Does India need a Sovereign Wealth Fund?

Isn't the infrastructure fund a type of SWF? Why not hold reserves in euros if the idea is to avoid the losses from a declining dollar? Our experts join the SWF debate.

Rajeev Malik,
Executive Director,
JPMorgan Chase Bank, Singapore

'SWFs can also play a vital role in our geo-political, economic and energy strategy'

Believe it or not, India has""perhaps inadvertently""already made a foray into the world of SWFs, by the setting up of a special purpose vehicle that will use a small portion of the foreign exchange reserves to aid infrastructure projects.

SWFs fall into two broad categories, depending on the source of the foreign exchange assets they manage. The first kind are commodity funds, such as those of Abu Dhabi, Kuwait and Norway, where the main sources are commodity exports, such as oil and gas. The second kind are non-commodity funds, where the countries running persistent current account surpluses (that is, excess savings over investment) dedicate a sizeable portion of the foreign exchange reserves to be managed by a separate entity. The Asian SWFs, such as those of Singapore and China, fall into this category.

The commodity-based SWFs originated with the need to manage the windfall from higher prices of their commodity exports so as to use them at a later date when the benefit of either higher commodity prices or the commodity base itself may not exist. The Asian SWFs manage the increase in foreign exchange reserves owing to the central banks' intervention to prevent the complete market-driven exchange rate appreciation.

Three key concerns are likely to be raised about an SWF for India. One, the country runs fiscal and current account deficits, the latter indicating that saving is short of investment. Two, it has no windfall earnings from commodity exports. Three, the massive overall balance of payments (BoP) surplus in recent years owing to surging capital inflows may not be sustained.

Still, there are several factors that tip the scale in favour of a SWF for India, in my opinion. One, we need to improve the returns on our foreign exchange reserves, which have crossed $300 billion. In the absence of a free-floating rupee, reserves will probably continue to increase owing to BoP surpluses (despite current account shortfall), though the pace of increase will be much slower. Also, the current investment mandate for the Reserve Bank of India is rather conservative (as is the case with most other central banks), which depresses returns owing to the importance given to liquidity and safety.

Two, higher returns on reserves can boost investment income, and favourably affect the fiscal deficit. Three, an SWF can play a vital role in securing our future energy needs, and can also play a constructive and complementary role in our geo-political and economic strategy. Four, the SWF could parcel out money for boosting the local fund management industry investing in overseas markets.

The limitation of the twin deficits is legitimate but should not hinder earmarking a small amount for a SWF, which should follow high standards for governance, transparency and disclosure standards.

(The views expressed are personal)

Rajiv Kumar,
Director and Chief Executive,
ICRIER

'Our reserves are not really ours "" how do you invest funds which can flow out anytime?'

Sovereign wealth funds (SWFs) seem to be catching on. Apparently even known renunciates like RBI Governor YV Reddy are open to their seductions, perhaps because central bankers from emerging markets fancy the prospects of becoming the unexpected saviours of financial sector Goliaths as has happened recently.

The other reason could be the more plausible one of minimising the losses from the double whammy of a declining dollar and sharply lowered interest rates on US treasuries. But then why not simply hold more of our reserves in euros and accelerate the emergence of an alternate global reserve currency? This will put greater pressure on the US to better manage its macro fundamentals and not repeat the mistake of generating gargantuan savings and current account deficits and expect the rest of the world to finance them from their savings.

The temptation to establish an Indian SWF, because our gross reserves have crossed $300 billion should be resisted. Unlike China, that has built up its reserves through sustained large-scale current account surpluses, year after year for a decade and a half, and which therefore are free from any encumbrances, our reserves do not yet represent net savings.

In our case, these represent the excess of capital flows over the current account deficit, that the Indian economy generates on a regular basis, except for a couple of years at the beginning of this decade. Of the total accretion to our reserves in 2007 (January to December) of $76.1 billion, $16.3 billion came from commercial borrowings and $33 billion from portfolio investment inflows.

Thus, a significant part of these capital inflows are either in the nature of portfolio flows that can surely flow out, though their value decreases sharply, or debt liabilities that have to be paid. So there is significant downside risks in running down these balances and invest part of them in risky equity holdings through SWFs.

Given the massive investment requirements in the domestic economy, and expected high rates of financial returns and even higher social returns, it does not stand to reason to look for investment opportunities abroad.

Finally, are we sure that the RBI or its associated agencies have sufficient management capability and market-savvy operators? Would our system of multiple checks and balances, which encourages extreme risk aversion, not drive these SWF managers to safe, sound and simple investments, which will earn returns almost equal to the going return on US treasuries?

It would be better then to focus the RBI's managerial capacity on better estimating the rate of inflation, making the banking system more efficient and streamlining an arms-length regulatory mechanism. Now is hardly the time to be seduced by SWFs!