Y V Reddy: Forex reserves, stabilization funds and sovereign wealth
funds - Indian perspective
Address by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Golden Jubilee
Celebrations of the Foreign Exchange Dealers' Association of India, Mumbai,
8 October 2007.
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Shri Sridharan, Chairman, FEDAI, Ladies and Gentlemen
I am happy to be here today with the members of the Foreign Exchange Dealers Association
of India, popularly known as FEDAI in the industry. FEDAI completes 50 years in 2008 and
the Reserve Bank and FEDAI have shared a unique and symbiotic relationship all these
years. Since the beginning of the reforms, FEDAI has partnered with the Reserve Bank to
ensure adoption of best practices in the profession of foreign exchange dealing. FEDAI also
plays a very important role as a communication channel between the Reserve Bank and the
banks authorised to deal in foreign exchange. FEDAI continues to provide valuable insights
in this vital segment of our financial markets.
I am happy that on the occasion of its Golden Jubilee Celebrations, FEDAI is releasing a
monograph on its 50 years' history and a brochure on foreign exchange facilities, which will
assist resident individuals who access these facilities. This is also expected to provide
greater understanding and awareness among the Authorised Dealers' branch level staff
dealing with customers and enhance the quality of customer service. The topic for the panel
discussion today is pertinent in the current context and we in the Reserve Bank look forward
to obtaining a feedback of these discussions.
There has been, in the recent past, a growing interest in the magnitudes and working of what
may be broadly characterized as national foreign asset funds. Despite several overlapping
features, they broadly consist of foreign exchange reserves, stabilization funds and
sovereign wealth funds. While these funds have the characteristics of being in the public
sector, the motives for establishment, sources of funding and institutional arrangements for
managing them vary considerably though there is a great degree of consensus on these
aspects as far as foreign exchange reserves are concerned. While there are difficulties in
generalizations in regard to these funds, other than foreign exchange reserves, due to the
sheer variety and complexities of features and arrangements in different countries, it is
essential to appreciate the broad characteristics of these funds, in view of their growing
importance in global financial flows. For the purpose of today's talk, "funds" would refer to
Stabilisation Funds and Sovereign Wealth Funds (SWFs) that are to be considered
separately from the foreign exchange reserves. Management of the foreign exchange
reserves is subject to international best practices and disclosure standards and traditionally
vests with the central banks or monetary authorities of the country. The distinction between
Stabilisation Funds and SWFs is not very clear in practice but, for analytical purposes, such
a distinction is useful.
The accepted definition of foreign exchange reserves includes external assets that are
readily available to and controlled by monetary authorities for direct financing of payments
imbalances, for indirectly regulating the magnitude of such imbalances through intervention
in foreign exchange markets to affect the currency exchange rate, and/or for other purposes.
To meet this definition, reserve assets need to be liquid or marketable foreign currency
assets that are under the effective control of, or "useable" by, the reserve manager and held
in the form of convertible foreign currency claims on non-residents. The management of the
foreign exchange reserves is typically the preserve of the central bank or the monetary
authority of the country.
Stabilization Funds, or commodity funds, are augmented mainly by "windfalls" from
commodity exports, more commonly petroleum. These funds may invest in a wider range of
assets than those in which the central bank would invest the foreign exchange reserves.
However, considerations of liquidity and moderate risk are also relevant because
Stabilization Funds may be drawn upon when such "windfalls" disappear and contingencies
warrant. A Stabilization Fund is designed primarily to achieve medium-term macroeconomic
stabilization objectives, arising out of domestic economic and financial effects of volatility in
export earnings. However, if there are sustained "windfalls" on export front and consequently
there is no draw down of funds, a Stabilization Fund may be converted into an endowment
fund as done by Norway by rechristening the Petroleum Fund as Government Pension Fund.
SWFs generally refer to special purpose investment vehicles created to manage national
savings to generate higher returns. The non-commodity SWFs are usually carved out of the
official reserves of a country. Countries having large balance of payments surpluses have
been able to transfer excess foreign exchange reserves to such investment vehicles.
Typically, countries that have set up SWFs have surplus on the current account due to
"windfall" or sustained current account surpluses, and usually a fiscal surplus as well.
Consistent with their objectives, the official foreign exchange reserves are generally
deployed in low-risk liquid assets. Typically these reserves are invested in debt instruments
representing sovereign/sovereign-guaranteed liability, in deposits with other central banks,
Bank for International Settlements (BIS), supranationals and with highly rated foreign
commercial banks. In some circumstances official foreign exchange reserves are also used
as a tool of domestic liquidity management by way of forex swaps.
Stabilization Funds are normally expected to constitute a macro hedge against a sharp fall in
the export receipts from commodities that are mainly exported. They are set up primarily to
insulate the budget and the broader economy from excess volatility, inflation, Dutch disease,
etc., by smoothening revenues flowing to the budget i.e. saving during a revenue windfall
and dis-saving during a price slump.
SWFs seek returns over and above that required to preserve the real value on a sustainable
basis. SWFs attempt to invest in a wide spectrum of high yielding assets, for example, longer
term government bonds, agencies and agency-backed securities, corporate bonds, equities,
commodities, real estate, private equity, hedge funds, etc. The investment horizon is
extended so as to enable sharing of wealth across generations or to achieve other long-term
objectives. To illustrate, the Economist of September 29-October 5, 2007 refers to the SWFs
as "The new Rothschilds" and sub-titles the write up as "State-run funds are pumping money
into the financial sector".
Whatever might be the medium-term or long-term objectives of Stabilization Funds or SWFs,
they could be utilized as official reserves as they are either under the control of the monetary
authority or can be made available to the monetary authority in case of need. Hence, these
funds are sometimes described as "quasi reserves". It is, therefore, useful to view all the
three as components of national foreign asset funds.
In most countries, the allocation of roles and responsibilities of agencies overseeing the
foreign exchange reserve management function are explicitly stated in the laws and
guidelines governing the reserve management entity. While it is usually the central bank or
the monetary authority which is entrusted with the task of management of the foreign
exchange reserves, in some countries, where foreign exchange reserves are owned by the
government, management responsibilities between the central bank/monetary authority and
government are clearly spelt out and disclosed. As custodians of the official reserves, the
central banks are accountable to their governments or central legislatures even if the degree
of autonomy of the central banks varies from country to country. In addition, central banks,
by virtue of their relationships with international organizations, like the International Monetary
Fund and the Bank for International Settlements, benefit by sharing best practices in
reserves management, in particular, and central banking in general, all of which greatly
contribute to fostering transparency and stability in the international financial system.
In contrast to the foreign exchange reserves, Stabilisation Funds and SWFs may or may not
be subjected to such rigorous accountability and transparency tests, internally, by the
governments concerned. The main reason for lack of clarity is that global benchmarks for
disclosure are yet to evolve, to which they may be expected to conform.
Even as the size of the official sector reserves and the stabilization/sovereign wealth funds
has grown considerably in recent years, fundamental issues like what really constitutes
"international reserves" are yet to be settled. It is universally accepted that, to be included as
part of the international reserves, the foreign assets of the Stabilization Funds / SWFs should
be easily available to the monetary authorities in the form of liquid foreign currency claims on
non-residents. In simple words, if the assets are part of the balance sheet of the central bank
and fulfill certain other criteria, then they are to be treated as international reserves. If,
however, the same assets are held by a long-term fund, which is a separate corporate entity,
then they may not be reckoned as part of the international reserves from liquidity point of
view. However, since these assets are either under the control of central banks or can be
made available to central banks, it cannot be said they are not available when needed as
reserves.
Basically, all foreign asset funds are owned by the public sector and, depending on the
country context, these are allocated among the Stabilization Fund and SWF. It is not
uncommon for a part of a wealth fund to be created out of foreign exchange reserves or
Stabilisation Funds. Much depends on a view being taken about the "windfall" gains
component due to commodity prices justifying a Stabilisation Fund and the transferring of
commodity wealth into a more permanent flow of income for future generations. SWFs may
also be carved out of foreign exchange reserves, to have a special focus on enhancing
returns by accrediting more flexibility. The choices between and allocations among these
vehicles of foreign assets in public sector are thus essentially a matter of domestic policy. In
this context, analytically it will be useful to address the links with fiscal policy, in terms of
rules governing inflows and outflows form fiscal to these funds. Similarly, there could be links
with monetary policy when the funds are carved out of foreign exchange reserves held by the
central bank. The investment policies of the funds are perhaps most critical from the point of
view of public policy. In all cases, it is reasonable to presume that, being part of public sector
assets, the funds would be subject to the appropriate standards of governance, transparency
and accountability. However, there may be legitimate concerns in case such a fund is
observed to be operating in a non-transparent manner or with predominantly non-commercial
considerations.
It is argued that some of the asset funds are similar to hedge funds and they themselves
invest in hedge funds, thus inviting regulatory concerns similar to those pertaining to hedge
funds. The major issue is whether there should be a presumption in favour of or against a
foreign public sector vis-à-vis a foreign private fund. The critical issue relates to standards of
governance and transparency that are adopted by such funds and the extent of comfort that
investee countries have in this regard.
The role of central banks in the establishment and operations of these funds cannot be
ignored. In some cases, central banks advise the government in the design and
establishment of Stabilisation Funds or SWFs. In some other cases, they also operate as
fund managers, but subject to formal principal-agent agreements. In a few cases, the central
bank creates a separate unit within itself to manage a fund. In view of the expertise and
credibility, involvement of a central bank in such funds to a significant extent appears logical.
In India, under the RBI Act, 1934, the Reserve Bank of India has been entrusted with the
responsibility of managing the country's foreign exchange reserves. The Reserve Bank also
consults the Central Government on important matters relating to the management of foreign
exchange reserves. It follows the internationally accepted measures of compilation and
dissemination of data relating to foreign exchange reserves. The Reserve Bank has
voluntarily opted for IMF's Special Data Dissemination Standard (SDDS) that enjoins upon it
adherence to internationally accepted best practices in this regard. In 2004, after a review of
the main policy and operational matters relating to management of the reserves, including
transparency and disclosure, the Reserve Bank decided to compile and make public
halfyearly reports on management of foreign exchange reserves for bringing about enhanced
level of disclosures. These reports are being prepared with reference to the positions as of
31st March and 30th September each year, with a time lag of about 3 months. Again with a
3-month lag, the Reserve Bank places on its website sources of accretion to foreign
exchange reserves. In addition, the Reserve Bank has been disclosing its risk management
policy with regard to foreign exchange reserves in its "Annual Reports" for the past several
years. To summarize, the country's foreign exchange reserves are managed according to the
law; the Reserve Bank adheres to the internationally best practices of measuring the
reserves and data dissemination standards; and the Reserve Bank follows appropriate
prudential norms in the management of the foreign exchange reserves.
However, of late, there have been suggestions that India should consider setting up a wealth
fund on the lines of either a Stabilization Fund or a SWF. As mentioned, the objectives of
establishing Stabilization Funds are to mainly smoothen the revenue flows arising out of
volatility in commodity export proceeds. India's export basket is diversified and does not have
a dominant "exportable" natural resource, which might bring "windfall" gains. Further, India
has experienced consistent current account deficits, barring a modest surplus for a few
years. Hence, creating a Stabilisation Fund may not be justified on the basis of current
situation. SWFs are generally created amidst current account surpluses when the foreign
exchange reserves attain a level higher than what is perceived as "adequate". If we follow
this global experience, consideration of an SWF for India may ideally await "more
comfortable current account" and "significantly improved fiscal" situations.
It is sometimes argued that in the context of significant growth in foreign exchange reserves
in recent years, the portion of the reserves that is in excess of a certain recommended level
may be carved out and invested separately for maximizing returns. In this regard, it is
necessary to view the concept of "excess reserves" from several angles, including from the
perspective of possible real sector shocks to the current account and the nature of capital
flows. India is vulnerable to shocks on account of oil price and fluctuations in food grains
production, which is still largely dependent on monsoon conditions. Additionally, a large part
of the capital flows are portfolio flows and a significant component of Foreign Direct
Investment is in the nature of private equity or for acquisition of existing firms and not in
greenfield projects. In a sense, therefore, capital account shocks, which would be
independent of the economic fundamentals of the country or domestic macroeconomic
environment, cannot be fully ruled out.
Concluding remarks
To sum up, it is necessary to recognize that Stabilisation Funds and SWFs are playing an
increasingly important role in global capital flows. The operations of these funds have
generated considerable interest among the policy makers and central banks. India has a
stake in the on-going debate by virtue of its increasing importance in the global capital flows.
More generally, in India, we have been seeking comfort in respect of the nature of
investment associated with capital inflows through hedge funds channels and participatory
notes. Similar issues could also be relevant in respect of private equity flows. While it is
essential to recognize the public sector nature of the Stabilisation Funds and SWFs that may
be investing in India, it is also useful to study the evolving global practices of investee
countries' approaches to these funds.
At this moment, as mentioned in the foregoing, circumstances in India do not seem to
warrant a serious consideration of establishing either a Stabilisation Fund or a SWF.
However, if and when such a consideration is given, it would be essential to put in place
sound governance, transparency and accountability standards that would provide necessary
comfort to the domestic fiscal and monetary authorities and, additionally, to the investee
countries.
I would like to thank the organizers for giving me the opportunity to share some of my views
on a subject of emerging importance and in regard to which we have just begun the learning
process.
I wish the FEDAI's Golden Jubilee Celebrations a grand success.
On the occasion of FEDAI's Golden Jubilee, I have the pleasure of presenting to FEDAI, on
behalf of RBI, a set of Commemorative Coins brought out on the occasion of the 50th
Anniversary of India's Independence.
Thank you.