The Hindu Business Line : Dr Reddy's thoughts on forex reserve management

The latest RBI Bulletin reprints the Governor, Dr Y. V. Reddy's talk in Singapore, where he endorsed the need to hold large forex reserves, given the fragility of global financial architecture. He also mentions several options to increase returns from the reserves, highlighting the Singapore model. S. VENKITARAMANAN agrees this is a good approach.

The latest issue of the RBI Bulletin carries the text of the speech delivered last month by the Governor, Dr Y.V. Reddy, on foreign exchange reserves, new realities and options. He spoke before a select audience at a seminar in Singapore in September on the subject of "The world in Asia, Asia in the world".

At $160 billion plus of forex reserves, India is in a comfortable position by any yardstick of reserve adequacy. But the question is, for instance, whether the RBI is doing right by the nation in investing the reserves in the Treasury Securities of the US or Europe, instead of using them for worthwhile purposes in the domestic sector, such as infrastructure spending.

The right management of forex reserves is, of course, complicated by the need to handle it in such a way as to be able to convert reserves to liquid form at short notice. Investment in domestic infrastructure may not satisfy this crucial test of instant liquidity in foreign currency.

Dr Montek Singh Ahluwalia was, however, not alone in raising the possibility of using the central bank's reserves for local expenditure. Dr Martin Wolf, in a recent article in Financial Times, pointed out that the Chinese Premier, Mr Wen Jiabao, himself had made a similar suggestion, referring to China's nearly trillion dollars of forex currency assets. He received a similar negative response.

Dr Reddy devoted his address to general issues, other than local investment, such as the currency and investment composition, the costs of forex management as well as various emerging ideas on the subject. In an address that was scholarly as well as refreshing in its openness to new ideas, Dr Reddy covered the whole ground in his characteristic expert manner. I propose to discuss some of the ideas that he propounded in his speech.

Sources of accretion

Dr Reddy pointed out that the need for large reserves was particularly validated as a result of experience of South-East Asian countries following the crisis of the 1990s. That large reserves are needed to withstand any crisis is a reflection of the fragility of the global financial architecture. The recent accretion of reserves has been, however, on a much large scale and lasted longer than was seen during the early 1990s.

BIS reports that between 2000 and 2005, emerging market economies accumulated reserves at an annual rate of $250 billion, or 3.5 per cent of their combined GDP, which was almost five times higher than the level seen in the early 1990s. The bulk of the reserve accretion was concentrated in Asia, particularly in China, Korea, India, Malaysia and Taiwan. Many oil exporting nations also saw a large increase of reserves.

Turning to the sources of their accretions, Dr Reddy points out that in some countries, like China, Korea and Taiwan, the accretions reflected large current account surpluses, while in India, they were capital account flows exceeding the current account deficit. Large reserves that owe their origin to capital account surpluses may be eroded if the capital flows reverse direction, as is likely, especially in respect of portfolio movements.

Dr Reddy faces head on the question of "carrying" costs of these crowns of thorns — foreign currency assets. Especially in countries such as India, where the domestic interest costs are higher than international costs, there are positive costs to holding forex reserves. The central bank holds these reserves in external assets, which yield a lower return than it would derive by using equivalent domestic currency for investing in domestic assets. It pays banks rupees for buying their dollars.

Carrying Costs

The central bank accumulates these foreign currency assets by using domestic currency to buy the forex from those who have acquired it through exports or remittances. This can lead to domestic currency expansion. In order to counteract the resulting M(3) expansion, the central bank "sterilises" these forex accretions by selling domestic securities in the market to absorb the excess domestic currency released.

Sterilised intervention implies a quasi-fiscal cost, that is, the difference between the interest earned on forex reserves and the interest paid on domestic securities placed for sterilisation. Dr Reddy points out that in a country like China, the carrying costs of the forex reserves are negative because the domestic interest rates are lower than the foreign rates.

The Governor pointed out that a number of interesting options have emerged recently to increase returns from the management of forex reserves. He returns to the Singapore experience in this regard. Singapore has perfected a device for investing its forex reserves in diversified portfolios of securities through its publicly held Government Investment Corporation as well as Temasek. This has meant a significant diversification of risks as well as enhanced returns. Singapore's example has been emulated by South Korea.

Dr Reddy referred to the Chinese variation on the theme. China invested part of its reserves in the equity capital of its ailing banks, thus strengthening their capital structure.

Obviously, this is an example, which can well be followed in India - by RBI investing parts of its reserves in the equity of a special purpose vehicle for investment in infrastructure. The spirit is willing, but the flesh is weak.

Singapore Model

Dr Reddy referred to other interesting ideas in regard to the management of reserves. Among these, he particularly mentioned the idea mooted by Prof Lary Summers, former US Secretary of the Treasury in his March 2006 L.K. Jha address.

Prof Summers' idea is to persuade the World Bank and IMF to create a joint facility, in which the countries with high reserves would invest.

The facility, to be jointly managed by the IMF and the World Bank, will take responsibility for investing these funds. In turn, it could lend resources on concessional and grant terms, besides investing in securities.

In effect, this means the emerging market economies with forex reserves should engage the IMF and the World Bank as their "external asset managers", subject to specific conditions on risks and returns.

While this sounds like a sensible proposal, I would vote more in favour of the Singapore model, where the national entity retains its control while using external management expertise to the extent needed. Politically, that would be more palatable.

There are, of course, other variations in the Summers' proposal, including one of creating a global currency based on the excess reserves. Dr Reddy says it is an idea worth pursuing. Shades of James Maynard Keynes' idea of "bancor", the global currency!

All in all, the speech of Dr Reddy covering in an exhaustive way the subject of management of forex reserves reveals an openness to new ideas and explores various options. I hope this will be a window to a better and more rational application of the country's billions of dollars than practised at present.

No idea should be eschewed if it will result in betterment of India's welfare without curtailing in any manner its external financial security and freedom from speculative attacks.

Here is to hoping that what Dr Reddy spoke about at Singapore in March 2006 will result in a truly national variation of that island-nation's experience in skillfully managing its foreign currency assets for its greater good and enhancement of global welfare.