The Hindu Business Line : Managing forex reserves — Asian Bond Fund as a safety mechanism

With India's forex reserves crossing the $100-billion mark, there are bound to be several suggestions on how best to manage them, including the setting up of an Asian Bond Fund. Jayanthi Iyengar says that such a Fund will help create an altern ative safety mechanism when the existing institutional framework fails.

NOW that India's foreign exchange reserves have crossed the $100 billion mark and the celebrations connected with the achievement have abated slightly, the ensuring months are bound to see a debate on how the Reserve Bank of India (RBI) should manage its burgeoning reserve.

Some of the suggestions, which are bound to be made, include the setting of an Asian Bond Fund (ABF) and bilateral swaps. A small beginning has already been made on the former with the Bank of International Settlements and some Asian central banks announcing a $1 billion ABF in June.

Bilateral swaps too have been discussed from time to time, and involve countries entering into a one-to-one arrangement to bail out each other in case of a financial crisis.

Both these concepts owe their genesis to the South-East Asian meltdown. Both these approaches factor in the inability of the IMF and other Bretton Woods institutions to bail out countries caught in a financial crisis and their ineffectiveness in containing the contagion effect of a South-East Asian-like crisis.

Both approaches consider the creation of an alternative safety mechanism when the existing institutional framework fails. Underlying both these approaches is the basic assumption that Asian countries — Japan with some $650 billion, China with about $410 billion and Taiwan with $200 billion — sit on far too large reserves.

Yet, the ABF approach differs to the extent that while bilateral swaps limits its prescription to creating a backstop facility for containing the impact of a financial crisis, the ABF extends the debate to how the funds released by creating a safety net should be utilised. Proponents of the ABF believe that foreign exchange reserves of a nation should be better invested, earning the respective governments higher rate of returns than the 2 per cent returns offered by US treasury, where the bulk of these reserves now lie invested.

They also argue that being Asian reserves, they should be invested in Asia for the development of the region instead of being offered to the developed countries to fund their fiscal deficits and their development programmes.

An important component of the ABF concept is that central banks would contribute to the fund which, in turn, would invest in a basket of available instruments including sovereign, quasi-sovereign and private sector bonds. This would diversify the fund's risk. It would also make available fund to Asian governments, institutions, the public and private sector for their development.

So far so good, but the problem is that the whole concept is built on the premise that in case a contributing central bank needs funds, it would be able to exit from the fund with its investments safe.

While this is feasible when one bank is in trouble, it would be untenable when all the contributing central banks are caught in a financial crisis, similar to the one seen in South-East Asia. It is unlikely that residents would be able to pick up the bonds offloaded by their crisis ridden central banks or that foreign capital, which is shy in a financial crisis, would step in the first place to bail out flailing central banks halfway across the world.

This is possibly why the corpus of the ABF still remains small in spite of the growing foreign currency reserves of the Asian countries. However, based on the ABF principle, it may be worth the RBI's while to consider another option.

The ABF endorse the concept of the foreign exchange reserves of Asia being used for the development of the region, including for private enterprise, which are now seen as growth engines.

Based on this principle, the RBI could consider opening a limited ECB window from its reserves.

This window could be opened up only when the RBI is forced to clamp down on ECB as part of its exchange rate management to ease the pressure off the rupee.

Besides, the credit available from this window could also be capped at a predetermined level, say either $5 billion, or five per cent of the reserves.

This approach has many advantages. It would make available dollar funds to corporates at all times, regardless of the monetary policy concerns of the government and the RBI. Besides, this window would be available only to quality entities, since the ability to raise ECB lies only with sound corporates with a strong balance-sheet.

Making available credit from the reserve only when the commercial window has been closed will ensure that this policy does not interfere in anyway with the functioning of the lenders.

That should save the government from the wrath of global bankers, loan syndicates and their consultants, who would undoubtedly bridle with self-righteous anger if the ECB window is closed to them at all times.

Opening up dollar credits to corporates from the reserve will ensure that it does not stifle growth of the corporate sector, dampen spirits when there is a revival, as is happening now, and also serve the larger goals of liberalisation, globalisation and free markets, apart from serving the mandates of a central bank.

Such a bank would tend to be committed to a three-fold goal on the foreign reserve, exchange rate and foreign debt management front.

It would have to manage the currency value till it is freely floating. It will have to manage the reserve and also make available foreign currency for all legitimate purposes.

The last is currently not being served by the RBI, though it sits on the largest-ever stockpile of foreign currency reserves accumulated by the country.

(The author, a freelance writer, can be contacted at jayanthiiyengar1@yahoo.com

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