Speaking at an international capital markets and emerging markets roundtable in Washington, Reddy said, “It may be possible to argue that a part of the reserves, which may be considered to be in excess of the usual requirements, be managed with the primary objective of earning higher returns. Given the limitations placed on the central bank by its mandate, it can be held that it will be appropriate to bestow this responsibility on a different sovereign entity.”

Reddy further explained that if and when the country considers setting up of a SWF, one of the methodologies could be to fund SWF by purchasing foreign exchange from the central bank, to the extent required. “These foreign currency funds could then be used by the sovereign entity for seeking higher returns by investing in assets, which a central bank’s mandate may not permit. As the SWF will be a public enterprise, it will be required to conform to the applicable governance, transparency and disclosure standards,” said Reddy.

The returns on the foreign exchange reserves, under the present framework, are constrained by the mandate to RBI, which understandably lays a greater emphasis on safety and liquidity. However, the central bank chief said while it is possible to make a case for an Indian SWF, there are also weighty arguments for caution in this regard.

First, it would be very difficult to reckon in the Indian context “as is the case with many other countries, the ‘reserve adequacy’ in a dynamic setting and on that basis divert a part of ‘excess’ reserves for a higher return from riskier assets.” Second, while most other countries that have set up SWFs have amassed large reserves either on account of persistent current account surpluses or due to revenue gains from commodity exports, in particular of oil and gas, the Indian economy has twin deficits — a current account deficit as also a fiscal deficit. India’s export basket is diversified and does not have any dominant “exportable” natural resource output, which might promise significant revenue gains at the current juncture.

Third, India has experienced consistent but manageable current account deficits barring very few years of a modest surplus. India also has a negative international investment position (IIP) with liabilities far exceeding assets. The country has not yet considered regulatory initiatives specifically addressing SWFs. The existing provisions in regard to the fit-and-proper or take-over code are, however, applicable to all investors, including SWFs. Currently, the pros and cons for the establishment of an Indian SWF, as generally understood now, are still under debate. India is monitoring recent developments in regard to enhancing transparency and disclosure in respect of hedge funds, private equity and SWFs.

In particular, India is watching with great interest the development of global codes, standards and practices in regard to SWFs, both in view of the presence of SWFs in the financial markets and the ongoing debate on establishing an Indian SWF.

Ready for sovereign funds?

What are sovereign wealth funds (SWFs)?

These are assets held by governments in foreign currency. When a country accumulates more forex reserves than it feels it needs, it can create an SWF to manage these "extra" resources.

How many countries have such funds?

Currently, over 20. Half-a-dozen more are keen to set up one. Norway has a large SWF, as do places as disparate as Alaska, Canada, Russia, and Trinidad & Tobago.

What is their total size worldwide?

The current total, as estimated by the International Monetary Fund’s quarterly magazine in September 2007, is $3 trillion. It could reach $10 trillion by 2012.

Is India ready for an SWF?

The government has not yet decided on setting up such a fund. But burgeoning forex reserves and the low returns they generate have put pressure on the RBI and the government to consider setting up one.