R Ravimohan: Far excess forex reserves?

All of us know that India is now sitting on a mountain of foreign exchange (FX) reserves, currently estimated at $137 billion (as on December 30, 2005), well in excess of our needs. What use do we have for it? Are there any risks that might emanate from it and what do we do about it?

The current FX reserves are due to a healthy capital account net inflow, largely on account of foreign institutional investors (FIIs), invisibles, and remittances, and despite the oil import bill being so substantially high. It is indeed a strong endorsement by the world's wealthy of the prospects for our country. Usually, healthy FX reserves attract more inflows when foreigners feel comfortable investing in such countries, strengthening the countries' currency (in our case, the rupee) value against the reference foreign currency (in our case, the dollar). It is also a good indicator of debt protection measure, as the reserves provide a comfortable cover over the combined requirements of the import bill and foreign exchange outflow towards repayments. It also cushions the repayment burden of all those that have borrowed in foreign currency, as they have to spend fewer rupees to buy the contracted amount of foreign exchange. The importers also benefit by having to pay fewer rupees for the same dollar value of import. Also, since India imports most of its oil requirements, it has so far been impacted far less because of the good FX reserves.

So, are the large FX reserves an unmitigated boon? Definitely not. The more the FX reserves, the greater the risk of outflows and indeed of a contagion, as starkly reminded by the frightful impact of the massive outflow of FX caused to the Asian countries. Let me hasten to add that there does not appear to be any imminent cause for worry. Indeed, the continued attraction of FIIs to our equity market seems to suggest that this inflow will continue unabated for some more time at least. However, there is nothing to stop markets to act in a manner that may be adverse to our interest. It is, therefore, prudent to think about what we should do to minimise the effect, should the risk precipitate despite our best efforts.

In addition to the risk of outflows, strong FX reserves strengthen rupee-reducing export competitiveness. Second, as the rupee gets stronger, the market valuation dampens as currency risks play up. Fear of regulatory intervention also perks up as the reserves build up. So even if there are no outflows, the regulator might perceive an unsustainable build-up and can initiate a "soft-landing" into a perceived crisis. None of these is a palatable thought, especially since we are finally basking in our appointed place under the sun.

Clearly, we need to address these risks so that our country can continue to enjoy the benefits of surplus FX reserves. Discounting all possible "hard interventionist" solutions, the strategy should be to find ways of sustaining the strong foreign exchange inflows. Sustainability would include:

a) Diversity of sources which are contributing to the net inflow. If the inflow comes from different sources, rather than only the FIIs, it reduces the risk associated with all institutional investors withdrawing money at the same time;

b) Extended maturity of funds that come into the country will even out the outflow and, thereby, reduce contagion risk;

c) Permanency of the nature of inflows is an important element to be desired in the foreign inflows, because this stabilises the system against contagion exigencies.

What is that magic mantra that will bring in foreign fund inflows with these characteristics? FDI is the most potent of the sources, having all of these desirable characteristics. Obviously, policies that encourage foreign investment into the country are key strategy to sustain this new power we have obtained on the global platform. Foreign investments will not only stabilise FX reserves, but if strategised well, could also bring the much-needed capital to fix a few important segments of our economy. Infrastructure, agriculture, urban investments, and social investment in health and education are some of the areas that need massive investment. They also offer the good potential for absorbing large amounts of foreign investment. I am not arguing that FX reserves be spent on these sectors. I am suggesting that the policies that are currently limiting investments in these areas be streamlined to make them attractive to both internal and foreign investment interest.

Even though every year the Budget increases allocations for these sectors, they appear inadequate, because these sectors seem to be slipping instead of improving. While the inadequacies of social, rural, and urban systems are self-evident, the power sector is an example of how policies need to be sorted out before any investment flows in. Even if not specifically targeted at foreign investment, given the India interest, investor-friendly policies will automatically attract foreign investors. Such investments will be long-term and will stabilise FX reserves by extending the outflows in future and diversifying the inflow sources. The finance minister engineered a smart policy for allowing foreign investment only in new real estate projects and banning them from buying existing properties. This will encourage good new development and keep the foreign money invested in productive assets for the long term.

By way of example, policies that are developed around themes like the grant of a higher floor space index for real estate development for those projects that do appropriately large city development (which will hasten urban infrastructure), or the grant of central power subsidy to states equal to the amount of foreign equity invested in distribution (which will encourage distribution reform) or the allocation of port terminal for setting up appropriate irrigation and cold storage system in rural areas, are some idea starters that can be developed into appropriate policies. Needless to add, these policies should consider all aspects of development, including investor's return. Grounding such policies will attract a good inflow of long-term strategic investments from global investors, not only substantially mitigating the risk of foreign exchange depletion, but also catalysing the much-needed development in critical sectors in our country.