During the last fiscal year, India added more than $105 billion to its stockpile of international reserves. These reserves are largely held in the form of US government securities or other deposits, which are characterized by very low yields. Consequently, the latest figures indicate that the return on foreign currency assets, after accounting for depreciation, was only 4.6% in 2006-07. With an annual inflation rate of 5.42% during the same period, the real rate of return on these assets was -0.82%.
The trend was similar over the past few years also, with the rates of return on foreign currency assets being consistently lower than the inflation rate.
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Such low rates of return have led many to question the rationale of accumulating a massive volume of reserves. Traditionally, reserve adequacy, that is, how much reserves the central bank should hold, has been measured by using several standard benchmarks, and reserves in excess of such benchmarks have been deemed excess reserves. The most common benchmark used to determine reserve adequacy is in terms of months of import cover, that is, the number of months of imports that can be financed by the existing volume of reserves. Generally, three to four months of import cover has been suggested as being adequate. Another often-used benchmark is the Greenspan-Guidotti rule, which states that sufficient liquid reserves should be maintained to meet external obligations arising within a year without any external assistance.
However, recent research undertaken by the author (Icrier Working Paper 206) illustrates that using a single benchmark of reserve adequacy in isolation to calculate the volume of excess reserves may not be appropriate. The import cover rule as a measure of reserve adequacy fitted in a world where financial markets were not integrated and trade openness reflected a country’s vulnerability to external shocks—the Bretton Woods period.
In today’s world, countries hold reserves for a number of reasons other than immediate current account financing and meeting short-term obligations. For example, the kind of exchange rate arrangement a country follows is a key determinant of the reserves it should hold. Countries whose exchange rate is constant vis-à-vis another country are more likely to hold more reserves to maintain that arrangement than a country that allows the exchange rate to fluctuate. Other factors influencing the amount of reserves include the strength of the financial sector, freedom of foreign capital to move in and out of the country and quality of political institutions.
In India, the current level of reserves is far more than required to meet the above concerns. Even if one takes into account all the above factors influencing the demand for reserves, India would have required only $134 billion by end-June 2007. However, actual reserve holdings were in excess of $213.4 billion at that point in time. Thus, India was holding excess reserves worth $79 billion.
The cost borne by India to hold on to these excess reserves depends on the alternative uses of the resources devoted to reserve accumulation. Assuming an incremental capital-output ratio of approximately 4, the marginal product of capital is going to be significantly higher than the paltry 4.6% return that the reserves were earning. Calculations indicate that by devoting resources to accumulation of reserves, instead of augmenting the physical stock of capital, India was losing nearly $18 billion, or close to 2%, of its gross domestic product (GDP).
Another profitable utilization of the resources used for hoarding these excess reserves is to reduce the short-term external commercial borrowings (ECBs) of the private sector. Since the bulk of these borrowings takes the form of commercial bank lending, there is no direct source of information about the cost. But, the average cost of these borrowings can roughly be approximated to three-month Libor+2.5%.
Instead of employing resources in reserve accumulation, if these had been diverted towards reduction of short-term ECBs, India could have gained more than $2.5 billion last year, or around 0.3% of GDP. A similar gain would have been realized if the resources were used to reduce the stock of public debt on which the government is paying a much higher interest rate than 4.6%.
Finally, every time the dollar weakens against the rupee, there is a significant fall in the rupee value of India’s reserve stock. With the dollar losing ground rapidly throughout 2007, there has been a significant decline in the value of India’s reserves in domestic currency. For example, international reserves worth $100 billion, valued at Rs445 crore in January 2007, were worth only Rs391.3 crore in November 2007—that amounts to a loss of nearly Rs54 crore.
Given these high costs associated with reserve accumulation, there is an urgent need to rethink the strategy of hoarding reserves and investing them in low-yield securities. One of the ways would be to stop accumulating the reserves and invest the resources freed in more profitable ventures, such as those outlined above. However, given the volume of capital coming into India to take advantage of the interest rate differential and its strong currency, a halt in reserve accumulation would cause the exchange rate to appreciate—something our poli-cymakers seem averse to allowing.
Alternatively, the Reserve Bank of India could maintain an adequate level of reserves in the form of low-return, highly liquid assets for meeting needs such as current account financing, short-term external debt obligations, restraining excessive volatility in the exchange rate, etc. And it could park the excess reserves in an account with the objective of maximizing returns, subject to acceptable risks. The funds in such an account could be profitably invested in non-treasury-based assets such as equities, private equity firms and real estate, which are all associated with higher returns.
Such investments are not new—Singapore and Korea have been doing this for a number of years now. Singapore’s GIC and KIC in Korea have been investing a large part of their reserves in a variety of top-grade corporate and sovereign bonds, equities and real estate holdings spread across the globe. In recent times, China has also initiated a move away from US treasurys to more profitable equity holdings.
Abhijit Sen Gupta is former fellow, Icrier, New Delhi. These are his personal views. Comments are welcome at email@example.com