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India mulls utilising forex reserves for infrastructure

HOW should India utilise its bulging foreign exchange reserves to fund capital-guzzling infrastructure projects? That question has never been far from the minds of policy makers ever since the idea was mooted by Montek Singh Ahluwalia, deputy chairman of the Planning Commission in 2004.

Essentially, the suggestion is: foreign exchange reserves at over $200 billion are well above the comfort level required for making external payments and ensuring stability in the exchange rate. So why not deploy the "excess" reserves (which earn low returns for the economy) to build the much-needed infrastructure facilities and thus boost the country's growth?

The finance minister P Chidambaram picked up the idea, conferring upon it a kind of formal acceptance as a policy initiative. However, nothing came of it. Critics pointed out that the proposal, if implemented, would push up the fiscal deficit. Meanwhile, reserves mounted steadily and the idea gathered momentum with a senior World Bank official airing it publicly.

Chidambaram referred to it once again in the latest budget. This time he was armed with the report of an expert committee, headed by the redoubtable HDFC chairman Deepak Parekh, which has suggested using a small part of the reserves for infrastructure funding "without the risk of monetary expansion".

The committee has suggested the establishment of two wholly-owned overseas subsidiaries of the government-owned India Infrastructure Finance Company (IIFCL) with two broad objectives. One of the subsidiaries will guarantee the fund-raising activities of SPVs or special purpose vehicles of public sector firms or public-private partnerships (PPPs) seeking to raise money abroad.

The other subsidiary will lend the forex it will borrow from the Reserve Bank of India (RBI) to infrastructure initiatives that are seeking to import capital goods or meet their need for external borrowings.

These subsidiaries could also invest funds borrowed from the RBI in highly rated collateral securities, and provide 'credit wrap' insurance to infrastructure projects in India for raising resources in international markets.

The loans by the RBI to these two subsidiary companies will be guaranteed by the Government of India, and the RBI will be assured of a return higher than the average rate of return on its incremental investment.

Effectively, RBI lends a small part of its reserves to Indian companies implementing infrastructure projects at home to meet part of their capital expenditure abroad such as import of equipment etc. It will earn a higher return on the funds deployed for such lending than what it earns on the deposits or bonds of other central banks (mostly US Fed) in which it parks most of the reserves. Apart from funds support, the involvement of IIFCL subsidiaries will enable the companies to raise money abroad at a cheaper cost.

On the face of it, the scheme appears a win-win for all concerned. That has, however, not deterred critics from raising a few objections. Some critics have contested the underlying assumption that India's foreign exchange reserves are "excessive" and need some out-of-box thinking for purposeful deployment. True, at $200 billion, they are adequate for an import cover for a year or so. However, length of the import cover may not be the sole or even the most important criterion for judging adequacy of the reserves in a globalised world.

A large part of the reserves consists of hot money such as portfolio investment and NRI deposits. Developments in other countries, over which India has no control, may occasion large movements of capital. As India gets increasingly plugged into the global economy, it will be difficult to predict how big a war chest it will actually need in a financial crisis. So while it may appear that $200 billion in reserves is a lot of money idling away, it should be touched only as a last resort.

Second, for all its convolution and obfuscation, the scheme will lead to an increase in money and inflationary pressures. Ideally, if the entire amount borrowed from the RBI is spent on imports, then forex reserves would decline by this amount. Money supply would remain unchanged because the increase in domestic assets of the RBI (from the additional government bonds) would be fully neutralised by a corresponding decline in foreign assets.

If, however, the entire additional investment is not spent on imports, the additional expenditure will not lead to a corresponding decline in forex reserves. The additional money supply will, therefore, fuel inflation. This is more likely to happen as much of infrastructure investment is not import-intensive e.g. roads, irrigation, ports and airports.

In fact, the Reserve Bank has itself voiced some reservations on this count. In a note submitted to the finance ministry, it has pointed out that the proposal to use foreign exchange reserves for infrastructure projects has implications for the overall policy on external commercial borrowing (ECB), since the proposal is to onlend RBI funds to companies involved in infrastructure in India or co-finance their ECB requirements. This assumes significance since the apex bank has made no secret of its concern over the impact of ECB inflows on money supply.

Thirdly, Indian private sector is not in dire need of the official support implicit in the scheme. It has demonstrated time and again its ability to borrow abroad without any crutches. Indian companies find it cheaper to borrow abroad to fund domestic expansion plans, particularly in the context of the rising interest rate regime at home. Experience of telecom and civil aviation sector shows where there is a clear business model, lack of ability to borrow abroad has not been a spoiler.

Indeed, it may not be a good idea to invest forex reserves, which by many adequacy ratios, barring import cover, are still not impressive, in a sector that is notorious for its lack of transparency, long gestation, archaic labour laws and a history of negative returns. The first task for New Delhi ought to be to revamp the regulatory framework and push investors into realising its true potential in terms of high returns. Most governments create enabling environment and leave the rest to private investors.

To all this criticism, one could reply that the amount of forex being considered for the purpose is $7 billion or just 3.5 per cent of the total reserves. Deployment of such an amount, in the context of continued capital inflows, cannot affect the adequacy of forex reserves, however defined. Since it will be spent, very substantially if not wholly, outside India, its impact on money supply growth and inflation will be even smaller.

The idea is not as outlandish as some critics make it out to be. A recent study by the Delhi-based Research & Information Systems for Developing Countries (RIS), assisted by UNESCAP, has suggested creation of a Regional SPV by earmarking 10 per cent of the $3 trillion regional forex reserves for investment in global equity indices and utilising the profits-estimated at $15 billion a year-to meet the financial viability gap of private sector investments in infrastructure.

Singapore has its own pioneering model of investing reserves in world equity markets alongside safe securities in order to earn higher returns, a system now followed by Korea. China with its trillion dollars (end December 2006) used its dollar earnings to recapitalise its banks; alongside it has used its reserves to create markets and buy oil (and influence) in Africa. No harm if India too looks around for more productive ways of deploying its forex reserves.