Save the cash

Indian Express, 25 October 2011

The debate about foreign exchange reserves and their uses has resurfaced after news that the RBI has turned down a Ministry of Finance proposal to buy raw material sources using reserves. The Government of India appears to have a lot of confusion about the concept of reserves and who owns them.

First, the balance sheet of the Reserve Bank of India and the Government of India is often discussed as a consolidated balance sheet when we think of the country as a whole. But the two are different. Foreign exchange reserves are an asset of the central bank. Against each dollar held in reserves the RBI has issued rupees, which are its liablities. Also, if the government of India borrows from the RBI, the RBI buys government bonds and issues rupees. The asset side of the RBI balance sheet thus consist of the total of government bonds and forex reserves. On the liability side of the RBI's balance sheet are the rupees in circulation in the country.

Second, the purpose of holding reserves is to be able to have international currencies in case there is a sudden need for them, and they cannot be borrowed quickly overseas. Many countries in the world hold their reserves in dollars. Not really in cash, but in US government short dated treasury bills. These can be sold when the country needs dollars without there being a loss of value and without having to spend time finding a buyer as the market for US government treasury bills has millions of participants.

The last time the RBI used reserves was to help banks and firms obtain liquidity when trade credit had dried up just after the Lehman crisis. More then 20 billion dollars were sold by RBI in a three month period to ease dollar liquidity tighteness for Indian firms.

A proposal to use foreign exchange reserve to buy, say, oil fields or coal mines abroad could possibly be done in two ways. One would be for the RBI to start buying and owning these resources. Even if RBI makes the right decisions, has the management capacity and teams to do this, something that no other central bank in the world does or wants to do, these mines would be substituting for the US treasury bills currency being held by RBI.

Now imagine a situation like the Lehman crisis and RBI trying to find buyers for its coal mines and oil fields in order to ease the dollar liquidity crisis. Two difficulties can be foreseen. First, prospective buyers who would normally buy these would also use banks and money markets to raise the money for the purchase. They will not be able to do that easily. A crisis may be the worst time to need reserves, yet one needs them only in the time of the crisis. Second, fire sales don't usually get a good price. Markets for such raw material sources are not large liquid markets with millions of buyers and sellers, and trying to sell coal mines under duress is unlikely to get a good price. It makes no sense for RBI to hold coal files as reserves, instead of US treasury bills.

Perhaps the intent is not for the RBI to hold coal mines, but for the government to do so. For this the goverment would need to turn to its banker, the RBI. Suppose the government had a budget surplus then with its surplus it could approach the RBI and purchase US dollars. These it would then use to set up, say, a Government of India Resource Fund that would buy oil fields and coal mines around the world. This would have implications for the balance sheet of the RBI. In contrast to the date before the GoI approached it, the RBI would hold less cash on its liabilities side, by the amount the government gave it, and less dollars on its asset side. For the government's balance sheet this means that on the asset side the government will now hold less cash and instead hold oil fields and coal mines.

But if the government does not have the money to buy the dollars from the RBI, it would have to borrow them. In this case the RBI would hold rupee bonds, give the government rupees, which the goverment would use to buy the dollars from RBI. On balance this would impact the RBI balance sheet in that on the asset side the RBI balance sheet would now contain less dollars and more Government of India bonds. For the goverment's balance sheet this means that there is a bigger deficit on its liability side and there are oil fields and coal mines on its asset side.

What is not possible is that the government simply take say USD 20 billion from the RBI foreign exchange assets and buy coal mines, without giving RBI goverment bonds in return. In other words, if the goverment wants to own more assets, it can borrow from it banker, but it cannot simply take the money from it.

The policy question to discuss is not one about use of reserves. One not so minor issue is about the already large fiscal deficit and whether this should be increased at present. But apart from that, the main issue that needs to be discussed is whether the Goverment of India should buy and own oil fields in other countries. The answer to this question needs to be found in the history of nationalisation of natural resources in many developing countries when faced with political turmoil, revolution or merely conflicts with the interests of the ruling classes of that country. What are the difficulties that may arise in the case of nationalisation of oil fields purchased by India by their respective countries? What are the military and political resources India is able, and willing to put aside to defend its property in these countries should the need arise. India needs a bigger policy debate on the question of buying strategic natural resources. Posing the issue as a use of reserves is confusing the question.

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