Surging Forex Reserves: SWF or Investment in Domestic Infrastructure?

With the advent of financial globalization, an argument—to be precise, a syllogism—has taken strong roots: developing nations need foreign capital to grow; but such inflows can also result in unintended consequences that can prove to be costly if the developing countries do not pursue prudent macroeconomic policies and appropriate regulations; and, therefore, developing countries must be careful in managing the inflow of foreign capital.

This is palpable even in the context of managing our surging foreign exchange reserves, which have, in the recent past, touched a figure of $316 bn. As the forex reserves are mounting up, the concern for the losses—arising by virtue of the Reserve Bank of India investing the dollars mopped up by it against the sale of government securities and investing them in the US treasury bills that give lesser return vis-à-vis the government securities back home—suffered by the RBI in managing the reserves has attracted the attention of many.

If the current growth of $100 bn per annum under forex reserves is a reliable indicator of the future accretions, this problem is all set to get further exacerbated. Indeed, this has already prompted many to suggest that India should set up a Sovereign Wealth Fund (SWF)—a state-owned fund that acquires stocks, bonds, property and other financial instruments for better returns in the global financial markets. Looking at the kind of losses that the RBI has been suffering from the management of forex reserves for the last five to six years and the kind of returns that the SWFs floated by countries such as Abu Dhabi, China and Singapore are generating by investing trillions of dollars in different kinds of assets in the US and other developed and developing world markets, a strong debate has been set off from within the country for creation of a similar fund by the RBI.

Reacting to the debate on creation of SWFs by India, the RBI Governor has strongly asserted that “Given the limitations based on the Central Bank by its mandate, it can be held that it will be appropriate to bestow this responsibility on a different Sovereign entity. If and when the country considers setting up of an SWF for the purpose, one of the methodologies could be to fund the SWF by purchasing foreign exchange from the Central Bank, to the extent required.”

That aside, the RBI Governor has made two other interesting observations over the issue, which merit consideration by all: One, although one can make a case for setting up of an Indian SWF, whether it is possible to ignore the difficulties associated with the assessment of ‘reserve adequacy’ in a dynamic setting and, based on it, divert a part of ‘excess reserves’ to the proposed SWF for earning higher returns by investing in riskier assets; and two, India being a country suffering from both current account deficit and fiscal deficit, coupled with no known dominant exportable natural output like crude oil by the Gulf countries, which promises significant revenue on a long-term basis, shouldn’t we evaluate the idea of floating an SWF with caution? This phenomenon gets further accentuated if we factor in the other reality—the fact of our having a negative international investment position—liabilities far exceeding the assets.

Reflecting on the proposal for the creation of an SWF by India, one wonders: Is India suffering from inadequate investment demand that compels the State to look for investment avenues elsewhere? On the contrary, the truth is that India, according to the Union Minister of Finance, P Chidambaram—as he put it at an interactive session with Arni Mathiesen, Minister of Finance, Iceland, organized by the Confederation of Indian Industry (CII), on November 23, 2007—needs an investment of $475 bn in infrastructure alone in the next five years to support the anticipated 9% growth.

This obviously raises the question: Why not invest excess reserves in the creation of infrastructure within the country instead of creating an SWF for investing the reserves in the global financial markets for earning higher returns.  It is needless to argue here that it is only by creating the required infrastructure in the country that we can build scope for generating an assured and continuous stream of revenue through exports in which we enjoy a known and accepted advantage—such as IT, ITES and other knowledge-related services—that can alter the current account balance significantly over a period of time. Despite these known probabilities, we have been all along dilly-dallying with the idea of using the mounting forex reserves for infrastructure development under the fear that we have no known and dependable method of assessing the ‘adequacy’ of reserves and the fear of capital fleeing the country; for, a big chunk of our current reserves are  either of debt nature or stock market investments of FIIs which are particularly known for leaving a country, lock stock and barrel, at the  slightest provocation.

For one thing, floating an SWF may appear as a better choice for managing forex reserves: theoretically, assets under SWF can be liquidated much faster to beat the balance of payment crisis, if any, though the current experience under the subprime crisis speaks differently. This makes one wonder: Would it not be more appropriate to use the forex reserves for domestic investment? After all, it is a known fact that wealth is never created without taking a risk, and hence, we must get emboldened to use the reserves for creating the much-needed infrastructure in the country. Investment of forex reserves in infrastructure is, no doubt, exposed to the same risks that the RBI governor has articulated, but it is at least better-suited to aid the economy grow than an SWF, that too, on a sustainable basis.

(May, 2008)