drop in the valuations of its bond and equity holdings, on the one hand, and foreign exchange loss arising out of the appreciation of Swiss franc against euro by 5 per cent, on the other hand. The nominal trade-weighted external value of Swiss franc rose by 5 per cent during 2022. Due to the loss, the equity capital that the SNB had built up in recent years fell from around CHF 204 billion to CHF 66 billion.

A major highlight of the income of the RBI in 2022-23 was a whopping exchange gain of ₹1,03,308 crore — an increase of about 50 per cent over 2021-22

In the case of the RBI, the valuation loss on the holding of foreign securities in 2022-23 was Rs.71,240 crore, taking the cumulative valuation loss for 2021-22 and 2022-23 to Rs. 1,74,343 crore, or about US$ 21.5 billion. This was a major component for the net decrease in the size of the foreign currency assets (FCA) of the RBI during this 2-year period by about US$ 27 billion. The valuation loss in 2022-23 at about 1.7 per cent of the average FCA during the year was lower than the corresponding figure of 2.4 per cent in 2021-22 and cannot be termed as excessive. However, it is apparent that the style of portfolio management of foreign securities holdings involves a low level of ‘churning’ indicating a largely passive and risk-averse approach and not much use of interest rate derivatives.  

However, a major highlight of the income of the RBI in 2022-23 was a whopping exchange gain of Rs. 1,03,308 crore – an increase of about 50 per cent over 2021-22. To put some more perspective, the exchange gain was the single-largest item of income, surpassing all other major ones like interest income from domestic sources (Rs. 82,776 crore) as well interest income from foreign sources (Rs.60,297 crore) by wide margins. Exchange gain is recognised on sale of foreign currencies, mostly US dollars, by the RBI. The numbers in the table below can throw some light on the provenance of the spurt in exchange gain in 2022-23:

Source: rbi.org.in    

To be sure, increased sale of US dollars in 2022-23 was occasioned by the significant downward pressure on the rupee since the beginning of 2022, which intensified as the year progressed with the US dollar reaching a high of Rs. 82.83 on October 7, 2023. However, as has been the case in the recent years, the forex market interventions in 2022-23 also involved large volumes of buy-sell swaps in addition to spot sales of US dollars for controlling the resulting changes in rupee liquidity. As it happens, buy-sell swaps almost invariably result in exchange gain and from the data released by the RBI, it is apparent that there was a build-up of buy-sell swap positions from the month of May, 2022 onwards, with an addition of 3-12 months swaps taking place in October, 2022.

All else being equal, longer term buy-sell swaps result in more exchange gain. While it is nobody’s case that swaps should have no place in intervention operations, yet a few relevant facts need to be borne in mind in this context: (i) US$/Rupee buy-sell and sell-buy swaps are essentially money-market instruments used for swapping liquidity in the two currencies for the tenor of the swap. However, between a term repo and a US$/Rupee buy-sell swap of the same maturity, which would have the same effect on rupee liquidity, the latter would generally be more profitable, and (ii) Not many central banks use forex swaps as a liquidity management tool on a regular basis. SNB, for example, did not engage in any forex swaps for the purposes of influencing conditions in the Swiss franc money market in 2021 as well as in 2022.  What is more important, the exact purposes for which the RBI undertakes both buy-sell and sell-buy forex swaps more or less regularly are not very clear to all and sundry. It would benefit all if the RBI elucidates more on this issue, including by making public the conclusions of an empirical research to be undertaken to verify whether the objectives of forex swaps are indeed achieved in practice.

All else being equal, longer term buy-sell swaps result in more exchange gain

Another country with large forex reserves – around US$ 400 billion – whose currency also faced significant selling pressure in 2022 is Korea. The won lost about 18 per cent of its value against the US dollar vis-à-vis the level at the beginning of 2022 in the second week of October, 2022, when exchange rate volatility was particularly pronounced in many markets.  The Bank of Korea (BoK), like the RBI, had to sell US dollars in a big way to provide support to the won. This resulted in large exchange gain for the BoK. However, it lost money in selling its investments to generate US dollar liquidity for intervention purposes.

The BoK’s aggregate holdings of foreign assets and gold is around 85 per cent of its total earning assets, while this ratio is around 75 per cent in the case of RBI. These structural features are broadly reflected in the composition of their interest incomes. However, the BoK’s exchange gains in 2021 and 2022 formed only 0.07 per cent and 11 per cent respectively of its income as against 43 per cent and 44 per cent respectively of the RBI. The US dollar sales of the BoK were lower by several orders of magnitude. In any case, forex sales of the two central banks are not comparable, since the BoK does not undertake forex swaps.

Are there adequate policy-driven controls that keep the incentive to generate more and more of exchange gain in check?

All in all, interventions in the domestic forex market by the RBI is discretionary. This is particularly true about forex swaps. Emergence of exchange gain as the most important contributor to the RBI’s income within a relatively short period of time raises a valid question: are there adequate policy-driven controls that keep the incentive to generate more and more of exchange gain in check?        

The move to strengthen the contingency fund (CF) by Rs. 1,30,876 crore out of the surplus generated in 2022-23, thereby raising the RBI’s available realised equity (ARE) to 6 per cent of its balance sheet size from 5.50 per cent in the previous four years is a prudent one. From a risk management point of view, this ratio needs to be raised to 7 per cent as a matter of priority. Also, in recognition of the fact that foreign assets entail much higher risk compared to domestic assets, the appropriate size of ARE should be the higher of 7 per cent of the balance sheet size and a certain proportion, say 10 per cent, of the forex reserves.    

(The writer is a former central banker and consultant to the IMF)