Partha Mukhopadhyay: Making better use of the reserves

It is possible to utilise forex reserves for infrastructural development and still make money.

There has recently been much discussion on whether our foreign exchange reserves should be used to fund infrastructure, with many articulate opinions on both sides of the debate. It is argued here that reconciliation is possible.

The proposal envisages a new reserve management policy by the Reserve Bank of India (RBI), the transfer of "excess returns" to a special fund, and Performance Based Deferred Payment (PBDP) concessions for infrastructure services.

Under this arrangement, the RBI retains control over foreign exchange reserves and only modifies its reserve management practice in line with many other countries with a high level of reserves.

Second, the money is used not to create assets, which often fall into disuse, but to buy services, thus carrying greater assurance that the infrastructure investment will translate into higher economic benefits. Third, such an arrangement can actually lower the fiscal deficit by increasing government revenue. How, then, will it work?

It is useful to start with a review of our foreign exchange reserve management, for which the RBI has been widely praised, given the objectives.

The current policy is to manage reserves conservatively, investing in short-term US treasury instruments, to yield a return of around 2 per cent in dollar terms. This is a strategy that is practiced by most countries around the world and is appropriate for the primary function of reserves, which is to provide liquidity in times of crisis.

However, in some countries, particularly those that have accumulated a high level of reserves as a result of their exchange rate management, such as Hong Kong, Korea and Singapore, it is now common to follow a more nuanced approach by dividing reserves into two parts.

One part is earmarked for providing liquidity and is invested in traditional instruments like short-term OECD treasury bonds. The other part is invested with a view to generating returns.

In Korea, for instance, a portion of this investment portfolio is outsourced to asset management companies and benchmarked to the Lehman Brothers Global Aggregate Index. This portfolio can comprise instruments such as corporate bonds and asset- and mortgage-backed securities with a credit rating of AA and above.

Hong Kong allows a fifth of its reserves to be invested in equity, of which a fourth (that is, 5 per cent of the total) can be in the domestic market.

Of course, each of these high-return investments, even if they are all highly liquid assets in actively traded markets, brings an increased element of risk, which has to be managed in an informed manner.

Our current reserve levels put us in the same bracket as these countries. Consider for a moment an alternative scenario where the RBI creates a separate investment portfolio out of our existing reserves, which is managed more aggressively.

Assume that the return on this portfolio is 6 per cent, that is, an extra return of 4 per cent compared to current levels (for comparison, the annual mean return on the Lehman Brothers Global Aggregate Index for the past four years was 8 per cent).

For every billion dollars in the investment portfolio, the RBI thus makes an additional $ 40 million a year. It is time the RBI adapted its reserve management to changed circumstances, accepted a little more risk and generated higher returns.

The RBI can either manage this investment portfolio itself or use external fund managers, given the expertise required for active fund management. The RBI already uses external fund managers for a small portion of its reserves, but mainly for the access it gives to information, benchmarking and so on.

Active management would entail a significantly deeper level of engagement. As an added bonus, the RBI's multi-billion fund management business may help Mumbai become an international financial centre, much as Korea might have hoped for Seoul when it capitalised Korea Investment Corporation with $ 20 billion.

But isn't $ 40 million too small when the discussion is of using $ 5 billion to $ 10 billion for infrastructure? That is where PBDP concessions and domestic capital markets come in.

A PBDP concession is an agreement where the service provider agrees to provide a defined level of service in return for a stream of deferred payments conditional on an acceptable level of service from the purchaser, which is usually a government agency.

The domestic capital market securitises this deferred payment stream to fund the initial investment.

The critical benefits of PBDP concessions are that they ensure immediate investment without direct fiscal outlay as well as a continued level of service in the future.

This is because the service provider is paid based on performance, that is, only if the road is well maintained and free from potholes or if the treated wastewater meets with previously specified standards. The incentive to provide acceptable service is much stronger compared to standard operations and maintenance contracts since both profits and the recovery of initial investment is tied to the level of service.

It ought to be apparent that PBDP concessions should not be used to build more power plants or ports, that is, investments that can be financed with commercial user fees.

A smidgen of discipline is now beginning to show in the power sector and it would be unfortunate if this emerging commercial ethos were buried under a mass of state-sponsored investment.

However, there are many instances where the fee collection can be usefully separated from service provision, for instance, roads "" but here shortages in execution capacity are starting to appear "" or where it it is not either sensible or practicable to charge direct user fees, for instance, waste-water treatment "" a crying need in our penurious cities.

Many economically necessary investments also need to be made without immediate financial return, such as supply of electricity, water, telephony, health and education to rural areas. For all such investments, PBDP concessions are a useful method of assuring service delivery, compared to mere asset construction.

Moreover, PBDP concessions are already in use in India. One example is the annuity contract for highways, awarded by the National Highways Authority of India, where the concessionaire is paid a fixed sum every six months for 15 years for building, operating and maintaining the road for this period.

Indeed, using the annuity bids as a benchmark, $ 40 million a year, transferred to a special fund similar to the Central Road Fund, could leverage $ 250 million of investment.

Thus, if the RBI puts $ 20 billion in an investment portfolio with a benchmark annual return of 6 per cent, that is, an "excess return" of 4 per cent, this will generate $ 800 million, which can be leveraged through PBDP concessions to generate $ 5 billion of investment.

Note that the RBI will still have over $ 100 billion in its liquidity portfolio, which still gives it a healthy safety margin. Using this approach for the incremental addition to reserves, a high level of investment can be undertaken for subsequent years also.

One downside of this approach is that it commits the investment portfolio for the next 15 years. With 8 per cent growth and rising imports, our liquidity portfolio, too, will need to increase.

But, in the past two years, even though imports have grown by about 20 per cent in dollar terms, our reserves have also risen, driven by remittances and foreign direct investment, and these should see more growth in the future. The opportunity cost of this pre-commitment is, thus, unlikely to be high.

Whether the consequential extra revenues should be used to reduce the fiscal deficit or be earmarked for infrastructure can be debated separately.

(The views expressed in this article are personal and cannot be attributed to any institution to which the author is affiliated)