Why reserves are not resources

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Large economies having a vigorous interface with the global economy may require large foreign currency reserves to act as stored energy that smoothen the transmission of resource power to drive the growth engine. But the `resource power' will have to be derived from exports and capital inflows, which generate the ideas and energy that India needs to power the economy with, says G. Ramachandran.

G. Ramachandran

Not an ocean of tears nor all the guns in the world can transform those pieces of paper in your wallet into the bread you will need to survive tomorrow. Those pieces of paper, which should have been gold, are a token of honour your claim upon the energy of the men who produce.

Francisco d' Anconia, the money moralist in Atlas Shrugged; Ayn Rand (New York: Signet, 1957)

THE foreign exchange reserves held by central banks have been erroneously viewed by some as resources for funding economic development in the emerging-market economies. The erroneous identification of `reserves' as `resources' is most pronounced in India.

At least one apex chamber of commerce and industry has backed the proposal for using the vast foreign exchange reserves held by the Reserve Bank of India (RBI) to fund investments in infrastructure.

Foreign exchange reserves held by the RBI have been estimated at over $130 billion at the beginning of the year. The value of the vault places India behind China ($515 billion), Taiwan ($245 billion) and South Korea ($195 billion) among the emerging-market economies in the reserves league table.

The magnitude of the reserves in the vault is of unprecedented significance to a nation that had to first move its stock of physical gold and then pledge it to tide over an external payments crisis in 1991.

It is also a source of extraordinary satisfaction and confidence that all is well with the way the economy, especially the external sector, has been managed since those difficult days.

The appreciative nods have now shifted from the external to the internal sector. Expectation and hope have been stoked. Can some part of the $130 billion be used to expand internal infrastructure?

The erroneous view is that it can be. The positive view is not surprising since India is seen to be deficient in infrastructure. Infrastructure is regarded as the key to rapid and sustainable economic growth.

Our own Wall Street!

The proposal backed by one of the apex chambers of commerce and industry is ill-founded. It has serious conceptual flaws. First, the resources assumed to be investible by the RBI are not the outcome of any physical or intellectual effort expended by it. The reserves owned by the RBI have been primarily `bought' by the RBI by money created through `printing' the Indian rupee.

If `printing' the Indian rupee can drive away India's capital shortages, then the RBI would have indeed `printed' India's prosperity since the days of garibi hatao (drive away poverty) in 1971.

Second, the proposal requires the transformation of the RBI from a `reserve bank' into an `institutional investor' or a `commercial bank'.

The RBI will have to become an equity investor or a lender in infrastructure projects or be an investor or lender to special purpose vehicles that fund infrastructure projects.

It would be quite amusing as well as amazing to have an institutional lender or investor that can print its own money and then buy foreign currency. If the RBI could indeed do this, the Prime Minister and Finance Minister will not have to `sell' India's economic strengths to Wall Street.

With Mint Street in our pockets, who needs Wall Street!

Fantastic financial engineering

Third, some foreign direct investment (FDI) and foreign institutional investment (FII) may be headed towards India for infrastructure funding.

These foreign currency inflows may be `converted' into Indian rupee funds by authorised foreign exchange dealers or by the RBI. The Indian rupee funds will, in either case, be used to fund infrastructure.

However, if the RBI makes the rupee funds available, reserves will be `created' by the RBI, and the FDI or FII will also fund infrastructure. Then some chamber of commerce will propose the use of reserves for infrastructure funding.

This will be financial engineering at its creative best: India will create twice as much infrastructure per dollar as other countries do. India could and would if such financial engineering were feasible! Unfortunately, this belongs to the realm of financial fantasies.

Fourth, the proposed utilisation of reserves for funding infrastructure overlooks the double counting of the monetisation in the domestic currency the Indian rupee which results from foreign exchange inflows. In the main, some part of foreign currency inflows resulting from exports, FDI and FII are the sources of reserves.

While buying into these reserves, the RBI releases Indian rupees. These are available for investments in infrastructure. The first question to be asked is if they are invested in infrastructure. The second question: If not, why not?

Flywheel and capacitor

Soon after the Boxing Day tsunami struck the Indian Ocean rim countries, a moral and economic question pertinent to the utility of foreign exchange reserves held by central banks was asked (Business Line, January 1).

If a country's foreign exchange reserves can be used expeditiously and with ease to provide humanitarian relief to those devastated by the tsunami, then reserves can plausibly be used to fund human development and investments in infrastructure over the long term. However, there have been no helpful suggestions or responses to this question. This is not surprising.

Foreign exchange reserves may be compared, even if only weakly, to the energy stored by the flywheel in an automobile engine.

They may also be compared to the energy stored by a capacitor in an electrical circuit. The energy stored in a flywheel is tapped from the internal combustion engine. The energy stored in a capacitor is tapped from the voltage source in the circuit.

If an engine is a resource, the flywheel is incapable of becoming an engine. If a battery is a voltage source, the capacitor is incapable of becoming a battery. But the flywheel and the capacitor have a role to play. They smoothen the transmission of resource power from the engine and the voltage source.

The flywheel releases stored energy when the engine comes to rest. The capacitor releases stored energy when the circuit's voltage dies. In either case, no new energy is produced. Moreover, big engines require big flywheels; high-voltage circuits require big capacitors.

From such a perspective, large economies having a vigorous interface with the global economy may require large foreign currency reserves to play the role of smoothening flywheels and capacitors.

The size of the reserves will be determined by how smooth the economy's action, interface and interaction should be.

But the `resource power' will yet have to be derived from exports and capital inflows. They generate the energy. India needs new ideas to power the economy with new energy. A dying economy can draw down its reserves. A dying economy will, of course, draw down its reserves.

(The author is a financial analyst. Feedback may be sent to

(This article was published in the Business Line print edition dated January 21, 2005)
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