India has accumulated $272 billion in foreign currency reserves but these are still being invested in low-risk OECD government securities and bank deposits yielding less than 5 per cent.
With $95 billion added to reserves in 2007 alone, Indian policymakers have been caught unprepared for this rapid increase in "sovereign wealth". As this pool of capital has increased, so has the cost of an overly risk-averse investment strategy.
When one considers that Temasek has earned 18 per cent on its $100 billion portfolio and Harvard University 13 per cent on its $35 billion endowment since inception, the scale of lost earnings are going to be staggering.
It is therefore time for the Indian government to evaluate options to get the best risk-adjusted return for this wealth which ultimately belongs to Indian citizens.
India is now one of the few countries with large foreign asset holdings that have not created a sovereign wealth fund ("SWF") to enhance its investments. In fact, India is now the fourth largest holder of forex reserves and the eight largest holder of foreign assets in the world (SWF assets do not typically get counted in reserves).
However, we are one of only four countries along with Japan, Taiwan and Saudi Arabia in the top ten to not create an SWF (Saudi Arabia, however, diversifies its holdings on the central bank balance sheet so it is really Japan, Taiwan and India).
While the idea of investing reserves has many supporters in India, there remains strong opposition from within the Indian government. The three major arguments against creating an Indian SWF are:
-
India's reserves are built from capital account inflows and are hence encumbered assets that are subject to capital flight:
The fact that India has a merchandise trade deficit of $65 bn and a current account deficit of $9.9 bn does make us different from other large reserve holders whose reserves have been built up from huge trade surpluses. However, the current account deficit as a percentage of GDP is manageable and if you add software and services income, the trade deficit is reduced to $32bn.
As a result, India's balance of payments and trade position appear stable given the size of the economy. In addition, the RBI estimates that the ratio of volatile capital flows (cumulative portfolio investment and short-term debt) was only 38 per cent of the reserves as of March 2007. Clearly, at $272 bn we have far exceeded the cushion needed for any capital flight and to cover the current account deficit.
-
India should reduce reserves by opening the capital account and making it easier to invest abroad:
While there is no doubt that is should be made easier for Indians to invest abroad, the marginal return on capital in developing countries like India that have scarce capital and surplus labour should always be higher than in developed countries. Hence over the long term, we should continue to see capital move from developed countries to high-growth developing countries like India. Opening the capital account for outward investment may slow down net capital inflows but is unlikely to reverse the process. This means that the RBI will, therefore, have to continue to accumulate foreign currency to prevent more appreciation in the rupee, which will further increase the reserves and the need to have an appropriate investment framework.
-
An Indian SWF will be subject to corruption and mismanagement and could be misused to promote domestic political or foreign policy objectives:
A very valid concern, given governance in India and the scale of funds involved, however, one that can be mitigated through designing the fund correctly and limiting the amount of funds available. In order to minimise this risk, the fund should have the sole objective of maximising returns and the structure should be designed to minimise government interference, increase transparency and enhance accountability. Norway has already set up a good template for its fund that has now in effect become the gold standard for other SWFs.
None of the arguments above are reasons enough to justify the huge loss in income that Indian citizens are bearing. In fact, India's reluctance to form an SWF is more symptomatic of a fundamental malaise affecting Indian policymaking.
Firstly, India still has to come to terms with its new prominence in the world financial order where developing countries' reserves and GCC oil wealth have made these countries powerhouses in the world financial markets. Witness the recent investments in OECD financial institutions from Asian and Middle-Eastern SWFs.
Secondly, the Indian establishment still remains uncomfortable with India's integration into world financial markets with the resultant rapid flows of inward and now outward capital.
- The finance ministry and the RBI should, therefore, immediately go back to the drawing board and evaluate the creation of an SWF with the following five best practices that can be drawn from the experiences of other countries:
-
Ensure accountability through a board of directors that includes the Prime Minister, so there is a political cost of mismanagement (for example, Singapore and Malaysia).
- Use third-party fund managers, so professionals can invest and conflicts are reduced (for example, UAE and Norway).
- Determine asset allocation (public vs private and equity vs debt) and return expectations.
- Follow high standards of transparency and disclosure (for example, Norway).
-
Adopt socially responsible investment practices (again, Norway).
While this government may not have the political capital to implement this, it is essential that work on designing the fund starts now so that the proposal can be implemented when politically possible.
There is much that India can learn from other countries' experiences with SWFs. Denying the existence of our vast foreign asset holdings, losing income that can be earned from investing these or being unsure about our new position in the integrated world financial system cannot be great policy.
