With India’s foreign exchange reserves at over $300 billion and growing, there has been renewed interest in establishing a sovereign wealth fund (SWF), using a part of those reserves.
An SWF is a separate pool of assets, primarily (but not exclusively) invested outside the country, and controlled by governments to achieve economic, financial, and strategic objectives.
While there are well-established conservative international norms for investing forex reserves, this is not the case with the SWFs, which can engage in more aggressive risk-management practices.
India is a significant recipient of investments by SWFs from abroad.
While the SWFs have existed for several decades, their vastly expanded scale and scope of activities is a relatively new phenomenon.
Currently, among the institutional investors, pension funds have the largest assets, totalling around $25 trillion, while the corpus of SWFs is around $5 trillion. Industry experts estimate that the SWFs will grow to $20 trillion by 2015, while the endowment funds and foundations increase to $10 trillion.
The current stock market capitalisation of the world is around $50 trillion.
As with other institutional investors, SWFs also engage in partnership with private equity companies and hedge funds. SWFs can potentially facilitate a more efficient allocation of revenue from commodity surpluses across countries; help recycle current account surpluses; and enhance market liquidity. They also have potentially longer time horizons; and scale to employ more sophisticated risk management strategies.
Unlike in case of pension funds, there are no robust databases, either domestically or internationally, to monitor the financial flows of the SWFs. There are concerns about transparency and accountability of the SWFs, both for the home and the recipient countries. There are also concerns about conflicts of interest, potential insider trading, and reduced regulatory effectiveness.
The IMF has begun work on developing a code of conduct for the SWFs, which will include disclosure, reporting, transparency, and governance. Efforts are underway to also develop such code for hedge funds.
In India, the regulatory regime governing capital inflows does not recognise SWFs, hedge funds and private equity as a distinct category. Their investments are subject to normal prudential provisions.
There is, however, a concern that such an approach may be too benign given the complexity of the nature of transactions and the size of the SWFs. At the least, more robust database on incoming flows needs to be developed by the Reserve Bank of India (RBI).
The case for establishing a SWF in India is mixed. Most analysts feel that while India’s international investment position is not very comfortable, its gross reserves are adequate, even after considering high precautionary needs due to its current account and budget deficits. Thus, unlike most other countries, India’s case for SWF does not rely on export surpluses, conversion of non-renewable assets into a more diversified portfolio of financial and physical assets, or contingent pension reserve.
Instead, in India, a major reason for setting up an SWF is the possible use of forex reserves to finance critical infrastructure needs; and to mitigate quasi-fiscal costs of sterilising reserves. These costs arise as returns on conventionally invested reserves are 3-4%, while domestic bonds need to be financed at 7-8%.
A more aggressive risk posture for 3-5% of forex reserves ($9-15 billion) could help mitigate the extent of quasi-fiscal costs, albeit at a higher risk.
Even if India does establish such an SWF, its size will be among the smallest globally.
The largest SWF in the World is Abu Dhabi Investment Authority, with assets exceeding $1 trillion.
Russia has recently announced its intention to use its excess revenue from oil through SWFs to increase its strategic leverage.
Establishment of an SWF will enable India to be on a learning curve in regards the complexities of establishing and operating such a fund. This, in turn, could assist in devising measures to better monitor the operations of foreign SWFs in India. It will also give India a standing in participating in international discussions concerning the governance code for SWFs. Also, as India’s pension assets (currently about 15% of GDP) continue to grow, some international risk diversification would become essential. The SWF experience could then prove useful.
The challenges in setting up a SWF in India include high initial setup costs, including specialised staffing, sustaining a transparent and accountable governance structure and managing the political economy. India’s democratic checks and balances will impose constraints on SWFs, which are usually not found in the state-capitalist economies most of the SWFs are located in.
The SWF may also distract the government’s urgent need to address more critical public policy issues concerning trade imbalances, fiscal consolidation, infrastructure and human resource development needs.
By some measures, India already has a SWF called the India Infrastructure Finance Company (IIFC). The government-owned firm has set up a subsidiary in London, and has borrowed $250 million from RBI in foreign currency by issuing it 10-year government-guaranteed bonds at Libor.
IIFC is mandated to lend to Indian companies to import capital goods for infrastructure projects in India, or to co-finance external commercial borrowings (ECBs) of Indian firms in select areas. But, while this does address the concern that using reserves domestically could create adverse liquidity and inflationary impact, this may adversely impact the domestic capital goods sector, and government guarantees may create severe moral hazard problem.
In a speech in Washington DC this month, RBI governor Dr Y Venugopal Reddy outlined the broad contours of a more traditional SWF, which would invest a part of India’s excess reserves in the global markets. Reddy suggested creation of a separate entity or company, which will purchase foreign currencies from the RBI, and in turn invest in higher risk-higher return assets internationally. He also suggested that the SWF be managed by an independent sovereign entity, and not by RBI.
It appears there is consensus emerging in official circles for setting up a traditional SWF. On balance, there is a case for such a move, but caution is needed in implementing it to ensure that appropriate safeguards are provided.
Source: DNA India