The Hindu Business Line : Autonomy goes with accountablilty

The Government’s decision to subscribe to bonds issued by the overseas arm of India Infrastructure Finance Company and its plan to commit funds from short-term, volatile forex flows for long-gestation infrastructure projects with uncertain rates of return have wide-ranging implications and raise several issues, says R. G. GADKARI.

The Government of India has reportedly advised the Reserve Bank of India (RBI) to subscribe to bonds issued by the overseas arm of India Infrastructure Finance Company Ltd (IIFCL) using $5 billion from the country’s foreign exchange reserves. This directive has wide-ranging implications and raises several issues.

Over the last few years, there has been a surge in capital flows into the country leading to swelling of foreign exchange reserves to over $225 billion. However, this is not purely a blessing.

Capital inflows lead to appreciation of domestic currency, thereby reducing the country’s export competitiveness and worsening trade deficit.

To prevent large-scale appreciation of the currency, the central bank intervenes in the market by buying foreign currency and releasing counterpart local currency. This leads to inflationary pressures in the economy, as the growth in money supply far exceeds the growth in the real economy.

To neutralise this inflationary impact, the central bank intervenes through sterilisation operations by selling securities in its portfolio and mopping up local currency. This process leads to upward pressure on domestic interest rates, thereby adversely affecting economic growth.

The country’s forex reserves are invested in overseas sovereign bonds that yield a much lower return than that on domestic bonds.

Further, this process creates distortion in the central bank’s balance sheet. Domestic assets in the form of government securities get substituted with lower-yielding foreign assets.

A reduction in the holding of domestic securities adversely affects the central bank’s stability to effectively intervene in the market through sterilisation operations.

Even though a central bank is not a ‘for profit’ organisation, the opportunity cost involved in terms of interest income foregone on domestic bonds being higher than the low return on foreign bonds cannot be ignored.

Managing forex reserves

For these reasons, it is imperative to revisit the issue of managing the country’s forex reserves. Various options have been tried with limited success.

These include issuing market stabilisation bonds to sterilise the inflows, and the use of the liquidity adjustment facility to absorb flows. In addition, forex swaps are used to postpone liquidity generated by inflows.

Another option suggested is impounding excess liquidity by paying interest on the deposits parked by banks over and above CRR requirements on a voluntary basis with the central bank.

Alternatively, the central bank can issue its own securities to mop up excess liquidity in the system.

This option will, however, require an amendment to the Reserve Bank of India Act. Moreover, it would result in upward pressure on interest rates with both the Government and the central bank competing for funds. The experience of central banks issuing their own securities suggests that such issuance results in losses for the central bank.

Infrastructure development

It is in this context that the Government has suggested the RBI’s subscription to the IIFCL bonds. Based on the recommendations of an expert group headed by Mr Deepak Parekh, it is proposed that a portion of the country’s forex reserves be invested in a special purpose vehicle (SPV) floated for this purpose.

The SPV, which will operate from an overseas international financial centre, will provide funds to finance equipment purchase and for investment by Indian infrastructure companies overseas. This process will not lead to creation of domestic liquidity and is thus supposed to be a solution to the problem of excess liquidity in the system generated by swelling forex reserves.

The use of forex reserves for infrastructure development by a country running current account deficit (CAD) raises certain issues.

There is a qualitative difference between the forex reserves of a country with current account surplus and those with CAD. In the former case, the reserves are ‘owned’ ones, while in the latter they are ‘borrowed’ reserves.

A simple example can be given to illustrate this concept. An individual can build balance in his bank account in two ways: by spending less than he earns or by borrowing money from his friends. The forex reserves of a country with CAD can be compared to the person building bank balance by borrowed funds. The CAD, in fact, represents the domestic savings-investment gap, which is filled by foreign savings coming in the form of portfolio investment and foreign direct investment.

Portfolio investment by FIIs in the Indian capital market has been a major contributor to the country’s forex reserves.

By their very nature, these flows are highly volatile and can go out of the country on account of any cause, not necessarily related to economic fundamentals, as the experience of the recent past has shown. Infrastructure projects, on the other hand, are long gestation projects with uncertain rates of return.

To commit the funds resulting from short-term, volatile capital flows for long gestation projects with uncertain rates of return would be to commit a cardinal sin in financing.

Reportedly, there is a proposal to guarantee the borrowing by IIFCL and the returns thereon by the government. This would only compound the sin.

Apart from the moral hazard issues involved in such a guarantee, it would also amount to deficit financing by the government by another name, and would mean bypassing the rigours imposed by the FRBM Act. All is certainly not well with India’s infrastructure development. But lack of finance is not a major cause for the sorry state of the country’s infrastructure.

There is no dearth of international lenders and investors willing to participate in infrastructure projects after carefully evaluating and pricing the risk involved. It is the lack of viable projects coupled with bureaucratic delays and issues relating to land acquisition that is holding back infrastructure development in the country.

Question of autonomy

More fundamentally, the Government’s ‘advice’ to the central bank to subscribe to the bonds raises the issue of central bank autonomy. Central bank autonomy implies freedom to pursue monetary policy to achieve the goal of macro-economic stability, independent of the government of the day.

Such fiats from the Government vitiate this autonomy and make the central bank subservient to the government in areas that are rightfully in its domain. The issue has been examined from a legal angle. But it is necessary to go beyond the narrow legalistic view.

Autonomy, however, does not mean lack of accountability. The people of the country have a right to demand that the country’s reserves be put to the best use and earn the highest risk-adjusted returns. An independent committee of experts to oversee the reserves management of the country will make the process transparent and improve the returns from the reserves.

(The author is General Manager in a public sector bank. The views are personal.)

More Stories on : Infrastructure | Insight

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Pipeline glitches

Economy: Growth drivers getting more broad-based

US economy in real trouble?

Autonomy goes with accountablilty

Signal decoders in the tax code

Asset ‘appreciation’

How ‘export of services’ is mired in tax complexity

Liability for TDS

Needless burden