Why India needs a sovereign wealth fund now

SWFs are not esoteric entities—unlike fanciful notions such as flying saucers or a woolly mammoth cloned from permafrost DNA. They have been around since the 19th century, when Texas set up the Permanent School Fund and the Permanent University Fund.

Many resource-exporting nations, including small phosphate-exporting Micronesian states, have used SWFs to stabilize their financial systems. The largest SWF, Norway’s Government Pension Fund-Global, was established in 1990 to preserve and grow the country’s oil revenues from the North Sea. Today, the fund manages $1.7 trillion and holds stakes in 9,000 companies across 70 countries. Although labeled a pension fund, it transfers its returns to the government, which can spend only the expected annual returns.

Singapore’s Temasek Holdings and GIC Pvt Ltd are well-known in India, having invested in companies like Bharti Airtel Ltd, HDFC Bank, ICICI Bank, and DBS, the Singapore-based lender that received the Reserve Bank of India's permission to acquire the troubled Lakshmi Vilas Bank.

India’s National Infrastructure and Investment Fund is an associate member of the International Forum of Sovereign Wealth Funds, which includes around 90 SWFs managing over $8 trillion in assets.

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Following the global financial crisis, the International Monetary Fund (IMF) urged the creation of a forum for SWFs, hoping they would serve as stabilizing forces in the turbulent world of global finance. Around two dozen SWFs, along with the IMF’s International Monetary and Financial Committee, collaborated to develop a set of guidelines known as the Santiago Principles, named after the Chilean city where the final drafting meeting took place.

These principles emphasize transparency, governance, regulatory compliance, and financial stability while balancing risk and reward, providing a reassuring framework.

Every country with foreign exchange reserves typically invests them in secure assets, with US government bonds of varying maturities being the most favoured. However, one key lesson from the 2007-09 global financial crisis was that when these supposedly ‘secure’ US treasuries flooded the market, the security vanished. Yields in the US were artificially suppressed, driving reckless capital allocation into risky areas, including Ninja loans—offered to borrowers with No Incomes, No Job, or Assets. These loans were used to create home mortgages that were bundled, securitized, and sold to investors, mixed with more creditworthy loans and derivatives, ultimately becoming collateralized debt obligations (CDOs) that credit rating agencies happily labeled as investment-grade.

After the financial collapse, China, which held the largest forex reserves, realized that relying solely on foreign government debt was unwise. In response, they launched the Belt and Road Initiative, financing infrastructure projects in developing countries through Chinese loans to secure diplomatic goodwill. China also created a few SWFs as part of this strategy.

For India, an SWF would allow the country to actively manage a portion of its foreign exchange reserves rather than passively investing them in US, EU, or Japanese government securities. Such an investment could achieve multiple goals, including generating higher financial returns than sovereign debt, supporting external projects funded by Indian foreign aid, and securing access to strategic technologies related to energy transition, carbon dioxide removal, advanced materials, synthetic biology, space applications, and quantum computing.

While most SWFs are funded from their sovereign's own assets, India's foreign exchange reserves are largely composed of unabsorbed capital inflows, not current account surpluses, making them liabilities rather than assets. Should India, therefore, create an SWF from these liabilities?

Should anyone invest using borrowed capital? The answer is a resounding yes—if the return on investment significantly exceeds the cost of capital. This logic applies to an SWF funded from national liabilities as well.

India's forex reserves have long been sufficient to cover nine months or more of imports, with six months’ import cover being considered financially prudent. The excess reserves present an opportunity: to channel this capital into the real economy more efficiently and to allocate a small portion to create an SWF. This fund could be deployed across various jurisdictions and sectors, providing India with a strategic leverage point.

Structuring the SWF

What should the structure of the fund look like? One proposal suggests creating a holding company for all public sector enterprises, leveraging its balance sheet to raise additional capital, and using this entity as the SWF. However, this approach is flawed.

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First, such a body would be unwieldy, with its board burdened by the dual task of managing the boards of public sector units (PSUs) while also overseeing new SWF acquisitions. This would dilute the effectiveness of the SWF. Additionally, this structure would weaken the accountability of public enterprises to any single cohesive authority. Currently, PSUs are answerable to their respective administrative ministries and parliamentary standing committees. While the constraints of this relationship have been criticized, the critical aspect of accountability has received less attention. The IL&FS crisis is a stark reminder of how 'professional management with Indian characteristics' can falter.

A better approach would be to adopt a structure similar to Singapore’s Temasek or GIC, both owned by Singapore’s central bank. The SWF should focus clearly on acquiring stakes in companies, articulating India’s strategic interests, monitoring global currency and financial trends, and hedging against risks. This should be the SWF’s primary function, not a task relegated to a bureaucratic department.

The main challenge will be ensuring ethics and integrity in managing the fund, once it is created. The SWF should be managed by professionals, with a remuneration structure that incentivizes long-term performance, free from political interference, and supported by a robust whistleblower policy.

Ideally, the SWF should have two lines of accountability: one to the central bank/finance ministry and the other to the Public Accounts Committee of Parliament, ensuring it remains insulated from political pressures.

There is little reason not to create an SWF, and strong reasons to do so—especially to secure benefits that only come with shareholding in strategic industries abroad.