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Managing foreign exchange reserves: where India cannot match China

Beijing better prepared to tackle consequences of economic success

INDIA AND China are being compared yet again, although this time it is neither on economic growth rates nor on development of infrastructure facilities. China is the clear leader in both (as in many other parameters including foreign direct investment). It is the way the Chinese authorities are tackling one consequence of their stupendous economic success that is attracting attention everywhere including in India.

Recently the Chinese authorities decided to invest $3 billion out of their massive $1.2 trillion reserves in a private equity firm Blackstone based in New York and reportedly very active in emerging markets. Recently Blackstone was in the news in India with its decision to invest in the Eenadu Group of Ramoji Rao.

China's investment decision is significant in many ways. The larger picture is what one must first look at. In varying degrees, China, India and many other developing countries have accumulated large forex reserves that are then invested abroad. The reasons for such large hoards of forex with Asian central banks are to be found in the skewed nature of world trade and in the direction of foreign capital flows. China and many other East and Southeast Asian countries, following a policy of export led growth, have been enjoying highly favourable trade balances with the U.S. and other developed countries.

In India, the accumulation of reserves has been primarily due to the large foreign portfolio inflows into the stock markets. In the normal course, the abundant dollar supply would have made the domestic currency appreciate. For many countries including India and China this is not a happy prospect. Hence their central banks have mopped up the dollars which mostly go into their reserves kitty. India has $204 billion of reserves; maybe a sixth of China's but impressive all the same.

Most central banks, which handle investments of such reserves, have traditionally favoured the American dollar — the world's reserve currency.

Deployment pattern

And because their overriding concerns were safety and liquidity rather than return, they have been content to deploy them mostly in U.S. government paper. That action, while guaranteeing safety and liquidity, has however led to low yields. The rationale for building up reserves is to stave off a financial crisis caused by sudden and large outflow of capital.

In India and elsewhere, there has been a growing clamour for higher returns from the investment of reserves. In the context of the Chinese investment in a private equity firm, should India adopt a less conservative strategy than followed so far? Answers to such questions are not easy. One reason is that no two countries' situations — whether it is India, China or some other country — are identical. Obviously China has been better prepared: a substantial portion of its trade surplus has gone into its domestic equity markets. Hence policy makers may be both familiar with and probably comfortable with the market mechanism. In any case, for quite some time now, its monetary authorities have been contemplating alternative investment avenues for its reserves. For all that, China's choice of a private equity firm for investment is significant. Private equity firms are redefining the corporate landscape in many developed countries including the U.S. One of them acquired the American automobile icon Chrysler from Daimler-Benz with which it was merged in a spectacular, but failed, trans-Atlantic deal a few years ago. Private equity firms have often exerted tremendous pressures on traditional managements and owners of companies to deliver results. In many instances, they have forced a restructuring of the companies they have bought into. Quite often they have bought the public shareholding in the target companies and taken them private. As a rule, privately held companies have fewer accountability issues to reckon with and are far more opaque than a listed company.

Options for India

On the other side, similar allegations of a lack of transparency have been made in many countries against their central banks that manage the reserves. In such a context it is clear that policy makers will be particularly constrained to approve an investment strategy in private equity firms and such others. Their conduct even in the developed world has been questioned.

One is perhaps not recommending India going the whole hog on investing in private equity or hedge funds. There have been other alternatives — for example, the model followed by Singapore through its Temasek Holdings or the one followed by the UAE. The Kuwait Investment Authority was set up as far back as 1953. Norway has opted to invest its pension corpus in globally managed funds.

But even to the point of being repetitive, it should be stated that in India the circumstances (the environment as it is called) are simply not conducive for such actions. As it is well known, decision making by the government and the public sector is based on risk-aversion.

C. R. L. NARASIMHAN

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