Forex reserves have very high opportunity cost

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D. Murali

ChennaiApril 15India's foreign exchange (forex) reserves have crossed $200 billion, from a near-zero position less than two decades ago. Though our current reserves are just about a sixth of what China holds, there are some important questions the lay may like to ask. Such as: Isn't every dollar in the pile of RBI's forex reserves represented as rupee equivalent in the current money supply? Does a surge in forex reserves cause inflationary pressure? 2) How can forex reserves be `utilised' for infrastructure, as recommended by some? 3) How different will any such `utilisation' be different from printing more currency? Are there examples of such forex use from around the world? Dr Sunil Rongala, Group Economist, Murugappa Group, answers these posers from

Business Line


On forex vs money supply.

Theoretically, every dollar or euro or yen that enters India for purposes such as investing in equities or as part of FDI (foreign direct investment) or when the RBI (Reserve Bank of India) buys dollars and which form the forex reserves of the RBI, is represented as the rupee equivalent in the money supply.

On forex surge and inflation.

A surge in forex reserves can potentially cause inflationary pressures. It needs to be understood that an increase in forex reserves is because of increased foreign inflows. Foreign inflows increase will impact the monetary base and consequently the money supply and since inflation is defined as "too much money chasing too few goods", an inflow can potentially add to inflation or cause inflationary pressure.

However, the RBI or any central bank can reduce this inflationary pressure by `sterilising' foreign inflows. Say $1 billion comes into the system because some foreign investor wants to invest here. This $1 billion is equivalent to around Rs 4,300 crore and this means that the monetary base has increased by the same amount. The RBI, to neutralise this inflow, will issue bonds to suck the Rs 4,300 crore out of the system. In effect, the money supply remains unchanged. However, while sterilization may thwart inflationary pressures, it is a fairly expensive process since the RBI gets a smaller return on the foreign money vis-à-vis what they pay on the bonds.

On utilising forex reserves for infrastructure.

Forex reserves have a very high opportunity cost, as the return on them is typically very low as compared to when the money is used for something else. Therefore, many have suggested that the money can be used for infrastructure projects because the government can't afford to pay for them and the RBI's foreign reserves are doing nothing and they could earn some extra money for the RBI.

In theory it sounds like a very simple and a `no-brainer' thing to do, but in reality it is a far more complicated issue. Whose money is it: the RBI's or the government's? Can the government force the RBI into this and if it does, what does it do for the image of the RBI as an independent central bank? The RBI is supposed to be fairly independent from the politicians and if this is forced upon them, it could have a catastrophic effect on the perception that people have of the RBI regarding its independence. People are more likely to trust the RBI because it is run by technocrats as opposed to the government, which is run by politicians who are focused on winning the next election.

The other issues are: The reserves of the RBI are meant as an insurance against speculative attacks as well as pay for imports. Can the money be diverted? Will the spending on infrastructure create no extra liability for the government? Does this new channel of resources for the government reduce its will to decrease its fiscal deficit? How will the conversion of dollars into rupees affect the exchange rate of the rupee? Will it be non-inflationary? Proponents say that using forex for infrastructure spending is not inflationary while opponents say that while spending on traded goods may not be non-inflationary, spending on non-traded goods is. Given the very high presence of `hot-money' in India, can the RBI afford to let some money go to fund infrastructure spending.The list of issues goes on and on.

On the difference between utilising forex reserves and printing more currency.

It is a huge difference from just printing more money. Printing more money for infrastructure funding is ruinous for a country because it causes inflation on a massive scale. Printing money for infrastructure projects is essentially creating new money whereas foreign reserves are existing monies and already part of the system. In terms of perceptions, printing money for any purpose other than for the normal running of an economy will be viewed a very bad thing and something that is only done by a country in desperation.

Any example of forex use from around the world.

China is planning to use its massive $1.2 trillion in forex for other purposes. They have established an agency to find ways of using these reserves and ensure a higher return than they would get if they were idle. China also wants to do this because it has been causing massive inflationary pressure on the system though they have managed to contain it. They don't need to use it for infrastructure; they already have superb infrastructure because their government had far more foresight. Instead they plan to use it for investing outside the country in such things as equities etc.

(This article was published in the Business Line print edition dated April 16, 2007)
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