The Hindu Business Line : Forex reserves: Rethinking volatility in capital flows

The popular view that the country’s swelling reserves justify riskier returns or a Sovereign Wealth Fund may be in for some severe knocking, says ASHOAK UPADHYAY.

The Reserve Bank’s policy statement for the new fiscal is not simply an inflation fighting exercise. Despite the rhetoric of price stability and inflation-anchoring, the RBI used just one weapon in its arsenal to thrust at inflation and that was the CRR hike.

Repo rates were left unchanged, so was the benchmark prime lending rate. Contrary to popular expectations, the RBI did not throw its weight into the war on prices, adjusting its aim prudently at the secondary conditions; excess liquidity.

By now, it is evident that supply shortages have fuelled inflation and the RBI can do little with the weapons at its disposal.

The initiative has to come from fiscal policy and a bit late in the day, New Delhi has woken up to measures that could have nipped the rise in its initial stages had the government acted at least a year ago when the first signs of an upward spiral became evident.

Not just a joust with prices

The RBI’s Credit Policy for 2008-09 is remarkable for more than its modest jousts with inflation. It uses the occasion to further liberalise foreign exchange use by individuals by raising the ceiling on outward direct investments by firms in the natural resource sector such as oil, gas and coal.

Though it has not specified the new limits that will exceed the current ceiling at 400 per cent of net worth, the RBI’s extended use of forex appears an indirect response to critics who have doubted the efficacy of its current forex reserves management.

Two years ago, Mr Lawrence Summers apparently suggested the central bank let the multilateral institutions deploy some of the growing reserves into high return sectors. Sensibly, Mint Street ignored the advice.

Traditionally, the RBI parks its surplus foreign currency assets in securities of other central banks or US government bonds earning modest interest.

Inefficient or just necessary?

Ever since reserves crossed the $150-billion mark, some analysts have expressed the view that the holding cost of burgeoning reserves warranted a more optimal return on investments and that India could learn a trick or two from China and Singapore that use their surplus reserves to buy overseas assets or invest in more profitable investments than central bank securities.

The idea of the Sovereign Wealth Fund carved out of a country’s surplus forex reserves, has now washed ashore to Indian shores with the Prime Minster’s Council on Trade and Industry suggesting a modest fund of $5 billion to underwrite overseas acquisitions.

The council’s recommendation hit the media just a few days after the RBI Governor’s views on such funds in Washington.

Dr Reddy lent reluctant support to the concept of an Indian SWF or “government-owned investment vehicle” suggesting a separate sovereign entity handle such affairs by buying the forex from the RBI. That was a neat way of washing the central bank’s hands off such new fangled idea. After all, the RBI Act prescribes the management of the reserves in a manner “consistent with global best practices” as Dr Reddy archly put it.

But that was not the last word on the subject for Dr Reddy had some basic reservations about the plausibility of such a fund for India.

Why it won’t work

A sovereign fund presupposes a large volume of reserves and of a size that can meet external debt obligations of a contingent nature. While central bankers have some idea of how to measure the adequacy of reserves for trade — 12 months import cover — and debt obligations by some rule of thumb yardstick based on historical data and can list some of the well-known contingencies, they tend to get very nervous if the country’s balance of payment shows up a persistent current account deficit.

How is one to determine just how adequate reserves ought to be much less the ‘excess’ for a higher return from riskier assets when the current account is in the red?

So the status of the current account determines just how adventurous a country can get with its rising forex reserves. SWFs or, from China, Singapore, Abu Dhabi, South Korea prowling Wall Street have funds that range from Singapore’s GIC with $300 billion (roughly the size of India’s total forex reserves) to Abu Dhabi Investment Authority’s $900 billion,

These SWFs were leveraged upon the huge current account surpluses based on export revenues as in the case of China for instance, or gains from oil or gas as in Abu Dhabi.

In its own way, the RBI has put a part of the reserves to profitable use. By liberalising the limits on individual use of foreign currency to the RBI leaves the initiative for global acquisitions to individuals rather than a “government owned investment vehicle” like a SWF.

That way the RBI allows the more profitable deployment of reserves in a discrete and regulated fashion, spreading the risks across a wider spectrum of users than would have been the case with investments by one single SWF owned by the government.

Yet the central question the governor posed in Washington remains. It is difficult to measure just how much of the reserves need to be kept aside for contingencies given the current account deficit and equally because of the ‘liquidity risks’ associated with different types of flows.

Net capital inflows rose by $81 billion between April and December 2007 compared with $30 billion the previous year.

Of the 172 per cent increase, portfolio investments accounted for $33 billion while direct investment inched a modest billion to $8.4 billion. External Commercial Borrowings too increased. But there was a net outflow of NRI deposits on account of reduction in interest rates. In sum, $67 billion were added to foreign exchange reserves in the six months to December 2007 against just $16 billion in the previous year.

The overriding presence of portfolio investments in the reserves and the fluctuations in NRI deposits with interest rate changes shape conceptions of reserves adequacy. Just how dependable a country’s reserves are will determine just how much of those reserves can be used for investments in more risky returns.

Writing in The Economic and Political Weekly of April 11, Nirmal Kumar Chandra, formerly with the Indian Institute of Management Calcutta, questions the RBI’s computation of volatile capital that, officially, are pegged at around 38 per cent of the official reserves.

Rethinking Volatility

NRI deposits, for instance, of more than a year are not considered volatile and do not figure as short-term debt by the RBI. But they are notoriously unstable as the data for the six months to December 2007 attest with reductions in interest rates inducing outflows. So Mr Chandra feels NRI deposits must be counted among the more unstable kinds of flows.

Portfolio investments are counted as volatile. But Mr Chandra feels the RBI “grossly underestimates” them because of the use of the accounting or historical data of net purchase “purchase minus sale”

The method does not potray a true picture of the liabilities given the constant, usually upward, movement of stock prices over the last so many years. In the event, Mr Chandra finds it more meaningful to consider market capitalisation of FII holdings as a better indicator of our external liabilities. .

With the help of data on daily market cap of all the companies listed on the BSE (over 4,900) and the FII share in each company, Mr Chandra compares the market value of FII investments and the RBI reserves over the last eight years and finds startling results.

Till 2004, reserves are in excess, then the gap narrows till end-2006 and, a year later, the market value of FII investments exceeds reserves. The RBI data show portfolio investments in 2006 to be $76 billion; Mr Chandra’s calculations show them to be around $127 billion, a difference of 73 per cent.

Add the NRI deposits to the FII holdings and the volatile capital in the official reserves is not 38 per cent as the RBI reckons but a staggering 93 per cent.

A surfeit or deficit?

Mr Chandra’s calculations have severe policy implications for the pace of the movement toward convertibility but, most crucially, for the country’s capacity to service even the debt obligations of which the RBI never tires of reminding those who want it to earn higher returns on its investments.

More than any other defence the RBI can find to justify its reluctance for a SWF, none is more effective than a re-look at what is really volatile in our swelling reserves.

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