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S. Balakrishnan

INDIA'S forex reserves hit a peak of $120 billion and have stayed more or less flat since - probably because of rising US interest rates, dollar-rupee forward premium and crude prices adding to the import bill.

Of course, our kitty is just a fraction of that of Japan and China and that of even small countries such as Singapore and Taiwan, which continue to rackup huge trade surpluses , come what may, in the global economy.

Although our reserves are small in relative terms, the problems in managing them are many.

For one, their continuous increase in the last few years was the cause of the embarrassingly large liquidity in the financial system. The RBI did not want excessive rupee appreciation and, to stop it, was always in the market buying dollars.

Secondly, sharply falling American interest rates meant that the reserves were far from earning their keep. In fact, the cost of servicing our forex debt is surely a few percentage points more than the return on forex assets. Unlike Japan and China, our reserves are matched by liabilities - the `equity' component (if one could call it that) of the country's forex balance sheet is negligible or negative.

This is similar to the Germans who saw hyperinflation after World War I and whose Bundesbank and ECB successor preferred to sacrifice growth at the altar of inflation control. We cannot forget the four decades after Independence when we were almost always badly in need of foreign exchange. This culminated in the 1991 crisis.

Never again, must have vowed our policymakers. But from those depths, we have today reached the comfortable situation where we can frighten off speculators against the rupee rather than be frightened of them. In fact, they would not even try, seeing our ammo.

Still the Government seems to be uncomfortable with the cost of maintaining such large reserves, earning possibly only 2%-3%, when there are far better investment opportunities in the real economy.

Infrastructure, for one, is crying out for funds. Hence, the latest thinking that up to $10 billion can be used to fund new projects.

The Government is keen that the exercise should not generate more liquidity and fuel inflationary pressures. It is already sufficiently worried about the latter and has taken steps to curb monetary expansion with a hike in the cash reserve ratio of banks.

On the fiscal front, duties on sensitive items have been reduced.

The plan is to finance the entire incremental investment with a drawdown of reserves. New investments need goods and labour services. Does the Government's line of thinking mean that it will import all that is necessary - steel, cement and machinery? Obviously you cannot import services such as transport nor labour. Nor can you pay them dollars. So, the new expenditure cannot be entirely rupee-neutral.

Even with regard to the physicals, it will not make sense to import if there is idle capacity at home, unless domestic prices are higher, which seems unlikely, say, in the case of steel, as we ourselves have become competitive players in the world market. Again, to import, say, cement is unattractive - given the transport costs and port logistics.

Where does this leave us? Forex reserves have to be viewed as a cushion which will enable us to achieve a higher level of investment than otherwise, because we can import commodities, machinery and consumption goods as and when needed if there is no domestic capacity or it is short or expensive.

They can also be very effective inflation-fighters and in controlling inflationary expectations, the Government can simply `import' away shortages that threaten prices.

On the other hand, an entirely forex-funded and outsourced investment programme, merely to use the bulging reserves, will not give the economy or the Indian industry the boost required to reach a higher growth plateau, which, after all, is the Government's primary objective in chalking out the plan.

Earning more on reserves is a matter of making the right calls on interest rates, exchange rates and asset allocation.

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