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Should India Use Foreign Exchange Reserves to Finance Infrastructure?

India's foreign exchange reserves increased during the 1990s as a result of measures introduced to liberalise capital inflows under the financial sector reforms undertaken since 1991. The Reserve Bank of India, in consultation with the government, currently manages foreign exchange reserves. As the objectives of reserve management are liquidity and safety, attention is paid to the currency composition and duration of investment so that a significant proportion can be converted into cash at short notice. The government of India intended to use a part of its foreign exchange reserves to finance infrastructure. Infrastructure projects in India yield low or negative returns due to difficulties - political and economic - especially in adjusting the tariff structure, introducing labour reforms and upgrading technology. There is no evidence that any other country has used foreign exchange reserves to finance infrastructure. The amount of foreign exchange reserves in India is modest when compared to some of the other countries in the region and it can be argued that the proposed plan may lead to more economic difficulties than anticipated benefits.

Should India Use Foreign Exchange Reserves to Finance Infrastructure?

India’s foreign exchange reserves increased during the 1990s as a result of measures introduced to liberalise capital inflows under the financial sector reforms undertaken since 1991. The Reserve Bank of India, in consultation with the government, currently manages foreign exchange reserves. As the objectives of reserve management are liquidity and safety, attention is paid to the currency composition and duration of investment so that a significant proportion can be converted into cash at short notice. The government of India intended to use a part of its foreign exchange reserves to finance infrastructure. Infrastructure projects in India yield low or negative returns due to difficulties – political and economic – especially in adjusting the tariff structure, introducing labour reforms and upgrading technology. There is no evidence that any other country has used foreign exchange reserves to finance infrastructure. The amount of foreign exchange reserves in India is modest when compared to some of the other countries in the region and it can be argued that the proposed plan may lead to more economic difficulties than anticipated benefits.


he unprecedented rise inforeign exchange reserves (FER) in some of the Asian countries raises a concern about their optimal size and appropriate utilisation. In India too, in recent months, different ways to utilise FER, in particular, to finance infrastructure, have been debated. The government of India (GoI) intended to use a part of its FER for infrastructure financing and had announced a scheme – yet to be implemented – in its annual budget in February 2005. There is no evidence that any other country has used FER to finance infrastructure. It is of interest, therefore, to examine India’s rationale for accumulating large volumes of reserves, to analyse the sources of such inflows, and to explore the benefits of using these resources to finance infrastructure.

The study is organised as follows. Section I presents a detailed discussion of the trend of FER in India, along with the objectives of reserve management, and the sources of and reasons for accumulating FER. Section II discusses the rising trend of FER in selected Asian countries, and briefly reviews the literature on accumulation of reserves and its utilisation. The specific issue of utilisation of FER for financing infrastructure in India is taken up in Section III. Finally, Section IV presents some conclusions.

I Foreign Exchange Reserves in India


India followed a restrictive external sector policy until 1991, mainly designed to conserve limited FER for essential imports (petroleum goods and foodgrains), restrict capital mobility, and discourage entry of multinationals. The external sector strategy since 1991, though gradualistic in approach, has shifted from import substitution to export promotion and has the following key elements – (i) sufficiency of reserves, (ii) stability in the foreign exchange market, and (iii) prudent external debt management. Foreign investment policy also underwent a gradual change to encourage foreign direct investment to India. India adopted current account convertibility of the rupee on August 20, 1994. However, India has been following a cautious approach on capital account convertibility (CAC), while initiating a process of gradual liberalisation since 1991, to avoid any vulnerability to the reform process from volatility of capital flows and contagion [McKinnon 1973; Wolf 2004].1

As a result of measures initiated to liberalise capital inflows, India’s FER (mainly foreign currency assets) increased from US$ 5.8 billion at end-March 1991 to US$ 140.1 billion at end-March 2005 (Table 1). The acceleration in the trend first emerged in 1993, as recorded by the rise in foreign currency assets, when India adopted the market-based system of exchange rates, and then in 2001 when the current account recorded a surplus after a persistent deficit since 1978 (Figure 1).2 The FER, in March 2005, exceeded 15 months of imports or about five years of debt servicing. The substantial growth in FER has led to a sharp decline in the ratio of short-term debt to reserves from 147.1 per cent in 1991 to 5.3 per cent in 2005.

Objectives of Foreign Exchange Reserves Management

The main objectives in managing a stock of reserves for any developing country, including India, are preserving their longterm value in terms of purchasing power over goods and services, and minimising risk and volatility in returns. After the east Asian crises of 1997, India has followed a policy to build higher levels of FER that take into account not only anticipated current account deficits but also liquidity at risk arising from unanticipated capital movements. Accordingly, the primary objectives of maintaining FER in India are safety and liquidity; maximising returns is

Figure 1: Foreign Currency Assets

140 120 100 80 60 40 20 0

capital, including deposits by non-resident Indians (Table 5). In 2004-05, of the total foreign investment of US$ 11.9 billion, direct investment amounted to US$ 4.7 billion. In the current account, a major contribution has been made by computer services and software exports (CSSE), mainly banking, financial and insurance, which increased from less than US$ 0.8 billion in 1995-96 to US$ 17.3 billion in 2004-05. In addition, inward remittances from workers abroad (IRWA), mainly from western Europe and the US, more than doubled from US$ 8.5 billion to US$ 20.5 billion over a

similar period.

US $ Billion 199119921993199419951996199719981999200020012002200320042005

Years —+—Foreign Currency Assets Note: Foreign exchange reserves exclude the reserve tranche position in the IMF. Sources: Handbook of Statistics on Indian Economy and Monthly Bulletin, Reserve Bank of India.

considered secondary. In India, reserves are held for precautionary and transaction motives, to provide confidence to the markets, both domestic and external, that foreign obligation can always be met.

The objectives in holding FER influence the currency composition of reserves. To meet the transactions motive, composition of FER should be closely related to the pattern of external trade.3 However, the data on currency composition for India, as also for other countries, are not in the public domain.4 In India, data on the direction of trade, despite a sharp change in trend, reveal that the US, UK and other European countries continue to be prominent amongst India’s trading partners, which would justify its holdings of US dollars, pound sterling and euros for transaction purposes (Table 2).5

In view of the high volumes of FER and their currency composition, the most significant question is: How are they being managed? The RBI, in consultation with the GoI, currently manages FER. As the objectives of reserve management are liquidity and safety, attention is paid to the currency composition and duration of investment, so that a significant proportion can be converted into cash at short notice. The essential framework for investment is conservative and is provided by the RBI Act, 1934, which requires that investments be made in foreign government securities (with maturity not exceeding 10 years), and that deposits be placed with other central banks, international commercial banks, and the Bank for International Settlement, following a multi-currency and multi-market approach (Table 3). A small component of reserves are also placed with external asset managers to access their market research and help the RBI staff to acquire adequate skills in reserve management.

The conservative strategy adopted in the management of FER has implications for the rate of return on investment. The direct financial return on holdings of foreign currency assets is low, given the low interest rates prevailing in the international markets (Table 4). However, the low returns on foreign investment have to be compared with the costs involved in reviving international confidence once eroded, and with the benefits of retaining confidence of the domestic and international markets, including that of the credit rating agencies [Reddy 2002].

Sources of Rising Foreign Exchange Reserves

The main sources of FER in India are inflows of foreign investment (more portfolio than direct) and banking

II International Trends and Evidence of Utilisation of Foreign Exchange Reserves

The substantial rise in FER has been noted for many countries in Asia since 1997, especially Korea, India, China and Japan. The seven largest holders of FER, account for more than US$ 2,200 billion or 58.4 per cent of the world reserves (Table 6). In 2004,

Table 1: Foreign Exchange Reserves*

(US $ million)

Year SDRs Gold Foreign Total Import Cover
(End of March) Currency Assets (Months)
1971 148 243 584 975 4.8
1976 234 281 1,657 2,172 4.2
1981 603 370 5,850 6,823 5.2
1986 131 417 5,972 6,520 4.4
1991 102 3,496 2,236 5,834 2.5
1996 82 4,561 17,044 21,687 6.1
2001 2 2,725 39,554 42,281 8.8
2005 5 4,500 135,571 140,076 14.3

Note: * Excludes reserve position in the IMF.

Sources: Handbook of Statistics on Indian Economy and Monthly Bulletin, Reserve Bank of India.

Table 2: Direction of Foreign Trade

(Per cent to total)

1987-88 2003-04 Exports Imports Exports Imports

OECD countries 58.9 59.8 46.5 37.6

of which: UK 6.5 8.2 4.8 4.1 US 18.6 9.0 18.1 6.3 Japan 10.3 9.6 2.7 3.4 Switzerland 1.3 1.1 0.7 4.3

OPEC 6.1 13.3 15.0 7.3 Eastern Europe 16.5 9.6 2.4 2.1 Developing countries 14.2 17.3 35.5 26.1 Total 100.0 100.0 100.0 100.0

Source: Handbook of Statistics on Indian Economy, Reserve Bank of India.

Table 3: Deployment of Foreign Exchange Reserves

(US $ million)

Items 2003 2004 2005

1 Foreign currency assets 71,890 107,448 135,571

  • (i) Securities 26,929 35,024 36,819
  • (ii) Deposits with other central banks and BIS 33,463 45,877 65,127
  • (iii) Deposits with foreign commercial banks 11,498 26,547 33,625 2 Special drawing rights 4 2 5 3 Gold (including gold deposits) 3,534 4,198 4,500 4 Total foreign exchange reserves 75,428 111,648 140,076

    Source: Report on Foreign Exchange Reserves, various issues, Reserve Bank of India.

    Economic and Political Weekly February 11, 2006

    India ranked fifth in terms of holdings of reserves and sixth if the size of reserves to GDP is considered.

    Why Countries Accumulate Foreign Exchange Reserves

    The desire to accumulate FER arises for several reasons. The earlier literature focused on the need for reserves to maintain fixed exchange rates and to intervene in the market [Flood and Marion 2002]. More recently, an increasing volume of empirical literature stresses that high FER are held for precautionary purposes [Ben-Bassat and Gottlieb 1992; Aizenman and Lee 2005]. Frankel and Wei (2004), using a regression tree technique, show that countries that hold low FER are prone to more frequent and more

    Table 4: Net Earnings as a Per Cent of Foreignand Domestic Assets

    Year (End Foreign Foreign Currency Domestic Domestic Assets
    of June) Currency Assets Net of Assets Net of Sale
    Assets Depreciation* of Securities**

    2002 4.5 4.1 7.6 6.0 2003 3.2 3.1 8.5 5.5 2004 2.8 2.1 5.9 3.3 2005 3.2 3.1 2.0 -2.2

    Notes: * Mark-to-market depreciation in securities. ** excludes profits on sale of securities.

    Source: Annual Reports, various issues, Reserve Bank of India.

    Table 5: Sources of Foreign Exchange Reserves

    (US $ billion)

    Ite ms 2002-03 2 003-04 2 004-05
    1 Current account balance 4.1 10.6 -6.4
    2 Capital account (net) 12.8 20.9 32.6
    (i) Foreign investment 4.6 14.8 11.9
    (ii) Banking capital 8.4 6.2 4.0
    of which, NRI deposits 3 3.6 -1.1
    (iii) Short-term credit 1 1.4 3.8
    (iv) External assistance -2.5 -2.7 1.9
    (v) External commercial borrowings -2.3 -1.5 5.9
    (vi) Other items 3.6 2.7 5.1
    3 Valuation change 4.4 5.4 2.4
    4 Total 21.3 36.9 28.6

    Source: Accretion to Foreign Exchange Reserves in India, various issues, Reserve Bank of India.

    severe crises. Feldstein (1999) concludes that the large FER, could be an important source of flexibility, protection and confidence in a crisis – serving as a first defence, a self-insurance

    – and reflecting a lack of confidence in the current international financial architecture. To illustrate, the GoI had to ship 47 tonnes of gold to the Bank of England in June 1991, amidst national humiliation, to secure a loan of about US$ 415 million before funds could be arranged from the IMF to ride out the financial crisis. Similar experience of delayed assistance from the IMF is reported by Argentina in the latest crisis of 2001-02. Feldstein (2002) argues that an absolute level of FER is important for deterring speculative attacks and suggests that one of the primary ways in which a country can reduce the risk of a currency crisis is by maintaining a substantial level of reserves.

    The role of the rate of interest has also been stressed in the literature. Calvo et al (1993) argue that the high interest rates in Latin America, as compared with the US, played a key role in the movement of capital internationally. Calvo and Reinhart (2002) argue that countries are building reserves as they fear floating, and that they use interest rates to manipulate the exchange rates. Ferrucci et al (2004) suggest that pull and push factors are responsible for the flow of reserves to the emerging economies, measured in higher growth rates and higher interest rates. However, in the select countries with large FER, the trend since 1992 is mixed, with their real interest rates being higher than in the US, especially in India and Hong Kong, since 1999, and for a few years since 1992 in China, Korea and Singapore. Japan, holding the largest amount of FER, however, has had lower interest rates than the US since 1994 (Table 7).

    In 2005, two interesting explanations of rising FER have been provided. Bernanke (2005) has argued that some of the developing countries are suffering from a savings glut and are able to find an easy outlet to the US, where national savings rates are currently low while investment continues to be high. McKinnon (2005), providing a long-term theoretical perspective, observes that some countries, with current account surpluses or capital inflows or both, attempt to prevent their currencies from appreciating. These countries peg their currency to the US dollar, which is the dominant international money, as a monetary anchor against unwanted domestic deflation. If any one of them was to yield to this external pressure, their currency would appreciate sharply

    Table 6: Trend in Foreign Exchange Reserves of Select Countries*

    1971 1981 1991 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
    All world of which 1 Japan 2 China 3 Taiwan 4 Korea 5 India 6 Hong Kong 7. Singapore 1 Japan 2 China 3 Taiwan 4 Korea 5 India 6 Hong Kong 7 Singapore 95 15 .. .. 1 1 .. 1 6.4 .. .. 10.2 1.5 .. 44.9 384 28 5 7 3 5 .. 8 2.4 1.7 14.5 4.3 2.6 .. 57.6 992 72 44 82 14 4 29 34 2.0 11.3 45.9 4.8 2.7 33.6 75.3 1,473 183 75 90 33 18 55 69 3.8 10.8 34.0 6.4 6.4 39.1 81.7 1,647 217 107 88 34 20 64 77 5.0 13.1 31.5 6.4 6.2 40.8 82.7 Reserves in US $ billion (end period) 1,707 1,758 1,885 2,028 220 215 287 355 143 149 158 168 83 90 106 107 20 52 74 96 25 27 33 38 93 90 96 108 71 75 77 80 Reserves as per cent of GDP 5.5 4.9 5.8 8.0 15.8 15.7 15.9 15.6 28.6 33.0 36.8 34.6 7.0 12.9 15.9 21.0 7.1 7.3 7.9 9.0 53.5 54.3 60.0 65.1 84.3 90.8 91.7 86.9 2,149 395 216 122 103 46 111 75 10.3 18.6 43.4 21.7 10.2 68.3 90.6 2,525 461 291 162 121 68 112 82 11.1 23.2 57.5 21.0 13.7 69.9 90.1 3,156 663 408 207 155 99 118 96 14.3 29.2 72.3 25.6 16.8 75.3 102.3 3,857834 614 242 199 127 124 112 18.0 37.2 75.7 26.5 18.4 76.1 104.9
    Notes: * Excludes gold. .. Not available. Source: International Financial Statistics, IMF.
    Economic and Political Weekly February 11, 2006 519

    causing it to lose mercantile competitiveness followed by a slowdown of economic growth and, if repeated, followed by outright deflation. The upshot is that official foreign exchange reserves just accumulate indefinitely as a residual that is subordinate to the exchange rate objective.

    Adequacy of Foreign Exchange Reserves

    Traditionally, the adequacy of reserves is determined by months of import cover (stock of reserves to volume of imports), with three or four months regarded as adequate. This measure implicitly assumes a time frame to successfully overcome a short-term shock in external payments. But in the case of south-east Asian countries, during the crises of 1997, an import cover of a few months was inadequate to absorb the shock. In addition to the experience of 1997, many changes in international financial markets since then have led to new measures of adequate reserves. The most prominent of these is the Guidotti rule (1999), which, though modified over the years, continues to stress that liquid reserves sufficient to meet external obligations for about a year without any external assistance be maintained. A cross-country comparison of the major adequacy indicators is presented in Table 8 (trend data from 1971 are presented in the Appendix Table). In terms of the adequacy ratios, except for import cover, India’s reserves are modest when compared with those of other countries.

    Use of Foreign Exchange Reserves: International Experience

    International experience in the deployment of FER is scant (Appendix Note). Of three important cases, the experience of Singapore, spanning nearly a quarter of a century, is most interesting. In Singapore, the Monetary Authority of Singapore (MAS) and the government of Singapore Investment Corporation (GIC) basically manage FER. GIC is the government’s principal investment agent, handling the bulk of the nation’s investments while the MAS holds reserves to maintain the stability of the Singapore dollar. GIC, incorporated in May 1981 as a private company and wholly owned by the government, manages more than US$ 100 billion of FER, as of 2005, owned by the government and MAS. GIC, with investments in more than 30 countries, is among the largest fund management companies in the world and has overseas offices in key financial centres including New York, London, Tokyo and Hong Kong. The GIC group comprises four main areas – public markets, real estate, special investments and corporate services – and a diversified portfolio of equities, bonds, real estate and money market instruments. The financial results of GIC are unavailable but according to Loong (2001), since inception, GIC’s portfolio returns in US dollars have exceeded 5 per cent annually. McKinnon (2005) argues that the small size of Singapore has helped GIC to successfully operate in international markets without being visible and that if China or Japan were to set up similar investment institutions, they would impact global markets. However, on the pattern of the GIC, South Korea has established the Korean Investment Corporation (KIC) in June 2005, which began its operations with a capital of US$ 20 billion. Malaysia, according to newspaper reports, is also planning to set up a similar investment corporation.

    Another interesting case is China, where FER have been utilised to strengthen the banking system without foreign securities being sold. China has transferred funds from its international reserves, held with the Peoples’ Bank of China (PBC) to a new company, Central Huijin Investment Company (CHIC), set up in December 2003 and jointly managed by the government and PBC. CHIC has used the reserves to recapitalise three large banks so far, by injecting equity amounting to US$ 57.5 billion – Bank of China (US$ 22.5 billion), China Construction Bank (US$ 22.5 billion) and Industrial and Commercial Bank of China (US$ 12.5 billion). The strengthening of financial institutions, among other developments, have prompted some global banks to bid for a share

    Table 8: International Reserves and Adequacy Ratios

    1995 2004 R/RM R/BM R/GDP MC R/RM R/BM R/GDP MC Per Cent Month Per Cent Month

    Japan 36 4 4 7 75 131821 China 31 1011 7 82 20 31 13 Taiwan 150 19 34 10 448 38 76 19 Korea 87 17 6 3531 382711 India 44 15 6 8125 28 18 16 Hong Kong 517 23 39 3 325 28 75 5 Singapore 570 95 82 7 840 89 99 8

    Notes: * Foreign exchange reserves excluding gold, as at end of the year. R = Reserves, RM = Reserve Money, BM = Broad Money (M2), MC = Import Cover.

    Source: International Finance Statistics, IMF.

    Table 7: Differential Real Interest Rates with the US in Select Countries

    (Per cent)

    1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

    Deposit rates Japan 0.3 0.7 -0.9 -2.5 -2.2 -4.1 -4.1 -2.2 -2.3 -1.7 -1.5 .. .. China -0.2 -7.5 -11.6 -6.3 -2.6 0.9 1.5 0.7 -2.1 -1.4 0.2 0.8 .. Korea 1.0 -4.5 -1.8 -2.5 -1.1 2.2 3.1 4.1 2.9 -0.9 -0.4 1.5 0.8 India 2.9 0.5 -1.9 -1.9 2.1 2.3 -0.4 3.7 2.7 3.4 1.8 3.0 2.7 Hong Kong -8.0 -7.1 -5.9 -0.7 -4.8 -3.7 2.1 6.5 6.7 1.1 1.4 6.2 2.4 Singapore -0.6 -2.0 -2.2 -2.5 -1.2 -0.9 2.5 2.5 -6.8 0.0 -2.0 0.9 ..

    Lending rates Japan 0.5 0.1 -0.9 -2.8 -2.8 -4.7 -4.8 -2.7 -3.1 -3.0 -2.5 1.4 .. China -1.7 -10.3 -14.1 -8.1 -2.9 1.1 1.3 1.7 -1.3 -1.1 0.7 1.2 .. Korea -1.6 -7.3 -4.3 -5.2 -2.7 0.5 2.3 3.0 0.7 -2.3 -1.5 0.5 0.1 India 6.2 3.0 0.3 -0.4 2.1 0.4 -1.6 2.1 1.7 2.2 2.3 5.2 5.3 Hong Kong -7.1 -5.7 -3.5 -0.5 -3.8 -3.0 1.6 7.9 8.6 0.5 3.2 8.2 4.6 Singapore -0.1 -1.7 -1.8 -2.5 -1.2 -0.9 2.6 4.0 -5.5 0.8 -0.5 2.7 ..

    Notes: The difference of real interest rates as compared with the US. GDP deflator has been used to measure the real interest rates. .. Not available. Sources: International Financial Statistics, IMF and Handbook of Statistics on Indian Economy, RBI.

    Economic and Political Weekly February 11, 2006 in the ownership of two of these institutions – Goldman Sachs is reported to be bidding for US$ 1 billion in the Industrial and Commercial Bank of China and Bank of America for US$ 3 billion in the China Construction Bank. The other global banks keen to acquire assets in Chinese banks, according to recent press releases, are HSBC, Citigroup, Bank of Nova Scotia, Standard Chartered and Commonwealth Bank of Australia.

    In still another, though dissimilar case, a portion of FER is assigned to a specialised fund for investment. The daily accruals of FER in Norway are split into four sub-portfolios, one of which is the Government Petroleum Fund (GPF); the Norges Bank (NB) manages the capital of the GPF on behalf of the ministry of finance. In NB, Norges Bank Investment Management (NBIM), established in 1998 is responsible for managing the GPF. NBIM’s sole purpose is to function as an investment manager and thereby take advantage of the benefits inherent in being a large institutional investor [IMF 2003].

    III Utilising FER for Infrastructure

    There is considerable consensus that improvements in India’s infrastructure would have a strong impact on GDP growth, but also that a prudent policy to finance it would be necessary. The infrastructure sector covers the services of transportation (railways, roads and road transportation, ports, and civil aviation), communications (telecommunications and postal services), electricity and other services such as water supply and sanitation, solid waste management, and urban transport. At present, significant fiscal problems have been noted in the infrastructure sector – persistent underperformance of revenue effort with unsustainable tariff structures and non-transparent subsidy schemes. In terms of financial aspects, many organisations providing infrastructure services lack creditworthiness, with opaque financial and accounting systems and limited treasury management systems. The country also lacks independent regulatory capacity to oversee the operations of private participants, ensure social obligations of the government, in particular to the poor sections of the society, and ensure application of environmental standards. The prevailing labour laws are restrictive,6 dispute resolution is slow,7 and transparency and public disclosure are lacking in the absence of focused rules, orders and regulations.8 Therefore, there are concerns and issues that need to be considered before utilising FER to finance infrastructure.


    In view of the above discussion, the most important question for India is: How sustainable are current account surpluses and capital inflows over the longer term? First, in a developing country, the current account is generally expected to be in deficit, but India recorded a surplus during 2001-04, mainly on account of export earnings from CSSE and IRWA. The surplus on the current account could not be expected to last long, and in 2004-05, with the revival of growth in the domestic industry and higher oil prices in international markets, the current account recorded a deficit of US$ 6.4 billion, or 1 per cent of GDP. Secondly, India was a financially repressed economy for many decades until 1991, which generally implies that residents might have held a part of their wealth in international markets. In recent years, with continued emphasis on liberalisation in the reform

    Figure 2: Changes in Foreign Currency Assetsand Other Macro-Aggregates in India

    Per cent

    Inflation i lIndustrial Differential GDP t lFCA (right scale)

    10 408 306 204 102

    0 1999 2000 2001 2002 2003 2004


    Notes: Interest differential refers to the gap between the real lending rates of

    India and the US. Sources: International Financial Statistics, IMF and Handbook of Statistics on

    Indian Economy, RBI.

    process, there is a strong possibility that such offshore capital might be returning to India as a part of a one-time portfolio realignment [Dooley 1997]. This reverse flow, however, cannot be assumed to last. Thirdly, the increase in foreign currency assets (FCA) has occurred not only because of strong fundamentals of the economy – consistently high growth rates and low inflation

    – but with real interest rates higher than those prevailing in the US (Figure 2). The rise in interest rates in the US could reverse this trend [Reddy 2002]. Finally, a significant component of accumulated reserves could be sensitive to economic and political developments in India. Gordon and Gupta (2004) report that outstanding deposits from non-resident Indians (23.4 per cent of total reserves outstanding) are sensitive to adverse domestic and external events.

    Another related concern is the quantity and quality of inflows. As a result of the external sector reforms since 1991, India has been able to attract more foreign portfolio investment (FPI) (outstanding amount at US$ 43.9 billion as on March 31, 2004) than foreign direct investment (FDI) (outstanding amount at US$ 38.7 billion as on March 31, 2004).9 India, in seeking to accumulate reserves as well as to globalise, has been encouraging foreign participation by liberalising investment regulations in various economic activities, including banking and insurance, especially since 1998. Further, with increasing level of FER, it may become necessary to adopt a cautious approach toward capital inflows, especially FII inflows from tax havens, to ensure financial sector stability [Reddy 2005].

    Thirdly, if the primary objective in accumulating FER is the precautionary motive with liquidity as an important feature of investment, then it may be inappropriate to use reserves for financing infrastructure. Infrastructure projects have long gestation periods and generally require substantial investment but yield low returns on account of a low user charges in India, inefficient technology and archaic labour laws. In fact, many infrastructure projects operating in India yield negative returns. For example, the performance of the electricity boards continues to be dismal despite specific power sector reforms initiated since 1991. The state electricity boards have continued to record negative rates of return ranging between 13 and 38 per cent during 1991 to 2005, and the difficulties in raising user charges on electricity have continued to deter private participation in power sector projects despite concerted efforts [GoI 2005].10 In most of the states, transmission and distribution losses, mainly because of low quality equipment and theft, range between 30 and 50 per cent in 2002 (latest data available) and in some cases reach 62 per cent (for example, Manipur) [GoI 2004]. The losses in power distribution account for over 1 per cent of GDP in 2004-05 [GoI 2005].

    Finally, some important concerns relate to the political economy aspect of a federal structure. Provincial governments also may seek such extra-budgetary resources for urgent public work projects under their administration. In that eventuality, prudent management of overall government finances, both federal and provincial, could then become difficult, as was the recent experience of some countries in Latin America, especially Argentina. Even in India, with the onset of reforms in 1991 and tightening of budget constraints, state government guarantees sharply rose from 4.4 per cent of GDP in 1996 to 8.0 per cent in 2001, when urgent measures were initiated to stem the rise [Singh 2005a]. Secondly, in a multiparty coalition democracy, a soft-budget scheme, though imaginative, is susceptible to exploitation. In India, the scheme of ad hoc treasury bills initiated innocuously in 1955 and repeatedly abused until 1997 is an interesting illustration.11 The strong fiscal-monetary nexus adversely affected the operations of the monetary policy. The share of the monetised deficit in the gross fiscal deficit of the central government ranged between 30 and 43 per cent during 1978

    91. The monetised deficit, on average, accounted for more than four-fifths of reserve money during 1970-99, and exceeded 100 per cent during 1980-91. Thirdly, the confidence of the markets could be adversely affected if FER-financed projects are delayed or abandoned for economic (for example, cost over-runs, introduction of labour-offsetting technology) or political (for example, opposition to the project initiated by the previous political party in power, labour reforms) reasons.


    India has always maintained, transparently, that it intervenes in the market to contain volatility in the exchange rate. Hence, given the official policy stance, the objective of exchange rate management cannot be altered and should rather be accepted as a policy tool of the RBI. However, given the increase in FER, many liberal measures for the free flow of capital across the borders have been initiated, though capital account convertibility has not yet been adopted. Some of the important measures are

    – substantial expansion of the automatic route of FDI abroad by Indian residents; provision of greater flexibility to corporates to pre-pay their external commercial borrowings; permission to commercial banks to liberally invest abroad in high quality instruments; prepayment of external debt; and adoption of LIBORlinked interest rates on non-resident rupee deposits. Further, to accommodate the accumulation of reserves without having an inflationary impact, the RBI has aggressively been conducting open market operations and adopting other measures to sterilise the inflow. However, as sterilisation measures are expensive, and FER continue to rise, alternatives need to be explored.

    The country experiences discussed earlier suggest alternative ways to utilise FER. First, financial institutions in India are already relatively healthy with low non-performing assets and adequate (relatively) credit-adequacy ratios; therefore the use of FER as per the Chinese pattern, may not be necessary. Secondly, the key objective of the Singaporean pattern is to enhance the return on investment. This objective can safely be pursued, if the reserves are large relative to the size of the economy and the liquidity of investment is not the primary objective for holding reserves. Also, in Singapore, the flow of FDI is very high compared with FPI. In the case of India, until it adopts a new primary objective of seeking higher returns on its reserves (implying a shift from the traditional objectives of safety and liquidity), the Singaporean model may be unsuitable. Finally, even the application of the Norwegian pattern to India may be inappropriate. In India the accumulation in FER is mainly emanating from CSSE. The competitive edge that India enjoys at present in CSSE may not last, with stiff competition emerging from China, Russia, Philippines, and other countries. Therefore, it might seem beneficial to consider allocating a part of the monthly accrual of FER, into a fund, managed by the RBI, to be used for the benefit of future generations, as envisaged in the objectives of the Norwegian GPF. But this policy would adversely impact the liquidity of reserves. In addition, money is fungible, and maintaining a separate fund for future generations or maintaining a separate investment pattern for the fund may not be a practical proposition in a crisis. And most importantly the economic situation of Norway differs from India in many aspects – Norway enjoys close ties with the European Economic Area, which permits free movement of goods, services, persons and capital. In contrast, India, still an emerging economy, faces stiff competition in the region, and would need to focus on its objectives of safety and liquidity of FER to maintain stability and confidence in the markets, necessary for high economic growth.

    Finally, ad hoc use of FER to finance infrastructure, as proposed in the Union Budget, could hinder the operations of monetary policy and result in higher public debt. As stressed by Aizenman et al (2001), financial engineering that ignores fiscal fundamentals cannot lead to healthy economic growth. The use of FER for infrastructure would expand the money supply (foreign currency assets would be sold for Indian rupees) normally requiring sterilisation by the RBI to stabilise the price level. Sterilisation is expensive, as the government rupee bonds issued to mop-up excess funds have to be serviced at the prevailing market interest rates. The supply of the “mop-up” bonds increases domestic debt

    – the issuance of which could be used to finance infrastructure in the first place. In discussions with experts on this issue, two views, both guarded, emerge, which are as follows:

  • (a) Richard Cooper,12 in principle, though cautiously, agrees that “excess” foreign exchange reserves could be used for productive purposes, if capital goods were sourced from abroad to avoid any short-term macroeconomic effect, or placed in long-term investment abroad. Cooper observes further that the reserves are India’s assets, in this case held in liquid claims on foreigners. If adequate liquidity is maintained, where “adequate” includes the various dimensions prudently decided by the authorities in India, then anything beyond that might be better placed in other assets that lack liquidity but yield higher returns. An extension of this idea would be to invest in foreign-produced capital goods that might be used productively in India. There would be no shortrun macroeconomic effect so long as the goods were purchased abroad, and imported, and therefore no “inflationary” effect. However, imports of capital goods could definitely affect the domestic industry/service sector within the economy.
  • (b) Ronald McKinnon13 argues against using foreign exchange reserves to fund domestic expenditures. Rather than spending official foreign exchange reserves domestically, it would be better, but perhaps still not desirable, to finance new infrastructure
  • Economic and Political Weekly February 11, 2006

    investments by issuing government rupee bonds directly, implying a transparent and direct budgetary transaction. Using foreign exchange round tripping disguises the true nature of the transactions and confuses the operation of monetary policy. McKinnon explains further that reserve accumulation occurs because private parties are net sellers of dollars for rupees at the existing exchange rate. To prevent undue appreciation of the rupee, the RBI is then forced to intervene to buy the excess dollars overhanging the market. This creates excess base money in rupees that could be inflationary unless the RBI sterilises the monetary consequences by selling domestic bonds to remove liquidity from the market. If these official dollar reserves acquired by the RBI are then recycled back into the foreign exchange market to finance domestic infrastructure investments, the RBI must then repurchase the dollars (to maintain its exchange rate obligation) to prevent further appreciation of the rupee. The incidental effect of this round tripping would be to further expand the monetary base

    – necessitating sterilisation through further sales of government bonds by the RBI. The net result is that new issues of government bonds in rupees are really financing the infrastructure investments. However, the foreign exchange side effects make domestic monetary management more difficult.

    IV Conclusions

    The policy to build an adequate level of FER in India has been based on a number of considerations – the current account position and size of short-term liabilities, and the composition, source and risk profile of capital flows. The reserves have succeeded in infusing necessary confidence, both to the markets and policy makers. However, neither the capital inflow to India nor the size of FER is significantly large when compared with some other countries in the region. The sources of accretion to FER are mainly CSSE, IRWA, and portfolio investments – not FDI (which is more stable) as in the cases of China and Singapore. Therefore, India, which is accumulating FER for precautionary and safety motives, especially after the embarrassing experience of June 1991, should avoid utilising reserves to finance infrastructure. Infrastructure projects in India yield low or negative returns due to some difficulties – political and economic – especially in adjusting the tariff structure, introducing labour reforms and upgrading technology. The use of FER to finance infrastructure may lead to more economic difficulties, including problems in monetary management. However, if India continues to accumulate reserves and seeks to enhance the returns on FER in the future, it may consider establishing a separate investment institution on the pattern of the GIC.

    Appendix Note: Cross-Country Experience

    Singapore: The Government of Singapore Investment Corporation (GIC) incorporated in May 1981 as a private company and wholly owned by the government, manages more than US$ 100 billion of FER owned by the government and the Monetary Authority of Singapore. The motivation to set up a specialised investment agency resulted from the rapid growth of foreign reserves in the 1970s. GIC groups comprise four main areas – public markets, real estate, special investments and corporate services. GIC measures its performance in two main ways. First, it has a wealth enhancement objective, which is to achieve a real rate of return over and above G3 inflation (US, Japan and Germany). Secondly, GIC benchmarks the performance of its investment groups against the relevant industry indices. GIC submits its financial statements and budget to the president of Singapore. The documents are also audited by the auditor-general’s office. China: (Used 10 per cent of international reserves to recapitalise state banks.) (1) In December 2003, the government injected US$ 45 billion (4 per cent of GDP) into two state banks. The transaction is as follows – (a) The central bank (People’s Bank of China, PBC) transferred funds from its international reserves (mostly US treasury securities) to a newly established company, the Central Huijin Investment Company (CHIC), jointly managed by the ministry of finance (MOF), PBC, and the State Administration of Foreign Exchange. (b) In the PBC’s balance sheet, the US$ 45 billion foreign exchange reserves were replaced by claims on the Central Huijin Investment Company. (c) The company used the assets to purchase shares in the Bank of China and the China Construction Bank, each of which received $ 22.5 billion. (d) Both banks are to retain the foreign currency assets on their balance sheet for about three years.

    (2) Another state bank recapitalisation using PBC Reserves was announced in April 2005. The Industrial and Commercial Bank of China, the largest bank in China, will receive a capital injection of US$ 12.5 billion through CHIC, in an operation similar to that used in December 2003. It will receive a similar amount directly from the MOF. Korea: (Plans to transfer 10 per cent of international reserves to an investment fund.) The Korea Investment Corporation (KIC) is modelled on Singapore’s GIC. The KIC would initially manage US$ 20 billion, of which US$ 17 billion of reserves from the Bank of Korea (BOK). More funds could be transferred in the future and the fund’s operations will be evaluated in 2008. The expectation is that by outsourcing the investments, the KIC would attract foreign asset managers to Seoul, eventually making the city an important financial centre in Asia. Under current plans, the BOK will retain the foreign exchange reserves as assets in its balance sheet (the KIC acts as asset manager and the BOK has a call option on the resources). The KIC is restricted from investing in domestic stocks, corporate bonds, and real estate, to safeguard the liquidity of reserves and minimise risks. Pakistan: (Put 30 per cent of international reserves under private sector management.) The State Bank of Pakistan (SBP) will put a portion of its reserves under private arrangement. The private firm will have to train the staff of the SBP. The SBP contracted an asset-management firm in Singapore to manage US$ 3.2 billion of its reserves in 2005.The funds continue to be treated as reserves and liquidity and low risk are priorities in the investment strategy. Increasing return is a secondary goal. Investments have to be AA on average, with a minimum rating of BBB. The contract also provides for training to be given to SBP staff, and the SBP expects to do in-house management of reserves at some stage. Taiwan: (Plans to use US$ 10 billion of reserves to finance infrastructure.) Taiwan is planning to set-up an investment company like the GIC of Singapore. The amount of such investment will be used to finance infrastructure in Taiwan. France: (Plans to sell about one-sixth of central bank gold to finance employment.) This operation is part of an agreement among European central banks to sell part of the gold they hold as reserves. The central bank (BDF or Banque de France) will sell 500 tonnes of gold (about US$ 7 billion) to buy international currencies over the course of the next five years. Annual profits from the operation, estimated at about US$ 250 million, will be transferred to the budget each year. Venezuela: (Directed 10 per cent of oil export receipts to a development fund.) The government plans to create a fund using oil revenue to finance infrastructure. Venezuela implements capital controls requiring all foreign exchange income to be deposited at the central bank. Part of the dollars earned by the state oil company are however directly allocated to a new development fund. Some estimates indicate that US$ 2 billion have been redirected to the fund so far. The objective of the fund is to invest in roads, ports and social projects, although no financing has yet started. Norway: In Norway, the Government Petroleum Fund was established in 1990 with a goal to smooth short-term variations in oil revenues and also to cope with the long-term challenge of funding pensions in the face of declining oil revenues. The ministry of finance is responsible for the fund, which is managed by Norwegian central bank, Norges Bank, according to the guidelines issued by the ministry. The fund is invested in a broad-based portfolio of international securities but cannot invest in hedge funds, private equities, real estate and Norwegian equities. The size of the fund at the end of 2004 amounted to US$ 138 billion and the fund earned a return of 8.9 per cent in 2004.




    [I am thankful to Stanford Centre for International Development for the financial support during my stay at the centre and while working on this project. I am thankful to Robert J Barro, Richard Cooper, Nicholas Hope, K Kanagasabapathy, Ronald I McKinnon, Jerald Alan Schiff, Nirvikar Singh and T N Srinivasan for insightful and detailed suggestions. I acknowledge and appreciate the research assistance of Chin Lum Kwa in preparing the appendices.]

    1 Rodrik (1998) observes that capital account convertibility should not be thrust on every country as it may worsen the economic situation.

    Appendix Table

    Country First Reporting Last Reporting 1971-75 1976-80 1981-85 1986-90 1991-95 1996-00 2001-04
    Year Year
    Foreign exchange reserves as a per cent of GDP
    China 1979 2003 .. .. 4.6 5.7 8.1 15.2 23.7*
    Hong Kong 1990 2004 .. .. .. .. 36.5 54.7 72.1
    India 1971 2003 1.6 4.5 2.8 2.1 4.8 7.5 13.6*
    Japan 1971 2003 4.1 2.7 2.1 2.7 2.5 5.8 11.9*
    Korea 1971 2004 4.4 6.1 3.4 5.0 5.8 12.7 23.7
    Saudi Arabia 1971 2003 29.4 30.2 25.2 23.2 6.8 9.9 10.5*
    Singapore 1971 2003 57.1 58.6 57.4 69.4 80.4 87.3 94.3*
    UAE 1973 1998 6.3 8.1 9.5 17.6 17.7 18.6** ..
    UK 1971 2003 3.9 5.0 3.9 5.0 4.4 3.0 2.6*
    US 1971 2004 1.0 0.9 1.0 1.2 1.1 0.8 0.7
    Foreign exchange reserves as a per cent of reserve money
    China 1985 2004 .. .. .. 19.2 22.1 36.8 59.9
    Hong Kong 1990 2004 .. .. .. .. 469.3 556.7 342.9
    India 1971 2004 15.3 37.2 21.8 14.1 32.8 54.5 104.1
    Japan 1971 2004 42.2 28.0 23.0 26.3 24.8 43.1 63.4
    Korea 1971 2004 43.1 57.2 56.7 68.1 75.3 258.9 444.1
    Saudi Arabia 1971 2004 502.8 276.5 231.1 150.5 57.8 98.2 112.0
    Singapore 1971 2004 362.9 323.5 336.6 390.5 517.1 662.1 759.5
    UAE 1973 2004 173.2 145.8 164.2 166.8 164.0 151.8 135.2
    UK 1971 2004 46.8 77.2 93.0 116.7 111.8 84.8 73.9
    US 1971 2004 14.4 14.4 18.0 20.5 19.4 13.3 11.0
    Foreign exchange reserves as a per cent of broad money
    China 1985 2004 .. 3.9 9.8 8.2 8.4 11.5 15.0
    Hong Kong 1990 2004 .. .. .. .. 21.4 27.5 28.7
    India 1971 2004 6.2 12.8 7.1 4.7 10.7 14.8 23.3
    Japan 1971 2004 4.8 3.1 2.3 2.5 2.3 5.0 9.9
    Korea 1971 2004 13.0 18.9 9.9 13.2 14.6 22.5 31.9
    Saudi Arabia 1971 2004 311.3 173.0 76.7 39.5 14.0 21.2 20.6
    Singapore 1971 2004 94.4 94.1 82.8 81.0 89.4 85.0 82.1
    UAE 1973 2004 30.3 30.4 27.2 28.8 32.8 35.5 30.2
    UK 1971 2004 9.9 15.0 10.1 6.6 4.9 3.3 2.1
    US 1971 2004 1.6 1.4 1.7 1.7 1.9 1.4 1.1
    Import cover of foreign exchange reserves in months
    China 1977 2003 .. 2.8 6.1 4.6 5.3 10.9 13.1*
    Hong Kong 1990 2004 .. .. .. .. 3.5 5.5 6.2
    India 1971 2004 4.4 8.1 4.5 3.7 7.0 8.7 14.8
    Japan 1971 2004 5.4 3.1 2.3 4.9 5.0 9.3 17.8
    Korea 1971 2004 1.8 2.3 1.2 2.1 2.7 5.1 9.9
    Saudi Arabia 1971 2004 39.1 18.4 10.1 10.5 3.6 6.7 7.5
    Singapore 1971 2004 5.2 4.1 4.2 5.2 6.5 7.6 8.3
    UAE 1973 2000 3.0 3.3 4.2 6.4 4.2 4.1 ..
    UK 1971 2004 2.4 2.5 2.2 2.6 2.4 1.6 1.4
    US 1971 2004 2.3 1.3 1.4 1.6 1.5 0.9 0.7
    Notes: .. Not available, * ending period 2003, ** ending period 1998.
    Source: International Financial Statistics, IMF.
    524 Economic and Political Weekly February 11, 2006

    Aghion et al (2003), argue that economies at an intermediate level of financial development are less stable than either very developed or underdeveloped economies. These economies may be destabilised by capital account liberalisation.

    2 India had a fixed exchange rate from 1947 till 1975 with the currency pegged to the pound sterling. From 1975 to 1991, the exchange rate of the rupee was adjusted regularly on the basis of the weighted average of the exchange rate movements of the currencies of India’s major trading partners, with the pound sterling as the intervention currency. The rate was adjusted downward in two stages on July 1 and 3, 1991 to effect about 18 per cent reduction in the external value of the rupee. The exchange rate regime, soon thereafter transited from a basket-linked managed float to a market-based system in March 1993, after a short experiment with a dual exchange rate between March 1992 and February 1993.

    3 Holdings of FER are associated with trade openness [Aizenman and Marion, 2002a and 2002b].

    4 India employed a currency-basket to determine its exchange rate during 1975-91; the five major currencies in the basket were the pound sterling, US dollar, Japanese yen, German mark and French franc. These currencies can safely be assumed to continue to dominate the currency composition of India’s holdings except that the franc and mark have been replaced by the euro.

    5 Goldberg and Tille (2005) drawing on data on invoice currency use in exports and imports for 24 countries, report that the US dollar dominates in the invoicing of world trade, both because the US is an important consumer and producer in world markets, and because of its use in invoicing many products that are traded on organised exchanges. Similarly, McKinnon and Schnabl (2004) argue that almost all the intra-regional trade in east Asia is invoiced in US dollars, except when the trade is directly with Japan. Eichengreen (2005) argues that in the foreseeable future (20 to 40 years), the dollar and the euro will share reserve-currency status.

    6 There are 45 central acts, which directly pertain to labour alone. Beyond this there are other acts, which indirectly concern labour. This large body of law has led to many inconsistencies [GoI 2005].

    7 There are 23 million cases pending in the courts as the number of judges are 10 per million while OECD countries have 50 to 100 judges per million. Since 1995, only 90 per cent of the new cases are disposed, so the backlog continues to steadily rise [GoI 2005].

    8 There are 3,500 central laws and about 35,000 state laws, in addition to subordinate legislation. Some of the laws go back to 1836. Old laws tend to have clauses that are incompatible with modern India.

    9 FDI inflows are stable as compared with FPI [Itay and Razin 2005; Lipsey, 2001, Dadush et al 2000].

    10 To attract private investment in the power sector, the return on equity, for costing and pricing of power projects was fixed at 16 per cent in 1995 though for the public sector it is notionally fixed at 12 per cent.

    11 In January 1955, an administrative arrangement for ensuring a minimum balance in the accounts of the GoI was finalised between the RBI and the GoI. Under the arrangements, it was agreed that the GoI would maintain a certain minimum cash balance with the RBI, and when the balance falls below the minimum agreed limit, the account would be automatically replenished by the creation of ad hoc treasury bills in favour of the RBI. However, over time, issuance of ad hoc treasury bills became a permanent and increasing means of financial support to the GoI from the RBI. The automatic monetisation of the fiscal deficit, representing unlimited borrowing from the RBI, severely restricted the operation of monetary policy. The amount of ad hoc treasury bills rose from an earlier negligible amount to 2.4 per cent of GDP in 1982, 6.1 per cent in 1987 and 12.0 per cent in 1991. As can be noted, these ad hocs were held within the RBI and constituted a significant component of reserve money

    – 19.0 per cent in 1982, 44.4 per cent in 1987 and 77.3 per cent in 1991. Thus, with the initiation of financial sector reforms in 1991, it was considered necessary to limit the issuances of ad hocs from 1994 and discontinue them from 1997 [Singh 2005b].

    12 Richard Cooper, Harvard University, private correspondence. 13 Ronald McKinnon, Stanford University, private correspondence.


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