The Hindu Business Line : Forex reserves can be better deployed

A small portion of the country's forex reserves is now assigned to external asset managers with the objective of improving returns. But the reserve can be put to better use, such as to finance major investment projects, prepay commercial debt and strengthen the capital base of banks.

There has been considerable euphoria among economists and bankers in India over the statement of Mr Lee Kuan Yew, Chairman of Singapore's Government Investment Corporation (GIC), that his organisation had earned an average annual return of 9.5 per cent in US dollars and 8.2 per cent in Singapore dollars since inception in 1981 through a judicious diversification of investments of the city-state's forex reserves. It was the first time that the GIC has publicly commented on its performance. Its reserves swelled to $128.9 billion in May to become the seventh largest in the world. The US, Europe and Japan account for 45 per cent, 25 per cent and 10 per cent, respectively, of the GIC's assets. The balance is in emerging economies.

According to Mr Tony Tan, Deputy Chairman, GIC, currently the Corporation invests half its assets in equities and between 20 per cent and 30 per cent in bonds. About 20 per cent is allocated to private equity, real-estate, commodities and other investments. It lets institutional investors manage 25 per cent of its funds.

Following Singapore, the central bank in South Korea set up the Korea Investment Corporation to manage its external assets. However, it retains the option to recall the assets in the event of an emergency, implying that the funds are effectively retained by it as international reserves though entrusted to the Corporation for management.

China is planning an International Reserves Centre in Shanghai to manage the country's gold holdings of 600 tonnes valued at $12 billion. It is reported to be aiming at augmenting its gold hoard through discreet and phased purchases using state agencies in the international markets so that its proportion to total reserves, now at 1.3 per cent, reaches 10-15 per cent as in developed countries.

Its forex reserves swelled to $925 billion in May, $300 billion of which is reported to be invested in US government securities. But China-watchers believe that the Centre may evolve eventually into something similar to the Singapore set-up.

Return optimisation?

Suggestions have been made that India's paltry return on investments of forex reserves (3.1 per cent in 2004-05) could be improved upon by adopting the Singapore model, diversifying its assets into private equities, etc., and allocating a part of the funds to other agencies for management. According to an article on the subject in the March 2004 issue of the Reserve Bank of India Bulletin, "while safety and liquidity constitute the twin objectives of reserve management in India, return optimisation becomes an embedded strategy within this framework". `Return optimisation' is doubtful. `Reasonable return` would be more appropriate.

As Adviser to the RBI Governor in the country's delegations to the meetings of the IMF and the World Bank, I used to attend meetings of international bankers and investment advisors in Washington D.C., where they canvassed for getting the country's reserves for management.

The idea was resisted for a long time. But, according to the RBI Annual Report, a small portion of the reserves is now assigned to external asset managers with the objective of gaining access to and deriving benefit from their market research, besides taking advantage of the their technology and providing training to the staff.

Funding investment projects

The fundamental question is about the utilisation of forex currency assets amounting to $157 billion, as on July 28, 2006. Why should the country think of the aforementioned ventures when there is a bigger adventure of building the nation with the resources? The country's GDP is a proxy for the return on domestic investments.

It is expected to be 8 per cent or above in the coming years in terms of domestic currency. It is more or less the same as what Singapore has achieved. It is a good enough return, comparable to any that we may get from investments abroad but devoid of so many risks.

Further, it will add to the productive capacity of the economy, laying the foundation for a bright future and providing plenty of employment opportunities, both to the skilled and the unskilled.

For long, the Government has bemoaned the lack of resources for the modernisation of the economy. And when we have them we can think only of the easy option of recycling the reserves to earn low returns in the Western markets. There are many sectors of the economy suffering from the obsolescence of plant and machinery. Their modernisation will require massive imports of sophisticated equipment for which we have the required resources now. Taiwan has set an example in this respect. It allotted $15 billion to banks for onlending to finance major investment projects that foster domestic growth. Of course, in this and the other suggestions below, some cut-off limit, say, $100 billion, may be set aside for debt service, forex market intervention, etc.

Prepayment of debt

An additional use to which the reserves can be put is the early prepayment of commercial debt carrying high interest. This will naturally exclude outstanding loans carrying no or low interest. The Government did make a beginning in this regard. During 2002-05 around $6.7 billion of high-cost loans were prepaid but it was not followed up in 2005-06. As of end-March 2006, commercial borrowings amounted to $25.56 billion or around one-fifth of the total external debt. The private sector loans could be prepaid and converted into domestic rupee debt with some financial reengineering. It is not necessary that all the eligible loans should be repaid at one go. It could be a phased operation so that there is no volatility in the market. The very fact of a low level of external debt resulting from such repayments will improve the credit rating of the country and facilitate fresh borrowings on favourable terms, in case of a need. In the meantime, the least that the country can do is to stop fresh external borrowing.

One does not understand the rationale behind the Government announcing from time to time loan sanctions from the Asian Development Bank (ADB) and other agencies for some project or the other.

After the ADB was established the country decided to forego any borrowing from it for long to avoid competing claims for funds vis-à-vis other less developed nations.

It was appreciated by the international community at a time when India itself suffered from a lack of foreign exchange. And now, when our pockets are full we are approaching the ADB for help.

Capital base of banks

An innovative way to use the reserves is to follow the Chinese example, that is, deploy them in strengthening the capital bases of banks. In January 2004, their central bank injected $45 billion from forex reserves into the Bank of China and the Construction Bank of China as capital.

Later it made a contribution of $15 billion to the Industrial and Commercial Bank of China. In contrast, a few years back New Delhi had issued bonds to recapitalise some of the nationalised banks in difficulty.

A study by the European Central Bank makes two important points. First, recapitalisation of state-owned banks was done not through the usual route of increasing the liabilities of the Government but by transferring assets. Second, the forex assets remained in the same currency on the books of the banks and were not converted into yen, thus avoiding any disturbance in the market.

Of course, the assets are subject to currency risks. But the measures helped the banks achieve the capital-to-assets ratio of 8 per cent, required under international standards. Further, the Government retained control over the management of the transferred assets through a newly-created investment company run jointly by the central bank, Ministry of Finance and the State Administration for Foreign Exchange.

Recently, the RBI allowed banks to augment their capital funds by issuing debt instruments abroad. It can consider the Chinese model, as it will be cost saving both at the initial and later stages.

(The author is a former Officer-in-Charge in the Department of Economic Analysis and Policy of the RBI.)