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.
Many commentators have complained that India?s reserves represent a drag on growth. It is a misallocation of capital away from high local rates return to areas of low foreign rates of return. Two-year US government bonds, a favourite of central banks, ?yields less than 3.0%. ?But this misses the point that during the 1990s developing countries ran large deficits and ended in economic rout, while during this decade, we have had unprecedented voluntary surpluses in developing countries and unprecedented growth. One way to square this circle is that high reserves have led to a powerful drop in the risk premia investors demand when investing in emerging economies.?
If reserve building was a good thing, how should reserves be managed??Reserves are an insurance policy and like any insurance policy, the insurer must invest in assets that can be turned into hard currency quickly and are unrelated to any deterioration in the condition of the insured. You can?t insure against a monsoon by investing in housing developments in monsoon areas?however attractive the yields may be.
Reserves held in excess of insurance needs might be invested alternatively, but this is too easily said. The temptation to use reserves for populist purposes will be very hard to avoid if domestic investment is allowed. Best not to permit it. There is a reason why most surviving SWFs are in countries where democracy is less energetic than in India: Abu Dhabi, Kuwait, Russia, China, Qatar, Brunei, Libya, Kazakhstan, etcetera. Norway is a notable exception, but even there,?the pension fund is a political football. ??
It is also impossible to know when a country has excess reserves, but the odds are that India does not ?despite the recent dramatic rise in reserves. Almost all other countries with SWFs have a current account surplus, and mostly this surplus is the result of a commodity windfall. These are the right circumstances for an SWF. India has neither a current account surplus nor a commodity windfall. India?s reserve build up is the result of optimistic equity investors and a weak dollar. Both factors are partly structural and partly cyclical, and they will partially reverse. India?s reserves will easily absorb a return of what is defined as short-term capital flows. But be wary of these figures. Foreign currency reserves are marked to market regularly, but long-term liabilities are not; and do not doubt the ingenuity of Mumbai bankers to turn long-term liabilities into short-term ones when required?especially if liberalisation continues. I have seen it done before?in Brazil in 1998 and Argentina in 2000. India?s liquid foreign exchange reserves are less than half its total external liabilities at current prices. India is in a far stronger position than ever before, but in the context of current global markets and future local reform, it is not an impregnable one. Stay the course, my friends.
Avinash D Persaud is chairman, Intelligence Capital Limited and Emeritus Professor of Gresham College