Recently, surpassing $2 trillion, China’s foreign exchange (forex) reserves make up close to one quarter of the total reserves in the global economy. Though a pittance compared with China’s reserves, India’s forex reserves have grown healthily over the last decade and a half and are in many ways a reflection of our success as an economy. With close to $260 billion—approximately 25% of our gross domestic product (GDP)—in forex reserves, our coffers are extremely well padded to tackle a crisis. But what’s disappointing is the Reserve Bank of India’s (RBI) reluctance to deploy these funds in creative and resourceful ways.
In his book, Making Globalization Work (2007), Nobel Prize winning economist Joseph Stiglitz dedicates a whole chapter to explaining how the global reserve system should be reformed for the greater good of the world economy. After analysing how Asian countries have accumulated significant reserves following the Asian financial crisis, Stiglitz says: “The money put into reserves is money that could be contributing to global aggregate demand; it could be used to stimulate the global economy. Instead of spending the money on consumption or investing the money, governments simply lock it up.”
Not surprisingly, India is a victim of this flawed strategy. RBI’s primary use of forex reserves is twofold: As an emergency fund in case of a fiscal crisis or food crisis, and to help mitigate any significant volatility in the rupee. In its half-yearly Report on Foreign Exchange Reserves, RBI states that, “safety and liquidity constitute the twin objectives of reserve management in India and return optimization becomes an embedded strategy within this framework.” Despite its stated intention, RBI conveniently chooses to ignore how return optimization will be achieved.
There are several ways to measure return optimization of forex reserves. One standard reliable way is to see if forex reserves meet, exceed or lag reserve adequacy ratios.
Some rule-of-thumb reserve adequacy ratios are: sufficient reserves to cover three-four months of imports; reserves that amount to 20% of M2, a broad classification of money supply; a reserves-to-GDP ratio of 10%; and reserves-to-total external liabilities ratio of 100%. Measured against all these global reserve adequacy standards, India’s forex reserves exceed the requirements. Our forex reserves can cover seven-nine months of import; they are at 85-100% of M2; at 25-27% of GDP; and cover our short-term liabilities five-six times over. By this count, the optimal level of forex reserves for India would be somewhere in the $170-190 billion range.
As a start, 10-15% of reserves can be invested in India for various purposes: infrastructure, agricultural loans, educational loans, and so on. Lawmakers and regulators should understand that deploying just $25-30 billion will in no way increase our external vulnerabilities and a sudden outflow of capital would still be manageable.
In fact, the Asian Development Bank endorsed this strategy in early 2008 and encouraged India to use forex reserves to augment infrastructure development. Recently, the India Infrastructure Finance Co. Ltd successfully tapped our forex reserves through its UK subsidiary to fund capital goods purchases for infrastructure projects. So, whether it’s creating special purpose vehicles for investment in India, forming a sovereign wealth fund (SWF) or allocating $100 million each to the best 100 investment ideas in India, the options available to RBI are abundant.
Creative deployment of forex reserves will have political hindrances —SWF investments, for instance, can be badly politicized. But as Stiglitz points out, the current alternative is “governments just (locking) up” these reserves without putting them to work. Old habits, such as investing heavily in government securities and staying satisfied with substandard returns for forex reserve funds, are hard to break.
Adhvith Dhuddu is an asset manager based in India and the US. Your comments are welcome at firstname.lastname@example.org