India should devise alternative investment avenues for its hard currency reserves.
India, China and other countries which have accumulated FX reserves have a dollar dilemma— read ‘dollemma’. These two Asian countries have invested most of their FX reserves in government debt securities of the US, Europe and Japan. As economic growth has slumped in G7 countries, sovereign interest rates have been brought down and are likely to remain low for the next few years. Consequently, these FX investments will provide low rates of return and the principal amounts invested may be eroded if the dollar depreciates.
This gloomy scenario can be contrasted with India investing its FX reserves within the country. As we know from interminable discussion on this topic, it is difficult to set up domestic projects which can absorb FX. On the basis of its relatively better growth prospects, India can legitimately claim that investors from developed countries are likely to receive a higher risk-adjusted rate of return by investing in India rather than in their own countries. If this is a credible claim why should India have to invest its FX reserves in the West? The response could be that the prime consideration for India is preserving its FX principal rather than maximising the rate of return. It could also be contended that there are no other investment alternatives, if principal is to be conserved, till such time as the Indian rupee (INR) becomes a convertible currency.
Currently, a preponderant proportion of portfolio and FDI investments from the OECD are made within the OECD and it is only at the margin that they seek higher yields and diversification benefits when they invest in emerging markets such as India. Presumably, when India seeks foreign investments, the logic is that although investors are exposed to market and currency risks there is no significant credit risk. Risk diversification is another factor that could be used to explain this apparent inconsistency between India investing its FX reserves abroad and seeking FX investments from foreign sources. It could be argued that India needs to reduce concentration of risk by investing its FX reserves overseas. Irrespective of the soundness of such rationalisation, issues such as the ‘optimum’ or required level of FX reserves in comparison to India’s potential hard currency liabilities and how India’s FX reserves should be deployed continue to be relevant.
It is clear now that it was correct policy for India to accumulate FX reserves in the last few years instead of allowing the rupee to appreciate beyond rupees 40 to a dollar in 2007-08. A pertinent question today is whether the RBI should have mopped up even more of the incoming FX and not allowed the rupee to appreciate beyond rupees 45 to a dollar. It should be evident even to those who had concerns about the cost of servicing market stabilisation bonds that the strategy to build up FX reserves well beyond a year’s worth of imports was justified.
As of 2 January, 2009 India’s FX reserves stood at $255.24 billion. The rate of return on FX reserves (foreign currency assets and gold) was 5.1 per cent in 2007-08 and 4.7 per cent in 2006-07. The sovereign interest rates in India, China and four hard currencies are listed in Table 1 (includes NRI dollar deposit rates).
| Table 1 SOVEREIGN INTEREST RATES AS OF 9 JANUARY, 2008 | ||||
|
3 month
| 1 year | 2 year | 5 year | |
| India (INR) | 4.52 | 4.7 | 4.96 | 5.89 |
| India FCNR(B) $ deposit rates |
-
| 3% | 2.44% | 3.08% |
| China (Yuan) | 0.92 | 1.07 | 1.15 | 1.78 |
| USA ($) | 0.06% | 0.40% | 0.75% | 1.51% |
| Japan (Yen) | 0.20% | 0.28% | 0.38% | 0.74% |
| UK (Pounds) | 0.89% | 1.02% | 1.60% | 2.68% |
| Germany (Euro) | 1.09% | 1.36% | 1.51% | 2.26% |
| Source: Bloomberg | ||||
US dollar sovereign interest rates are low across all maturities and at the 3-month Treasury Bills maturity it is close to zero. It is likely, therefore, that in 2008-09 and 2009-10 the rates of return on India’s foreign currency assets will be considerably lower than in the last two years. As can be seen from Table 1, the Indian government’s INR borrowing rates are likely to be higher than the rate of return on its FX reserves, which has invariably been the case in the last several years. However, there is an additional risk now stemming from a potentially significant US dollar depreciation over time, which has implications for the currency management of India’s external debt.
How do India’s hard currency liabilities stack up against its FX reserves? As of end September, 2008 India’s FX liabilities with remaining maturities of a year or less amounted to $91.4 billion (41 per cent) out of total hard currency debt of $222.6 billion. Table 2 provides the break-up of external debt by maturity buckets.
| Table 2 INDIA’S EXTERNAL DEBT AS OF END-SEPTEMBER 2008 IN US$ BILLION | |||
| Residual maturities up to 1 year | Residual maturities 1-3 years | Residual maturities more than 3 years | |
| Sovereign | 2.9 | 6.17 | 45.13 |
| Commercial Borrowings | 6.96 | 14.7 | 56.02 |
| NRI Deposits | 31.96 | 7.5 | 1.17 |
| Short-term Debt (original maturities less than 1 year) | 50.1 | 0 | 0 |
| Sub-totals (by maturity) | 91.92 | 28.37 | 102.32 |
| Source: Ministry of Finance | |||
About 79 per cent of NRI deposits carry residual maturities of less than a year. In the current straightened economic circumstances abroad it is conceivable that some NRI deposits may not be rolled over. However, since US dollar FCNR(B) deposit rates are 1.5-2 per cent higher than sovereign dollar interest rates it is possible that NRI deposits may not be eroded. However, the question remains of how would Indian banks generate the required rates of return in hard currencies to service NRI deposits. Indian banks offering such deposit rates would need to take market, currency or credit risk. Trade credits amount to 92 per cent out of the short-term debt category, i.e. original maturities of less than a year. And, since the last quarter of 2008, the availability of trade credit for Indian firms has been severely constrained.
To summarise, the proposed Public Debt Office (PDO) should be urgently made fully functional and responsible for managing external debt. Further, the PDO needs to coordinate its activities closely with the Reserve Bank of India unit responsible for managing India’s FX reserves. In the longer-term India could individually and collectively, with similarly placed countries, devise alternative investment avenues for its hard currency reserves.
(The author is Ambassador of India to Belgium, Luxembourg and the European Union. Views expressed are personal)
