The $400 Billion Question

India’s foreign exchange reserves recently crossed $400 billion for the first time in history. The increase in forex reserves by nearly 50 per cent in four years demonstrates the underlying strength of India’s balance of payments with robust FDI, FII and NRI investments pouring in, particularly since 2014.

The spurt in forex reserves has, however, thrown up two questions. One, does India need such a high level of foreign exchange reserves which, parked in US treasury bonds, earn one per cent annual interest? Two, how can the reserves be put to more productive use?

The current level of reserves cover 10.5 months of imports. In comparison, during the 1991 balance of payments crisis, reserves barely covered a few weeks’ imports. Forex reserves should essentially cover the current account deficit (CAD). In India this is running annually at around $120 billion in FY18 or a little over five per cent of nominal GDP. Clearly, Indian forex reserves are many multiples of this basic requirement. Reserves are also useful to defend the rupee. However, a flexible exchange rate policy followed by India since 1992 allows the Reserve Bank of India (RBI) to protect the rupee from big swings by buying or selling dollars.

It is often pointed out that China, which has a positive CAD, still holds over $3 trillion in forex reserves. Beijing’s reserves have however dipped from a high point of $3.8 trillion to $3.1 trillion. Of these, $800 billion are part of China’s sovereign wealth fund. Chinese foreign exchange reserves are therefore, in effect, $2.2 trillion if a like-for-like comparison is done with India’s reserves — roughly five times greater than India’s and in line with the relative size of the two economies.
 
The second question though is more critical: how can India’s forex reserves be put to better use? The one per cent return on US treasury bonds amounts to $4 billion (Rs 26,000 crore) a year, barely enough to pay for MNREGA. Indian policymakers are meanwhile, in a dilemma over whether to kickstart investment with a stimulus or maintain fiscal prudence. The commitment to not breach the 3.20 per cent fiscal deficit figure hangs heavy over the ministry of finance. The government though, needs to spur productive expenditure and set off a virtuous cycle of spending and consumption, supply and demand. Overall investment can then once again climb into the 33-35 per cent range from 30 per cent that it has dipped to.

Consider now some math: India’s total debt (external and internal) is $1.20 trillion (Rs 75 lakh crore). The annual interest outgo on this debt is Rs 5.23 lakh crore as per the 2017-18 Union Budget. This means India is paying an average interest rate of around 6.5 per cent on its overall debt, including around 7.5 per cent on Indian rupee debt.

This imposes a large burden on the Budget. The annual interest outflow is larger, for example, than the defence budget (Rs 2.62 lakh crore). Healthcare and education spending is dwarfed by the cost of servicing India’s national debt. It is a travesty that 25 per cent of India’s Rs 21.47 lakh crore annual Budget (2017-18) is spent on servicing debt due to past borrowing profligacy while social sector spending sags.

There are three specific ways in which the government can mitigate this problem by putting forex reserves to good productive use in building infrastructure, cutting the debt servicing outgo and still retaining the fiscal deficit at 3.20 per cent of GDP.

First: Convert a portion of the $400 billion reserves into a sovereign wealth fund — exactly as China has done. If the sovereign fund has an initial corpus of $100 billion (Rs 6.50 lakh crore), it can invest in infrastructure which will deliver returns of up to 10 per cent a year compared to one per cent from US T-bills. Moreover, the need to use budgetary allocations for infrastructure investment will be obviated. This would keep the fiscal deficit target of 3.20 per cent untouched. Investing Rs 6.50 lakh crore in infrastructure, healthcare and education will kickstart spending, create jobs and spur consumption.  

Second: Cut RBI’s key interest rate by 100 basis points. As the country’s largest rupee borrower, the government will immediately save one per cent on its domestic rupee borrowing of nearly Rs 50 lakh crore. That’s a straight saving of Rs 50,000 crore a year, thereby cutting the fiscal deficit by around 0.3 per cent.

Third: Fast-track PSU disinvestment. There are dozens of PSUs (hotels, airlines, etc.) that can be fully divested along with minority share sales in large, profitable PSUs like ONGC. A recurring target of Rs 1 lakh crore a year is feasible which will release extra funds for social sector spending without affecting the fiscal deficit.

One reason why the rupee has appreciated by over six per cent against the dollar during the past few months is the desperate search by foreign investors for higher yields. The Japanese and Swiss central banks offer near-zero or negative interest on deposits. The US and European central banks offer between one per cent and 1.5 per cent despite the US Federal Reserve’s determination to increase interest rates as global economic growth stabilises.    

India offers a safe six per cent return on sovereign debt. With the rupee holding firm and inflation moderating, US, European and Japanese investors are queuing up to invest in India. Hence the recent uptick in the balance of payments and the strengthening of the rupee against a basket of currencies. The fact that exports rose 26 per cent in September 2017 (when the rupee was 64 to a dollar) over September 2016 (when the rupee was 68 to a dollar) demolishes the myth that a weak rupee helps exports. Productivity, quality and delivery are more critical to export growth than a weak rupee.

For Indian policymakers, as the disruptions caused by demonetisation and GST fade, the focus must be on fiscal reform. At the top of the list should be finding a better way to deploy $400 billion in foreign exchange reserves. By 2019, at the current rate of accretion, they could rise to $500 billion. That represents both a challenge and an opportunity.