Knowledge Page Background Currency seigniorage, C = (c-g)*r - p Seigniorage Where c is the notes in circulation, g is the value of gold held to back currency, r is interest rate earned on assets and p is the cost of printing currency notes. Reserve Bank of India (RBI) in its Annual Report for FY 2018 reported a 26.63% rise in income at INR 72,800 Cr and 9.49% increase in the balance sheet size. In The Central Bank determines the demand for money supply based on the contrast, the total expense for RBI during same period was INR 28,200 Cr i.e. a projections of economic growth and inflation. The rise in currency in circulation or Net Margin of 63.9%. As a central bank, the RBI has the unique power of printing monetary base in an economy thus results into higher income for the Central and issuing currency notes. These notes are the liability of the RBI to the bearer Bank. of such notes as written on the currency note itself. For anyone except Central The Issue department of RBI is responsible for issuing currency notes and minting Banks, a currency note is a form of asset. The liability of currency notes does not of coins and thus also responsible for the assets and liabilities related to issuances accrue any interest cost to the RBI. of notes.

Illustration: 2. Seigniorage on Bank Reserves Let us assume that Person A has money worth INR 100 and there is no bank Seigniorage accruing from bank reserves arises from the funds banks have to between RBI and the public. Withdrawal of this money would entail conversion of maintain with the Central Bank in order to meet their reserve requirements, either the value INR 100 into currency notes of the same value. RBI would print an INR as interest-free balances or at below market interest rates. 100 currency note and hand it over to Person A. This value of INR 100 – in return for which the RBI issued the INR 100 currency note – will be invested by RBI. Seigniorage on bank reserves, B = b*r’ Thus, the issuance of INR 100 currency note will now earn the RBI interest Where b is the amount of reserves kept by banks with the central bank, r’ is the income. In this entire exercise, the only expense borne by RBI was the cost of rate of interest earned. The banking department is responsible for banking printing the notes. The currency note of INR 100 will keep circulating in the supervision and hence, reserves and deposits of banks. economy and becomes a perpetual liability of the RBI.

In modern economics, the concept of commercial bank seigniorage has also grown Introduction to Seigniorage in prominence. As discussed earlier, Seigniorage is the profit generated by money Seigniorage is defined as, the profit earned by the Central Bank of a country from creation. In modern times, money creation is believed to be primarily from the process of money creation and supply. It is an unconventional method of commercial banks. generating revenue for Governments. Seigniorage can be earned through 2 A commercial bank accepts deposits and uses the money deposited to lend further routes: Issuance of Currency and on Bank Reserves. (Credit Multiplier Effect). The bank charges higher interest on loans and advances as opposed to the interest paid on deposits. This difference earns the bank a 1. Seigniorage through the Issuance of Currency premium referred to as Net Interest Margin. As the name suggests, it is earned from the issuance of currency notes and is The Seigniorage on currency is generated through the need of currency for calculated as the notes in circulation (less the cost of printing and distributing exchange and transaction (Liquidity). Similarly, deposits with banks provide them) multiplied by the market interest rate, which is the potential rate of return liquidity to depositor. The higher the liquidity offered, the lower is the interest on central bank assets. earned on it. Banks use these deposits to lend further and earn a higher interest. Nine Decades of Excellence in Broking and Investment Banking

This cycle entails continuous circulation of money, thus generating profits for started to drop as a percentage of GDP – as lower the interest rates, lower the commercial banks in the process. Given these profits are generated through seigniorage. Similarly, if the composition of assets is skewed towards securities of money supply and creation, it is termed as Seigniorage by commercial banks. higher interest rate, the seigniorage income would be higher. This effect was observed in the years the RBI held more government bonds on its balance sheet. History of Seigniorage Post the financial crisis, the CRR requirements for banks were as high as 9%. This The word Seigniorage is derived from old French and literally means “right of the resulted into massive cash deposits with RBI and hence, higher seigniorage lord to mint money”. The term was introduced at the time when money was income as well. represented by coins which were backed by a physical commodity such as gold or silver. The value of the coin matched the value of the gold/silver it was made of. Conclusion The Royalty would authorize the mints to collect a small fee over and above the Seigniorage will remain a major source of income for central banks globally, even value of coin from their customers, typically bullions. As the global monetary if the dynamics change as central banks continue to explore and implement system developed, so did the nature of currencies. unusual monetary policies to respond to economic situations. The concept of Until the Bretton Woods System, the currencies at the time were directly or digital currencies may also play a role in the seigniorage income of central banks. indirectly backed by gold. With the collapse of the Bretton Woods Agreement, a The income earned by central banks is transferred to the government post new type of currency, referred to as ‘Fiat Money’, rose to prominence. Fiat money provisioning. Thus, the government also has an incentive in taking measures to is backed by a sovereign guarantee and not a physical commodity. The trust on increase seigniorage. However, increased global trade and foreign capital flows the value of Fiat money is derived solely from the trust on the government guarantee. In the case of India, the erstwhile framework adopted by the RBI required the maintenance of gold reserves worth at least 40% of the currency in circulation. The currency in circulation was limited and thus the seigniorage generated was also limited. In 1957, RBI moved to Minimum Reserve framework. This framework stipulated that the Central Bank maintain only a certain level of reserves in the form of gold to back the currency in circulation. The aim was to increase the currency in circulation, keeping in mind the expected economic growth without any obligation to commensurately increase reserves. This framework thus led to an increase in seigniorage generated.

Factors Affecting Seigniorage There are multiple factors that affect seigniorage including global and domestic interest rates, mix of assets in Central bank’s balance sheet, notes in circulation, impose constraints on monetary policies and hence affect seigniorage as well. Cash Reserve ratio requirements and mix of currency denomination among others. Figure 1: Trends in Seigniorage (Source: RBI)

Lower interest rates, reduce the income generated over the monetary base. This was the case after the 2008 crisis when seigniorage income of many central banks Nine Decades of Excellence in Broking and Investment Banking

Disclaimer: This report has been issued by Darashaw and Company Private Limited (CIN- U67120MH1994PTC076656) registered with Securities and Exchange Board of India (“SEBI”) as a Stock broker, Merchant banker, Portfolio manager, Research analyst. The information herein has been obtained from various sources and is meant only for general reading purposes. Darashaw does not guarantee its veracity, accuracy or completeness. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. This research report is not prepared for any particular recipient. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investor may seek financial and other advice before relying on the data set out in this report. It is possible that any possible inferred change in position of such securities may not happen. Investor should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Past performance is not necessarily a guide for future prospect and performance.

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