In early June, reserves hit a record high of $ 608 billion, making India the fifth largest reserve country in the world. Whatever the scale, we’ve come a long way since March 1991, when we were scraping the bottom of the barrel with reserves of $ 5.8 billion, enough to last just three weeks of imports.
Watch out for the foreign hand
Today our problem seems to be the excess, rather than the shortage, of foreign exchange reserves. Unsurprisingly, ‘the management of foreign exchange reserves’, an obscure topic that sparked a furious debate when India first hit the $ 50 billion mark in 2002, is once again in the spotlight. . Reports suggest that RBI is playing with the idea of hiring outside investment managers to manage a portion of its forex reserve fund. And might even consider investing in top-rated foreign corporate bonds to generate higher returns. Some global institutions have reportedly already contacted RBI.
It is against the law and against the practice. The guiding principle of reserve management has always been “Prevention is better than cure”. Barring a short-lived experience in using outside advisers that was (thankfully) aborted in the mid-1990s, the RBI has traditionally avoided the temptation to seek higher returns.
It’s not surprising. The legal framework for reserve management – Sections 17 (6A), 17 (12), 17 (12A), 17 (13) and 33 (6) of the RBI Act – only allows investment in safe lanes ; although with a provision that allows for some discretion by the central council.
So, what explains the about-face? Two possible reasons. First, sovereign bond yields have fallen dramatically and are expected to remain low as central banks flood the world with liquidity. Second, RBI is under increasing pressure to return more to Caesar (read: transferring more surplus to GoI). Hence the desire to obtain higher returns on investment from reserves, aided, perhaps, by the incentive (aggressive lobbying?)
It could be the thin edge of the corner. Okay, there is an opportunity cost to holding reserves, since resources that could have been used for domestic investment were instead used to buy reserves. The fundamental objective of reserve management must therefore be to minimize these opportunity costs compared to the benefits of holding reserves.
What are these advantages? Former RBI Governor YV Reddy put it right. In 2004, as the debate over the management of our then “booming” reserves raged, it listed them as “(a) maintaining confidence in monetary and exchange rate policies, (b) improving the ability of the RBI to intervene in foreign exchange markets, (c) limit external vulnerability to shocks in times of crisis, (d) give confidence to markets, in particular rating agencies, that external obligations can always be met , thus reducing the cost at which foreign exchange resources are available to market players, and reassuring markets that the national currency is backed by foreign currency assets ”.
These make the management of foreign exchange reserves a completely different game from the management of other funds. The main objective of other funds is to maximize returns within a specified risk-return framework. Safety and liquidity, while important, are less of a priority. However, when it comes to managing foreign exchange reserves, the primary focus is – and always should be – security followed by liquidity, with (far?) Third returns.
Why? Because the raison d’être for which a country builds up foreign exchange reserves is different. They cannot be entrusted to investment managers whose DNA is hardwired to maximize returns and, worse yet, have an incentive to disaggregate portfolios to earn higher fees. Apart from that, there is also the question of liability. Unlike internal RBI officials, an investment manager, who is with one company today and another tomorrow, can hardly be held accountable if investing in a corporate bond, for example, turns out to be a missed.
Okay, RBI would think, it seems, to entrust only part of its reserves. Certainly, the size of our forex pot gives us considerable comfort. But our import coverage of around 15 months is lower than that of other large reserve holders like Switzerland (39 months), Japan (22), Russia (20) and China (16).
Even more worrying, the quality of our foreign exchange reserves takes away a lot of brilliance. Unlike China, whose foreign exchange reserves are made up of current account surpluses, ours are largely made up of portfolio flows (read: hot money) rather than long-term inflows like FDI. A sudden withdrawal of investors – an unlikely prospect in the event the US Federal Reserve signals a super-easy monetary reversal – can lead to a rapid depletion of reserves. We have seen this time and time again in the past, most recently during the tantrums of September 2013, when stocks dropped dramatically.
No wonder RBI, in its Bulletin for June 2021, timidly calls the high level of our foreign exchange reserves “misleading”. This admission alone should be sufficient reason for it to refrain from entrusting the management of foreign exchange reserves to individuals. The wisdom is not to put a fox to keep the chickens.