Reserves to the rescue?

For some time now, there has been talk of using the country's large foreign exchange reserves to greater effect. Of course, the primary purpose of accumulating reserves is to provide a cushion against shocks to export earnings and investment inflows, so that external obligations can be met without interruption.

And since most people would agree that $110 billion plus is more cushion than is necessary, there is a legitimate argument to be made for putting the excess reserves to more productive use than as short-term instruments in the Eurodollar market.

But questions arise as to the mechanics. These reserves got built up because the Reserve Bank of India (RBI) was resisting the appreciation of the rupee in a situation in which domestic private demand for foreign exchange was not large enough to accommodate the surge in inflows.

If this imbalance between demand and supply is enduring, the simple solution is to increase the domestic demand for foreign exchange. This can be done in two ways: reduce tariffs and other trade barriers to increase imports, and increase the extent of convertibility on the capital account.

On both these fronts, the government has moved a long way. Unrestricted convertibility for individuals is, of course, not fully in place and tariff rates could be brought down further but, in terms of the eventual impact on domestic demand for foreign exchange, further change in these two channels is unlikely to have a dramatic impact on the demand for foreign exchange.

There are still more than enough dollars and euros to go round. What then?

The government seems to be coming round to the view that this surplus can be used to kick-start investment in infrastructure. However, the reserves do not belong to the government; they are on the balance sheet of the RBI.

If the government were to acquire them, it would have to provide for budgetary resources to do so. It could do this by issuing additional domestic debt.

The country's reserves are not going to come into play for investment or any other purpose without the fiscal situation being impacted. The only advantage that the reserves provide is that, for the first time since independence, we do not face a foreign exchange constraint when we consider stepping up investment.

But if the government were to float more paper, it will add to surplus liquidity in the system and risk more inflation, unless of course much of the money is spent on project imports.

The availability of foreign exchange is only one of the several constraints facing investment, in infrastructure as well as other sectors. The main bottlenecks now are the slow progress on legislative and regulatory frameworks that will enable private investment.

The progress is certainly there, as exemplified by the number of power projects that have achieved financial closure since the passage of the Electricity Act last year. But, even if it were to speed up, the essential question and concern are still whether private investment will be enough to bridge the availability gap.

The merits of an across-the-board increase in public investment need to be debated. However, to cast this debate in terms of the availability of reserves is misleading.

Viable investment, whether private or public, cannot happen without the necessary policy and regulatory changes. Excess reserves can facilitate but not stimulate it.