A study by Abhijit Sen Gupta for economic think tank Indian Council of Research in International Economic Relations (ICRIER) says the country is losing more than 2 per cent of its gross domestic product (GDP) by accumulating reserves instead of employing resources to increase the physical capital of the economy. By diverting resources from physical investment and employing them for reserve accumulation, India lost nearly $13 billion, or 2.34 per cent, of its GDP in 2003-04.

In the following two years the loss was slightly lower due to a higher return on foreign currency assets. However, with a relatively low incremental capital-output ratio (ICOR) and hence a high marginal product of capital in 2006-07, the loss rose drastically to nearly $18 billion, or 2.16per cent, of GDP. “Thus, we find that in terms of physical investment foregone, India is paying a substantial cost,” the study said.

The cost of excess reserves has been increasing steadily and in 2006-07 stood in excess of $2.5 billion, or 0.30 per cent, of the GDP. The study makes three interesting observations: India has accumulated excess reserves, the cost of excess reserves and how returns can be maximised.

“By 2007 India had accumulated more than $80 billion of excess reserves,” says the study — Cost of holding excess reserves: The Indian experience. The cost of holding reserves is measured by the interest rate spread between the private sector’s cost of short-term borrowing abroad and the yield that

the central bank earns on its liquid assets.

“The Reserve Bank of India (RBI) could well do to maintain an adequate level of reserves in the form of low return but highly liquid assets for meeting its needs like current account financing, meeting short term external debt obligations, restraining excessive volatility in the exchange rate etc., and park the excess reserves in an account with an objective of maximising returns subject to acceptable risks,” Sen Gupta’s study points out.

The funds in such an account could be profitably invested in non-treasury based assets like equities, private equity company and real estate, which are associated with greater market risk and hence correspondingly higher returns.

The bulk of India’s reserves are held in the form of securities or deposits with foreign commercial banks and international organisations. However, the rate of earning on foreign currency assets and gold, after accounting for depreciation was only 4.6 per cent in 2006-07 and 3.9 per cent in 2005-06. The inflation rate during these two years was around 5.43 per cent and 4.38 per cent, implying a real rate of return of -0.82 per cent in 2006-07 and -0.48 per cent in 2005-06.

The low returns are due to the RBI’s cautious policies, which are guided by principles such as maintaining mark-to-market value and liquidity by taking minimal credit and market risk. The RBI limits itself to investing in short dated AAA-rated government debt securities. “Such low returns have raised several questions about the management of international reserves by the RBI,” the report said.

Such investments are not new — Singapore and Korea have been doing this for a number of years now. Singapore’s Government Investment Corp (GIC) and Korea Investment Corp (KIC) have been investing a large part of their reserves in a variety of top grade corporate and sovereign bonds, equities and real estate holdings spread across the globe.

By investing $3 billion of its reserves with Blackstone, China has also initiated the move away from US treasuries to more profitable equity holdings. Other Asian

countries like Malaysia and Thailand are also examining ways of lowering their exposure to low yield US bonds.

BIG MONEY, LOW RETURNS

• RBI gets low returns on forex deployment in low-yielding securities abroad

• Sen Gupta says forex should be deployed in high return areas like equity, real estate and private equity companies

• By diverting resources from physical investment and employing them for reserve accumulation, India lost $18 bn in 2006-07