We are not Kazakhstan

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In the early 1980s, I spent a fair amount of my student life sipping coffee in Wrights Bar at No 5, Houghton Street. Often, I would sift through accommodation listings on the back pages of the Evening Standard trying to understand the aggressive abbreviations used to save pennies on ad space: “swf, to shr 2 bdr, grd flr flt, gch, cls tbe”. In those days, swf stood singularly for single white female. Today, SWFs have become sovereign wealth funds and they are front-page news. SWFs are State investment vehicles, often spun out from central banks. Collectively, they manage $3.5 trillion. They seek higher rates of return than traditionally offered by central bank reserve managers. They have been fed by the commodity boom and new funds sprout up all the time. Just two weeks ago, Saudi Arabia announced it was establishing an SWF. Now that India’s foreign exchange reserves have topped $300 billion—around the same level as Saudi reserves—RBI Governor YV Reddy has been wondering aloud whether India should have its own SWF.

This is really two related but separate questions: first, is the reserve build-up the right thing, and second, is there room in the reserves to invest in higher yielding assets or perhaps even within India to boost development? My own experience—gained on foreign exchange dealing floors for the better part of two decades—suggests that India is right to build reserves and manage a moderate appreciation of the rupee, that there is little room in current reserve levels to establish an SWF today, and, sadly, it is dangerous to allow reserves to be invested in domestic assets. 

Exposure to international trade and capital flows brings competitive discipline; but sometimes these flows have sudden stops or reversals with severe repercussions.  Consequently, high reserves should be used as a shield underneath which the government can pursue purposeful liberalisation of trade and capital flows, safe in the knowledge that it has the means to protect the economy from any sudden deterioration in international markets. One day the Indian economy will be large enough and the financial sector deep enough that no one would worry much about external shocks. Then a largely freely floating exchange rate would be appropriate and high reserves would not be. But this is not that day.