India has more than doubled its foreign exchange reserves in the past two years. Isn't it time the country launched a sovereign wealth fund?
According to an RBI report of March 2008, India's foreign exchange reserves have accumulated to a massive $309.7 billion. (The global financial crisis has since had an impact on the level of India's forex reserves—as on September 26, 2008, the reserves stood at $291 billion) The fact of the matter is India has more than doubled the reserves in the last two years alone. A proud symbol of a strengthening external account at one time, the overflowing coffers of RBI now raise the question whether it is prudent on the part of the ministry of finance and the central bank to continue to hold these reserves and not invest them in high yielding assets. Our analysis shows that India will benefit by launching its own sovereign wealth fund to profitably deploy its excess reserves.
Most of the discussions on SWFs in India have in part been influenced by the global debate surrounding the governance and transparency of SWF investments and has, therefore , focused on institutionalising SWF investments into the country. Any suggestion towards investment of our reserves through an Indian SWF, however, gets arrested by an uncertainty regarding the adequacy of reserves . While acknowledging the humongous quantity of reserves, experts—including former RBI governor YV Reddy—have in the same breath expressed their concerns about a volatile capital account, high current account deficit and its vulnerability to oil prices. A comprehensive analysis, however, shows that India's reserves are adequate by all standards even after accounting for these concerns.
According to IMF guidelines, the forex reserves of a country should be sufficient to meet 3-4 months of its import requirements. In India's case this import coverage is for 14 months. Further, according to the Greenspan-Guidotti rule proposed by former Fed chief Alan Greenspan, the reserves should be no less than the short term debt liabilities of the country. India is secure by a large margin on this ground as well. Its short term debt totals to less than 15% of the reserves amount.
Some other empirical tests, such as that proposed by Icrier researcher Abhijit Sengupta , also prove the adequacy of India's reserves. According to a regression model that accounts for various influencing parameters, including capital account openness, share of imports, exchange rate flexibility, and even political stability, India had excess reserves worth $106.6 billion in 2007. Further, in order to address concerns regarding oil prices' impact on current account position, we conducted a scenario analysis to predict the level of import coverage (in months) in 2011 under various possibilities of oil prices, up to a maximum of $200/barrel. We find that in the worst case scenario assumed, India, even with its current reserve position, will have import coverage of more than nine monthsstill higher than the IMF benchmark of month months.
Thus it is unambiguously proven that India's forex reserves are indeed adequate and should be considered for more profitable investments than the risk-free , low-yielding US treasury bills. What further strengthens the case is the huge cost incurred in holding the reserves. RBI earned an average 4.6% return on its T-bills investment in 2006-07 . When adjusted for the average inflation of 5.4% in the same period it translates into negative return or a holding cost.
It is sensible to launch an SWF as a viable and profitable investment strategy. Contrary to popular belief, India is placed better than at least some of the SWF home nations on a comparison of macroeconomic parameters. For example, Norway had a current account deficit of more than 4%, higher than the less than 2% deficit of India, just two years before the launch of its fund. Similarly, in terms of the ratio of total short term debt to external debt, India fairs much better than China and Korea, both of which had this ratio in excess of 40% as against 15% for India. Thus, on comparative grounds India is favourably placed to join the elite league of SWF nations.
On absolute terms too, the returns earned by existing SWFs make this option attractive. Government Pension Fund of Norway posted a return on equity of 12.67% in 2007-08 . China Investment Corporation (CIC) of China and Abu Dhabi Investment Authority of UAE have locked in returns of 9% and 11% respectively through investments in fixed return convertible debt securities of distressed investment banks Morgan Stanley and Citigroup. Evidently, investing through an SWF can earn India a much higher return than the meagre 4-5 % currently earned on US T-bills.
Another reason why India should launch its SWF is, it can potentially attain some of its strategic objectives through this vehicle. The Indian SWF may invest to secure energy assets for the future through such companies like ONGC-Videsh or finance the import requirements of Indian infrastructure companies . Although the current climate for accomplishing strategic objectives through an SWF is unfavourable, if done gradually, with full disclosure and in a manner aligned with the evolution of common guidelines for SWFs, India can hope to achieve some of its most critical sectoral objectives.
Finally, owing to its emergence as a global trend, especially amongst its emerging economy peers, launching an SWF has become almost a necessity for India and no longer remains an option. SWFs are increasingly being seen, particularly by the west, as the tools of emerging economies to increase their dominance in global financial system. Indeed, by infusing capital to bail out several troubled US investment banks, SWFs have acquired the revered image of a sort-after investor with large investible corpus. India is already lagging behind China, Russia and Brazil—all of whom have either launched or announced the launch of their respective SWFs. As global norms for SWFs crystallise a condition of reciprocity is expected to be imposed on all SWF home nations that will force them to welcome investments from other SWFs. India should act swiftly in this regard too.
Our analysis shows that India can sequester a maximum of $56 billion for investment through the SWF. This figure is equivalent to the long term portion (after removing portfolio money and short term debt) of excess forex reserves, calculated as the difference between the reserve level predicted by a regression model (that accounts for multiple influencing parameters) and the actual reserve level. After due consideration of the SWF management structures adopted around the world, it can be concluded that Korea's structure will be most suited to India. A steering committee comprising of civil experts overseeing a team of external professional fund managers should be entrusted the responsibility of managing the fund. Appropriate vigilance, audit and compliance committees should be assigned the task of regulating the functioning of the fund. Finally, given the time required to make the necessary regulatory and institutional arrangements for the fund, and also the fast-catching pace of SWFs as a global trend, it will be in the best interest of the country to act on the formation of an SWF right away.