In the present scenario, it makes sense to look at reserves as a money back-cum-insurance policy

News of India’s foreign exchange reserves rising to a new high week after week has become commonplace.

Whether the RBI aims to reach a desirable level of reserves, whatever it may be, or whether it will endlessly keep adding to them is still a mystery.

What is true, however, is that Dr Jalan believes that until the Bretton Woods architecture can address the problems of volatility and instability of the current international environment, it is up to each country to cope with the risks it takes in opening its capital account.

Globalisation has great benefits, it is argued, through the movement of goods and capital across national boundaries. However, if a country is to avoid the fate of Indonesia, South Korea or Argentina, it must have large reserves.

In a speech in July, Dr Jalan said that India’s foreign exchange reserves are now adequate to take care of all reversible capital flows as well as current account deficits, and are more than required under the conservative ‘Guidotti rule’ (which suggests reserves coverage for one year’s capital account liabilities).

India’s short-term debt is very low and RBI’s forward liabilities have been reduced to less than 1 per cent of reserves. But despite being ‘adequate’ as of July, reserves continued to grow from $58 billion in July to $ 66.5 billion in November.

There is a continued lack of consensus about the optimal level of reserves. What seems to be true is that we are in a new regime of holding large reserves and adding to them rapidly.

There are many analytical difficulties with such a position. Costs and benefits of the policy can be measured in many ways. There is case to look at the opportunity cost of holding reserves from the viewpoint of the country rather than narrowly from the viewpoint of RBI’s balance sheet.

How does RBI invest reserves? In general they are invested in short-dated government securities of OECD countries. These yield low rates of return, such as 0.5 per cent to 1 per cent per annum in real terms.

From the viewpoint of India as a whole, this is a bad deal for several reasons. On the margin, capital inflows into India earn the marginal product of capital, which is probably around 9 per cent in real terms.

RBI invests this at around 1 per cent in real terms. Hence, India loses 8 per cent (on the margin) for incremental reserves. If we think that roughly $20 billion of foreign capital is earning the marginal product of capital in India, then this amounts to a cost of $1.6 billion per year. This is a substantial price-tag for an insurance fee.

Effectively, with a current account surplus, India is now a net exporter of capital, but capital controls prevent individuals from doing international diversification of their own portfolios.

RBI’s staff are performing the function of fund management of the international investment of Indian households. Should the country’s savings continue to be allowed to be invested in some of the lowest yielding securities in the world? Or, should, given the size of India’s investment abroad, there be an attempt to earn higher returns on India’s dollar portfolio?

International experience suggests that in addition to the present paradigm of reserves management, there are two alternative mechanisms that have been used elsewhere.

One possible path that can be taken is to create a separate investment vehicle for the Government of India, which would manage internationally diversified portfolios. These investment agencies would earn the global marginal product of capital, which would be a substantially higher rate of return when compared with short-dated government securities of OECD countries.

A part of the total stock of reserves may be held as highly liquid short-term US treasury bills while the rest may be invested to earn more.

Examples of such a strategy are the Abu Dhabi Investment Authority (ADIA) and the Government of Singapore Investment Corporation (GIC). Each of these agencies now controls between $100 billion to $200 billion of assets, which are large sums when compared with the reserves of most countries.

Both agencies have obtained significantly higher rates of return when compared with the low returns seen in reserves management. They work by primarily outsourcing the fund management function to professional fund managers all over the world.

Incidentally, both happen to be significant investors in India, through fund managers that were recruited by them. They engage in performance measurement, establishment of incentive fees, harnessing competition between multiple fund managers, etc. ADIA typically outsources to over a hundred fund managers across whom the assets are dispersed.

Another fairly obvious path that can be taken is to recognise that there is a fundamental difficulty with government agencies trying to be fund manager on behalf of the citizens.

Fund management is innately a difficult business; it involves taking risks, it poses governance problems, and it is difficult to deal with accountability of a government agency when business decisions go wrong (and they innately will go wrong every now and then).

Every household has its own distinct preferences governing risk and time, and no government can do the kind of financial planning that each household would like to do for itself.

This path entails opening up to outward capital flows. This would imply that Indian citizens would control internationally diversified portfolios. They would put these assets outside the control of the Indian government, which has many interesting ramifications.

From the insurance perspective, local investors are likely to behave in ways which are relatively uncorrelated with that of foreign investors. If there is a flight of foreign capital, and domestic asset prices drop, domestic investors (who do not suffer from asymmetric information) are likely to be buyers.

Conversely, domestic investors are likely to be more effective in using their superior information to punish poor policies. A large stock of foreign capital controlled by domestic investors may be a tool for monitoring economic policy in the country as well.

The RBI seems to have an innate fear for allowing outward capital flows and seems to form policies based on the belief that domestic instability would lead to capital flight. One would therefore be surprised if the latter path is acceptable to it.

It, therefore, makes sense to start looking at reserves as a money back-cum-insurance policy rather than a pure life insurance policy and worry about how better returns can be earned by improving the returns earned on India’s investment abroad.

ila@icrier.res.in

problem — Deepak Lal