Using forex for infrastructure

If India does decide to use its forex reserves for developing infrastructure, it is essential to do so in a way that maximises the chances of success.

India's accumulation of foreign currency reserves represents the new international financial architecture of the 21st century. In this system, emerging economies such as India and China that are experiencing export-led growth and large inward capital investment purchase foreign currency to maintain a competitive exchange rate. They then invest these foreign currency reserves in low-risk developed country securities thus financing the imports of the developed countries. The IMF estimates that the world will have $5 trillion of reserves by March 2007 of which non-industrialised countries will account for as much as $3.5 trillion! Since India is now the fifth largest holder of reserves in the world (increased to $225 billion as of September), we are becoming a critical and powerful player in this new world order.

These emerging economies have recently started taking a more active investment management approach by creating Sovereign Wealth Funds ("SWFs"). The purpose is to invest with a longer time horizon and across multiple asset classes as opposed to solely in low-return government securities. While the most prominent new ones are from China and Korea, Malaysia has also recently increased the focus on Khazanah, its SWF. These new funds follow the first wave of SWFs that were mostly stabilisation funds created by countries like Norway and UAE in the 1970s to manage earning from oil exports (GIC in Singapore being the only exception). Today, there are as many as 25 SWFs globally and Morgan Stanley estimates that they manage close to $2.5 trillion in funds. The funds managed are expected to grow to $12 trillion by 2015, an extraordinarily large number given that hedge funds merely manage $1.6 trillion globally. As the table shows, most countries with our size of reserves have already created such investment vehicles (those who have not are actively contemplating it). This delay has resulted in lost interest on our reserves with every 1 per cent lost interest representing $2.2 billion or approximately Rs 9,000 crore. In addition, there are further costs (negative carry) to maintain these reserves that earn 4-5 per cent since the government has to issue debt at approximately 7-8 per cent to keep money supply constant.

By deciding to use $5 billion of our foreign exchange reserves to finance infrastructure development, the government has taken the initiative to create our own sovereign wealth fund, although one of the smallest in the world. The proposal is to create an overseas subsidiary of the Indian Infrastructure Finance Company (a government-owned financial institution) that will borrow $5 billion from the RBI's reserves. This subsidiary will then lend to Indian infrastructure companies for foreign exchange expenditure on equipment purchases or for overseas investments that benefit Indian infrastructure, for example, hydro-power in Nepal that can be imported. The unique structure is designed to use reserves to increase investment in infrastructure while preventing an increase in money supply and inflation by not converting the funds to rupees. In addition, since the amount is small, it does impact our total reserves (as one of the main arguments against this is that our reserves are built through capital account inflows, hence subject to risk of capital flight).

However, it seems that by coming up with an overly complex plan we risk making it unworkable. We are essentially asking this new entity to i) restrict investments to those that benefit India's infrastructure and that too overseas, ii) make direct loans/investments in companies, iii) maintain high credit standards while competing with the private sector, and iv) manage this under direct government control and pay-scales from an offshore destination. While countries are trying to simplify their SWF structures, increase transparency and accountability, and use third-party fund managers, are we going against prevailing wisdom in our plan and overstretching in our first initiative? Probably the worst example of overstretching is China's fund where they are making direct investments in companies ($3 billion in Blackstone) and the fund is expected to grow to $200 billion without the right professionals or transparency; experts, therefore, expect it to run into trouble.

One cleaner alternative would be to start with a more modest initiative with a simpler set of objectives. We could allocate a small portion of our reserves to experienced third-party international fund managers. This model has worked well for both the Norway and Abu Dhabi funds for decades. In addition, the objective could be simplified to just a risk-adjusted return that we are comfortable with. Once the government builds experience and a track record in managing these funds, it can increase the scale and widen the scope of its operations.

If we do decide to move ahead with the more ambitious proposal of using our reserves for infrastructure, it is essential to design it in a way that maximises the probability of success. This would include:

Following World-Class Corporate Governance Practices: This could be achieved by creating a board of directors with international experience in finance, infrastructure and government. In addition, there should be a senior political figure on the board that will increase the political costs of failure and level of scrutiny. For example, since Lee Kuan Yew is the Chairman of GIC in Singapore and Abdullah Badawi is the Chairman of Khazanah, they implicitly bear responsibility and accountability for their investments.

Providing Clarity on Investment Objectives and Philosophy: We need to specify if the priority of the fund is to provide a return on equity or to just increase investment in infrastructure. We also need a more refined view on what sort of risk profile and how much exposure to equity are appropriate. Finally, it would be preferable for the fund to use experienced investment managers.

Following Responsible Investment Practices: The fund should define parameters for socially responsible investing, since it is investing public funds. The Norway fund is the best example of this as it has created an ethical committee to oversee its guidelines (it has already banned investing in several US arms manufacturers and Wal-Mart).

Providing Structural Flexibility: This includes private sector pay scales, alignment of incentives, flexibility regarding hiring and minimal government interference in operations.

Increasing Transparency and Disclosure: The Norway Fund has often been regarded as the one with the best transparency and disclosures while others such as the ADIA are very secretive. As an open democracy, we should clearly try to emulate the Norway funds disclosure standards.

While a lot needs to be worked out, this initiative should be supported for being creative and well-timed. Unlocking the potential for using these reserves for infrastructure or any other public policy purpose in incremental steps is both bold and useful. However, this proposal needs to be designed for success due to the scale of public funds involved and the significant impact that failure would have on our ability to invest our reserves in the future. Since we are doing this late, policymakers should learn from others experiences and make this a gold standard for other emerging economies.

The author is an investment banker.