RBI transfer to increase liquidity and cause volatility

The much awaited Bimal Jalan Committee reports recommendations were accepted by the RBI board on August 26, 2019. The committee recommended a transfer of INR 1.76 tn, which includes INR 1.23 tn of dividend income and INR 526.37 bn of excess capital. Of the INR 1.23 tn, INR 280 bn has been transferred as interim dividend to the government for FY2019. This leaves INR 950 bn to be transferred in FY2020 of which INR 900 bn has already been budgeted for in the Union Budget FY2020. Effectively this leads to an excess transfer of INR 576.37 bn to the government for the year FY2020.


While there is still ambiguity on how the government utilizes the surplus funds, the government is more likely to utilize the windfall gain as a buffer against shortfalls in the tax collections during a period of moderating growth. Given the uncertainties of the amount of transfer, the finalized quantum led to a brief relief rally in the markets. However, the sentiment reversed quickly as the markets absorbed the details of the transfer and the reasons behind the substantially high RBI dividend of INR 1.23 tn for 2018-19. 

We analyse some of the reasons why the rally was stopped abruptly amid multiple worries as follows:
(a) Unusually large OMO purchases and change in methodology on forex operations is causing the worry. The committee is now using WACC (weighted average cost of capital) to determine exchange rate gains, which had been advised by the Malegam committee earlier. What this implies is that the quantum of dividend would probably mean revert as one do not expect same OMO purchases in future like last fiscal.
(b) Given that BoP is expected to be is surplus in FY2020 (as opposed to deficit in FY2019), the RBI would probably conduct dollar purchases to build on its reserves thus leading to lower build-up in foreign exchange gains. Since the Contingency Buffers are now at the lower end of specified threshold, additional provisioning will have to be done in line with the growth in RBI’s balance sheet which will also limit dividend transfers in future. 
(c) The DTC (Direct tax code) proposals is also disappointing people. Many had thought that they get 20% tax rates and retain all exemptions. But with new clarity on the tax slabs and not so much exemptions, the market is having second thoughts on the same.

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