The Hindu Business Line : RBI's Annual Report 2003-2004 — At what price protection from forex reserves?

There have been suggestions that some part of the RBI's forex reserves should be placed with Indian scheduled banks, which can lend them to creditworthy Indian corporates, which are otherwise raising ECBs in the external financial markets. This can earn higher returns, which can surely help to reduce the negative income phenomenon on our forex reserves.

IN MAY 2004, we had the semi-annual monetary and credit policy statement from RBI. In July 2004, we had the Economic Survey by experts of the Government, preceding the Budget. Now, we have the same ground covered exhaustively by experts of the RBI in its annual report for 2003-04.

Soon, we will have the October policy statement of the RBI. A feast of frequent analyses of the same facts may well produce an audience fatigue. There has to be a better way of using our scarce reserves of intellectual excellence in the sphere of economic analysis. We should perhaps go by the US precedent, where the Chairman of Federal Reserve gives an annual, and sometimes semi-annual, report to the Congress on the economic environment.

Familiarity and greater frequency of similar surveys does induce indifference, even to wise counsel, however efficiently rendered. It seems necessary to review the content and frequency of economic surveys by different agencies.

Leaving aside this general caveat, one has to grant that the latest annual report of RBI is an excellent piece of work — as much a tribute to the credible performance of the economy as to the deft management of the same by the central bank and the Ministry of Finance.

The report does a professional job of surveying the macro-economic developments of 2003-04, besides essaying a prognosis of what lies ahead. It takes note of the improvement in fiscal performance of the Government for the year. It also notes with legitimate satisfaction the improvement on the external front.

The annual report does note the rise in inflation in recent months, due mainly to the transmission of global pressures on crude oil prices, as well as commodities, like steel. The annual report is, however, reticent about what policy stance the return of inflation demands.

The report tries to play down the impact of inflation, which is essentially in respect of wholesale prices pointing out that the consumer price index (CPI) has not risen too sharply. The reason for the difference is that the weight of certain commodities, like steel, in the CPI, is lower than in WPI. But experience does show that while there is a difference between WPI and CPI, CPI measures do follow WPI with a lag.

The report tries to make the case that the wedge is more permanent, in that there is greater pressure on producers to delay the transmission of their costs to the retail level, thanks to greater global competitiveness. Whether this is true in a protected market, like India, which has rigidities, particularly in its retail structure, is still uncertain.

The report guardedly states: "Evolving global inflation and monetary policy responses elsewhere form an integral part of monitoring inflation conditions by the RBI. With increasing globalisation of the Indian economy, the pass-through of international prices to domestic inflation is becoming increasingly evident.

Accordingly, commodity price movements as well as the demand-supply situation in key commodities are constantly monitored to gauge their impact on the domestic inflation process." A cautious note administering warning!

The annual report also notes that: "Food stocks and foreign exchange reserves should provide a cushion against any pressures on food prices". This is not a policy prescription. Whether RBI will unleash its monetary weapons to manage inflationary trends remains still uncertain. Perhaps, we should wait till October when RBI's next monetary policy is due!

A legitimate purpose of the annual report conveys the health of the balance sheet of the Bank itself as much as it does about the balance sheet of the economy. The accounts of RBI for the year 2003-04 yield important nuggets of information on the state of health of RBI itself.

Reflecting the global and domestic lower interest regime, the gross income of RBI, which is primarily contributed by interest earned on its foreign exchange assets invested abroad as well as on its lending to Government of India, showed a sharp decline from Rs 23,185 crore in 2002-03 to Rs 14,323 crore in 2003-04. This is in spite of the forex assets in the reserves going up in the year.

The RBI's earnings net of depreciation on foreign currency assets during 2002-03 came to 3.1 per cent. During 2003-04, it came to 2.1 per cent. That is to say, RBI, in effect, earns a return of 2.1 per cent on its investments of foreign exchange reserves, be they in central banks abroad or commercial banks.

True, this reflects the continuing decline in global interest rates. But, we are engaged in a mug's game as long as we are incurring liabilities at the margin in the form of FDI and FII, leave alone bankers' deposits and NRI investments or corporate ECBs at significant premia over Libor.

We are getting a negative return on every dollar that we invest abroad, lending to developed country governments at low rates. Surely, there should be a better way of using our foreign currency assets than to deposit them at such low rates. The search for safety and security of our investments should not place us in a Catch-22 situation.

The global resource flow is such that the rich countries are thrusting their savings in the form of FDI and FII investments into India. So are NRIs. We are, in turn, investing these funds back into safe Treasury Securities of the same developed countries, but at significantly lower interest rates than we `incur' on our liabilities.

This is perhaps unavoidable, given the need for a safe level of reserves. The RBI has, on many occasions, attempted to answer the question how much is a safe level of reserves. As of now, we can only advise that the RBI should exercise the maximum caution in adding to more forex reserves since it involves a continuous quasi-fiscal loss.

True, the Asian crisis taught us that a healthy reserve level is necessary to safeguard us from vulnerability, but at what cost is the billion-dollar question.

There is no clear answer to this paradox. There have been suggestions made, including by this writer, that some part of the RBI's forex reserves should be placed with Indian scheduled banks, who can lend them to creditworthy Indian corporates, who are otherwise raising ECBs in the external financial markets. This can earn higher returns, which can surely help to reduce the negative income phenomenon on our forex reserves.

Another possible way out is to use part of the reserves to create an investment facility, like the Singapore Government's investment vehicle, which is managed by Government-owned Temasek Holdings. Reports are that the Temasek Holdings earns upwards of 18 per cent on its investments, made mostly in the financial markets of Asia.

If Singapore can do it, so can we, provided we choose professional managers and keep them out of any political influence. The Singapore model is at least worth studying.

Returning to the RBI's accounts, what is significant is that the reduced gross earnings translate themselves into a net decrease in amounts transferred to the Government of India from the surplus earnings. Table 1 gives a summary of the funds flow: The fiscal impact is clear. The Government's non-tax revenue has consequently taken a palpable hit due to the low return on the RBI's investments.

The annual report contains an interesting table on the net international liabilities of the country. This shows that while our forex assets are high, they are obtained through accumulation of liabilities which, while not necessarily debt-creating, are nonetheless costly — like FDI and foreign institutional investment, which derive substantial reserves.

The significance of Table 2 is that our liabilities to the rest of the world are still higher than our assets with reference to the rest of the world. The liabilities are primarily made up of our obligations to our lenders and investors in our economy.

While it is true that most of the developing countries do have such an excess of liabilities over assets, we should try to reduce the gap. This can come only to the extent our current account improves over time. Fortunately, there are trends which show we are on the right track.

On the whole, the annual report of RBI for 2003-04 tells a good story and tells it well. That it does not disclose policy directions is due to the fact that central bankers are occupationally trained to obfuscate rather than to communicate — except when they decide to remove the punch bowl just when the party gets going.

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