The Hindu Business Line : Foreign exchange reserves — Is the glass half full or half empty?

With India's forex reserves inching towards the $200-billion mark, there is the view that the cornucopia should be used more effectively, in creating infrastructure. Rather than do that, the Government ought to revamp the regulatory framework and allow investors to realise the true potential of the infrastructure sector, says ASHOAK UPADHYAY.

For the first time in its history, India came perilously close to defaulting on its international payments in 1991 when the foreign exchange reserves plummeted to a billion dollars. Fifteen years later, India's forex reserves are inching towards the $200-billion mark, prompting the view that such a cornucopia should be used more effectively than by simply earning the Reserve Bank of India and the country interest income of 3-4 per cent from deposits and securities of central banks around the world where a large part of the reserves have been parked.

Sometime in 2004 the Planning Commission Deputy Chairman, Mr Montek Singh Ahluwalia, floated the idea that a part of the forex reserves, then at $120 billion could be used to fund the critical infrastructure sector. In his 2005 Budget, the Finance Minister, Mr P. Chidambaram, picked up the suggestion, conferring upon it a kind of formal acceptance as a policy initiative. Nothing came of it even as the reserves mounted steadily but the idea gathered momentum with a senior World Bank official airing it publicly.

In the latest Budget, the Finance Minister once again referred to it; a committee chaired by Mr Deepak Parekh of HDFC on infrastructure funding has suggested using a small part of the reserves "without the risk of monetary expansion," a fear already anticipated by Mr Ahluwalia in a more refined version of his initial suggestion nearly three years ago.

New Prescriptions

The Parekh Committee, according to Mr Chidambaram, had recommended the setting up of two wholly-owned subsidiaries of the special purpose vehicle for infrastructure — the India Infrastructure Finance Corporation Limited (IIFCL), itself a brainchild of Mr Chidambaram — with the objective of borrowing from the RBI and lending to Indian companies engaged in infrastructure projects. Alternatively, to co-finance their External Commercial Borrowings solely for capital expenditure outside India and to place funds borrowed from the RBI in "highly rated collateral securities".

The subsidiary would also provide "credit wrap" insurance to infrastructure projects in India for raising resources in global markets. The RBI, according to the Minister, was being asked to study the legal and regulatory implications of using the reserves in such a manner.

Sources of forex reserves

The notion that the country's reserves can be used for development underlines a belief that they are more than adequate to account for the perceived risks of default that almost brought the country to its knees 15 years ago. It also reflects a confidence that at $190 billion, the reserves have only one way to go — up. The trend since 1991, when the reserves stood at $5.8 billion, lends credence to this view.

Ever since the economy began to open up, the increase in forex reserves has largely been on account of capital and other inflows. In April-September 2006, foreign investments, ECBs and banking capital, which includes remittances and NRI deposits, contributed significantly to the kitty. Of the two components of foreign investments, direct and portfolio, India has by far been the recipient more of portfolio than direct investment.

This is a trend that is evident all through the reform period. RBI data show that from a low $129 million in 1991-92, FDI steadily but modestly increased to $5 billion in the first half of fiscal 2006. On the other hand, FII flows, that began in 1993 rose cumulatively from $829 million at end December of that year to $47 billion at the end of September 2006. Outstanding NRI deposits rose from $13.7 billion in 1991 to $37 billion at the end of September 2006. Similar growth trends are evident for remittances over the same period.

The data above suggest an accretion to forex reserves through inflows that have magnified and diversified India's external liabilities even as they bear testimony to the country's financial integration into global capital markets. The increased benefits also carry newer and more complex risks. Barring FDI, much of the inflows that has added to the reserves depend on monetary policies in developed economies; a hardening of interest rates, especially in the US or Japan, could reverse the flow or at any rate reduce it.

Patchy Record

The vulnerability to short-term interests of certain capital inflows can be offset by more durable FDI inflows and by a surplus current account. India's FDI intake is still far below FII inflows. Equally, its current account has had a patchy and, of late, negative record despite the impressive merchandise exports and net invisibles earnings over the years.

Starting with a deficit in 1991 (3.1 per cent of GDP), India's current account turned surplus (0.7 per cent) by 2002-03; the following year witnessed a surplus of $14 billion on the back of impressive earnings mainly from software and other invisibles but nose-dived into a deficit the following year of $2.5 billion because of rising oil prices. Since 2004-05, the current account deficit has deepened ($11 billion in end September 2006) mainly on account of escalating import demand.

The feeble FDI inflows and a deepening current account deficit coupled with the profile of capital inflows widen the risk profile of a country to external shocks. In turn they alter the perception of adequacy of reserves to meet those external shocks. In 1991, India's main headache was meeting import commitments with a paltry $1 billion; today trade cover is only part of the problem and India appears well placed with ten months import cover

But the East Asian crisis of 1997 that dragged for months threw up the need for different indicators to measure comfort levels of liquidity for an emerging market such as India confronted with diverse payment obligations. "Liquidity at Risk" is one indicator that gauges a country's liquidity for a range of possible results from fluctuating financial variables such as commodity prices, exchange rates and credit spreads.

As the reserves have grown, the country has been able to prepay certain high-cost foreign currency loans taken by the government from multilateral institutions. But, equally, the current level of reserves allows the RBI to relax exchange restrictions for business and individuals; the recent phenomenon of Indian companies investing globally has been made possible by the confidence created by a growing forex reserves position.

According to RBI data on India's International Investment Position (IIP), direct investments abroad by Indians amounted to $12 billion as of end March 2006, which is more than double the FDI that came in. In this sense, the forex reserves are being used to build assets abroad but the IIP position is in the negative because the liabilities outstrip the assets by about $46 billion.

The view that a part of the reserves should be used for infrastructure is unique to India. Singapore has its own pioneering model of investing reserves in world equity markets alongside safe securities in order to earn higher returns, a system now followed by Korea. China with its trillion dollars (end December 2006) used its dollar earnings to recapitalise its banks; alongside it has used its reserves to create markets and buy oil in Africa.

Easy loans, buyers' credit, private investments not in the developed nations so much — China has only 20 per cent of its entire Africa investments in South Africa — but in the poorest nations from Cameroon to sub-Saharan Africa and the Congo, China is using its vast reserves to fund a sustained growth over the long term.

Infrastructure funding

In contrast, India would like to invest its reserves, which by many adequacy ratios, barring import cover, are still not impressive, in a sector that is notorious for its lack of transparency, archaic labour laws and a history of negative returns. The first task for New Delhi ought to be to revamp the regulatory framework and push investors into realising its true potential in terms of high returns. Most governments create enabling environment and leave the rest to private investors. That is how the reforms in the financial and industrial sectors worked in raising the level of investments and exploiting the growth potential. That is a lesson some policymakers in New Delhi seem to have forgotten pretty quick.

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