The Hindu Business Line : Reserves deserve better returns

First mooted in late 2004, it was debated and discussed to death (as we, in India, tend to do in these matters). There was a lot of heat and some light till the whole thing simply disappeared from view.

The drivers of the scheme were clearly the fiscal deficit constraining government spending even on worthwhile projects and the large accretion of reserves. If the latter are like idle cash in the bank, it would make sense to deploy them in viable projects - so goes the argument.

Mr Raghuram Rajan, the India-born IMF economist, thinks this is a fallacy. Aren't the reserves already invested in dollar, euro, sterling, etc. assets, he asks?

And if the RBI bought dollars from the market, it must have created equivalent rupee liabilities. In short, he says reserves are not `unencumbered' or lying `idle', as proponents of the scheme believe.

But, then, does the fact of large reserves make no difference at all? The capacity to invest in new projects is surely enhanced in some way by the level of reserves.

At the very least, reserves could finance the forex expenditure involved, which, otherwise, must be borrowed. There could also be the need to import capital, intermediate or consumer goods if domestic production is short and the excess demand will provoke prices.

Reserves are, therefore, handy to control inflation, when, because of an investment boom, demand runs ahead of the productive capacity of the economy.

In contrast, in a reserves-scarce situation, there is always the fear of over-investment and inflation, which can be dealt with only with harsh monetary measures, endangering growth.

If the government uses reserves instead of (say) issuing bonds to fund projects, does it mean investment has increased without increasing the fiscal deficit? There is a mistaken belief that this is so. Actually there is no difference between the two situations. Recourse to reserves means buying them from the RBI with rupees. An expense is an expense, whether in forex or rupees and the deficit impact is the same in both cases.

To the extent that reserves are `equity', i.e. not collateralised by foreign borrowing or investment, it is logical to deploy them in domestic investments which yield better returns than the meagre earnings from US treasury bills and bonds.

Another option is for the government to lend these funds to public sector banks, which can then onlend to first class Indian companies. They would save on their spreads in offshore financial markets, which are out of line with their domestic credit rating.

It will be a win-win situation for all - the government and RBI, on the one hand and corporates on the other. Such is the gap between the cost of forex borrowing and yield on forex investments.

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