The Hindu Business Line : The multibillion-dollar questions

Citing the recent thinking, both in China and India, on the best way to manage forex assets, and suggesting the adoption of a Singapore-like model to manage investments, S. VENKITARAMANAN argues that the RBI's reserves can indeed be put to better use helping India's infrastructure grow faster than in financing the infrastructure of G-7 countries by investing in their Treasury assets.

China's Prime Minister, Mr Wen Jiabao, recently set the world's financial markets aflutter by reviewing the way in which the People's Bank of China, China's central bank, manages its reserves. China today has reserves in excess of $1 trillion, which are continually rising and may, within a few years, double. Today, China invests most of the reserves in low-yielding securities of the US Treasury and the like. Mr Wen has, in this latest review, questioned whether this is the best way for China to manage its forex assets. He had also reflected earlier on whether and how these reserves can be better used for improving the conditions in China's countryside — in particular, its education and health facilities. The latest discussions focussed on improving returns from reserve management — of course, such reserves as are left after acquiring strategic raw material resources abroad as well as foreign technology companies.

China's foreign currency reserves are currently managed by an entity that is part of its central bank. It is called State Administration of Foreign Exchange (SAFE). SAFE has been reluctant to disclose the currency composition of its reserve deployment. But it is believed that it is mostly in dollar-denominated Treasury Securities of the US and other G-7 countries.

China's clear intent

The Financial Times of January 22, 2007, reports that the Chinese Premier's suggested policy-switch opens the way to establish an agency akin to Singapore's Government Investment Corporation (GIC), to handle a portion of its massive reserves. This will necessarily mean diversifying out of investment in fixed income bonds and moving into stocks.

The Financial Times notes that the Premier's statement did not specify any particular change. It was cautiously worded. Commentators are quoted as having said that China will definitely proceed to diversify its management of foreign currency assets. However, setting up an agency similar to Singapore's Government Investment Corporation appears to be some time in the future. Many bureaucratic problems are yet to be solved. But the direction is clear and has been set. Mr Wen's discussions and decisions to nudge the central bankers to a more active management of reserves cannot have come at a more appropriate time. For one, the US currency is depreciating, especially with reference to such peers as the Euro, and the value of China's investments in US dollar-denominated assets will be exposed to an erosion as the greenback depreciates. For another, the returns will also decline in real terms. Hence, it is appropriate for China to consider new avenues to invest its forex reserves.

Dr Reddy's plan

It is significant that the RBI Governor, Dr Y.V. Reddy too had devoted an important speech he delivered in New York last year to this question. He had stressed that he was open to the idea of alternative methods of deployment. Attention was drawn to this speech in articles in Business Line dated July 24, 2006 and November 6, 2006.

The first article cited the statement of the venerable Chairman of Singapore's Government Investment Corporation, Mr Lee Kwan Yew, who had pointed out that since its inception, the Corporation had earned a return of 9.5 per cent, in US dollar terms, over the last 25 years.

This compares with the annual return of 3.1 per cent on our reserves, which the RBI's management was able to achieve. It was pointed out that if India had successfully followed Singapore's example, it could have earned an extra six percentage points on is reserves of over $170 billion dollar. This would amount to at least $10 billion equivalent income per year. In rupee terms, the RBI could have contributed Rs 45,000 crore a year to the Government coffers. Not a sum to be sneezed at! It could have easily filled the infrastructure financing gap to a substantial extent, even if the corpus of the reserves were to remain unused — a subject referred to later.

Recapitalisation in China

The Financial Times story of January 22, 2007 discloses yet another aspect of China's use of its forex reserves. China is using a few billion dollars of the reserves to recapitalise its China Renaissance Group before it lists in the market place.

The article also discloses that China used a hefty $40-50 billion of its reserves to capitalise its ailing banks. This is an idea that is worth pursuing in the Indian context, where the debate rages as to whether it is proper and feasible to use forex reserves for local financing.

The RBI could definitely invest a sizeable part of its reserves — say $10-20 billion — into the capital of the Government's newly-created infrastructure financing funds. This can help the institution leverage its borrowings.

The Government can very well guarantee returns on the investment if it ensures proper pricing policies for the output of the infrastructure projects, such as power, roads, water-supply, and so on — a policy reform that is anyway on the Government's agenda.

It appears that the Centre is tentatively pushing ahead with pursuing the approach discussed above and will be able to crack the problem of abundance of riches. The Government will guarantee the RBI a better return on its reserves by ensuring the return on its infrastructure investments, for which RBI will capitalise the infrastructure financing facility.

Incidentally, this will free the RBI from the charge that it is preferentially financing the infrastructure of richer G-7 countries through its low-cost investment in their Treasury assets. At the same time, it will help Indian infrastructure to grow at a faster pace.

Singapore model

China's Premier has doubtless other ideas up his sleeve for managing the country's abundant forex assets. I am sure the Prime Minister, Dr Manmohan Singh, cannot be far behind, with his own ideas and practical proposals for better utilisation of India's reserves for the greater good of the country and, incidentally, for a better balance sheet of the central bank.

It obviously makes more sense to invest the RBI's forex assets partly in India's infrastructure directly rather than lend it to international governments and agencies who will then send part of it back as FDI in India's infrastructure projects.

Critics can observe that the strategy of diversification of investment of central bank's reserves on Singapore's model requires an approach similar to that island-state's protocol of governance. It is obvious that the changes required to do this will carry a cost. They cannot be accomplished on a business-as-usual mode.

I had occasion to visit the offices of Temasek a few years ago. I was pleasantly surprised to see a number of non-resident Indian youngsters of the IIT and MBA type, gathered around a table. They were among the brains behind the innovative investment strategy that brought Singapore's GIC its excellent returns. There was also the support from world famous investment banker, Goldman Sachs, to which GIC had outsourced some of its investments.

It is definitely possible that India can also draw on a combination of local talents with its own technical personnel and also outsource firms abroad to manage its investments on a modified, Singapore-like pattern. There is tremendous advantage to be gained if India adopts the diversification mode that Mr Wen Jiabao seems to have signalled. We have been avid imitators of China in many respects.

Why not in the better use of our forex assets for better returns besides building better facilities in our own backyard?