India has wasted three years debating a modest proposal for diverting some of its foreign reserves to plugging the country’s abysmal infrastructure deficit.
It’s only now when China is all set to carve out $200 billion (Rs8.2 trillion) from its reserves into a sovereign wealth fund that India is hastening to reach a decision on what to do with its own low-yielding cache.
Finance minister P. Chidambaram said in a speech at the London Business School last week that the government has “persuaded” the Reserve Bank of India (RBI) to lend $5 billion from its $212 billion kitty. The money will go to a special purpose vehicle (SPV) formed last year to enable long-gestation projects to raise funds cheaply.
India urgently needs to boost investments in roads, ports, airports, power stations and railways. The latest official estimate puts the amount of funds required in these areas at a massive $475 billion over five years.
Those who oppose using reserves for infrastructure investments highlight two key risks: The economy may overheat because of additional domestic liquidity, and the country may lose hard-currency cover in the event of a run on the rupee.
Neither of these arguments holds much water.
After four years of 8.5% compounded annual growth in gross domestic product, there is a danger that the economy is exhausting its productive capacity.
Bloated order books bear testimony to serious supply constraints. Bharat Heavy Electricals Ltd, India’s biggest maker of power equipment, has a three-year order backlog. Pakistan’s cement makers are hoping to benefit from a shortage of building materials in India.
All of this provides a perfect setting for spending a few billion dollars from foreign reserves to import turbines, railway coaches, port equipment and air traffic control systems.
With adequate leverage, even $5 billion can have an amplified impact on a $1 trillion economy. India Infrastructure Finance Co., the SPV, can then have a significant corpus to provide credit lines to companies that will import capital goods.
So while spending foreign reserves at home may shore up domestic liquidity and inflation, utilizing the funds overseas will help the economy achieve a better balance between strong demand and tepid supply. At $65 billion, the annual trade deficit is both large and widening. However, that shouldn’t deter the country from accelerated machinery imports. India’s basic balance of payments, or the sum of net exports of goods and services and foreign direct investment, is quite healthy. The minuscule $1.2 billion shortfall in the year ended 31 March was only a third as large as in the previous year.
Those who support the plan to make use of reserves emphasize the low returns on the central bank’s foreign assets, which are financed by selling high-cost local debt.
RBI recently issued three-month treasury bills at a 7.2% yield to mop up some of the excess local liquidity created by its purchase of US dollars.
The central bank is buying dollars to stem the pace of appreciation in the rupee, Asia’s second best-performing this year after the Thai baht. However, it isn’t making much on the assets it’s acquiring with those dollars. In the year ended June 2006, RBI earned 3.9% on its reserves.
The domestic economy—especially infrastructure—promises significantly higher returns. NTPC Ltd, the country’s biggest power producer, sold a 10-year dollar bond last year, paying a coupon rate of about 5.9%.
The higher returns from domestic infrastructure lending, sceptics say, will only be a reward for sacrificing safety and liquidity, the two essential features of reserve assets.
In this view, lending to Indian companies will compromise RBI’s balance sheet, leaving it unprepared for a currency crisis. This argument, too, is an exaggerated one.
India’s reserves exceed short-term debt by a multiple of 16, providing a much greater cushion than mandated by the Guidotti-Greenspan principle.
That rule of thumb, named after Pablo Guidotti, a former treasury secretary of Argentina, and Alan Greenspan, the former US Federal Reserve chairman, says that countries should hold reserves equal to foreign liabilities coming due withina year.
Even if India were to pay off its entire foreign borrowings—short term and long term—it would still be left with $44 billion. So, even by a conservative estimate, a fifth of India’s reserves are surplus. Out of this, the current proposal only envisages using $5 billion. How big a risk can that pose?
Using reserves to finance the acquisition of foreign-made capital goods is undoubtedly a roundabout way to achieve a goal that may be as easily reached if the central bank were to just stop buying the incoming dollars. An appreciating rupee will automatically make imports cheaper.
That will altogether be a more satisfactory solution than creating a new layer of state interference.
However, after witnessing New Zealand’s helplessness against carry traders who are pushing its currency too high, the Indian central bank isn’t likely to leave the rupee entirely to market forces. So it will acquire dollars even when further reserve accumulation doesn’t make economic sense.
From this perspective, putting a small part of the treasure trove into infrastructure will at least be a second best alternative to laissez-faire.
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