India's foreign exchange reserves are burgeoning at about $120 billion, perhaps double the level required by prudential considerations. Key infrastructure sectors are starved of investment, especially public investment.
So why not deploy the "excess" reserves (which earn low returns for the economy) to build the much-needed infrastructure facilities and thus boost the country's growth? What could be more obvious? The obvious sometimes invites weird and interesting schemes.
Some eight or nine years ago, when we had our first taste of abundant reserves, the Planning Commission (or at least one of its articulate members) had wanted to use the reserves to restructure loss-making public enterprises!
Saner counsel prevailed and the proposal was stymied. This time around newspaper reports indicate that the Planning Commission (henceforth PC) is pushing for a more structured scheme to use forex reserves for infrastructure financing. Is this scheme sounder than its predecessor?
First, what seem to be the key elements of the scheme? There is a lot of confusing talk of special purpose vehicles and special accounts. Judging by reports, the heart of the proposal seems to be as follows.
The government will increase the Centre's fiscal deficit (over and above levels implicit in the Fiscal Responsibility and Budget Management Act) by a specified amount, say, Rs 20,000 crore (Rs 200 billion) a year, to fund worthwhile public infrastructure investment.
To ensure that this additional deficit does not raise interest rates and crowd out other investment, the entire amount would be raised by placing an equivalent value of government bonds directly with the Reserve Bank at the prevailing interest rate.
Since this constitutes monetisation of the deficit with the potential for increasing money supply and inflation, the new public investment will be structured to be import-intensive.
Ideally, if the entire Rs 20,000 crore was spent on imports, then forex reserves would decline by this amount. In effect, the increase in domestic assets of the RBI (from the additional government bonds) would be fully neutralised by a corresponding decline in foreign assets (reserves), thus leaving the supply of reserve money (and hence broad money) unchanged.
Abracadabra! The scheme thus claims to accomplish Rs 20,000 crore a year (only an illustrative figure) of additional public investment ("out of the RBI's forex reserves"), without fanning inflation and without crowding out other ongoing investment and with only a cosmetic increase in the fiscal deficit.
In the likely event that not all of the additional public infrastructure investment will constitute imports, the reports suggest that the government will undertake other measures such as customs duties reductions and/or currency appreciation to bring about the full forex decline required to neutralise the fresh monetised government borrowing.
This seems to be a pretty good deal. But appearances can be deceptive. It's time to raise a few doubts. First, much of infrastructure investment is not import-intensive; for example, roads, irrigation, and airports. The additional expenditure will not lead to much decline in forex reserves.
That means the effect of monetisation will have significant inflationary consequences. As for the suggested measures of customs duty cuts and currency appreciation, these could (perhaps should?) be done anyway in a context of "excess reserves". Their desirability is not linked to RBI-financed government investment.
Second, although the suggested option for cutting import duties is reasonable from a trade liberalisation perspective, it does entail revenue loss and hence a higher fiscal deficit with the usual consequences of pressure on interest rates and crowding out.
Third, while the effects of the higher fiscal deficit entailed by the basic scheme are claimed to be neutralised through monetisation, what about its public debt consequences?
In particular, won't there be an increase in India's already high (85 per cent of GDP) and rising public debt to GDP ratio? And won't this lead to a higher debt service burden on government finances?
The adverse signalling consequences of higher fiscal deficits (even if monetised) and rising public debt ratios should not be underestimated. Fourth, nor should the trajectory of FRBM targets for various fiscal ratios be lightly tampered with.
Especially not to accommodate the government's own scheme, as distinct from unforeseen shocks and contingencies.
Public investment in infrastructure should be increased, but through the normal methods of raising more tax and non-tax revenue resources and containing low priority current expenditures.
Fifth, there is something distinctly odd about suspending normal practices for managing the government's borrowing requirements and undertaking ad hoc placement of the illustrative Rs 20,000 crore infrastructure-financing-bond directly with the RBI.
Surely, the conduct of public debt, interest and liquidity management policies of the RBI should not be hostage to specific components of government expenditure? Isn't macroeconomic policy all about aggregates?
Must we encumber it with a typically Indian proclivity for dubious special cases? If a special modality is constructed for this case, might there not be many other competing claimants for special dispensation for freedom from the fiscal constraints of the FRBM?
Talking of special expenditure components and their right to elaborate special treatment, it is more than a little disquieting that the best examples of sizable government expenditure, which have the property of debiting wholly on abundant forex reserves, is provided by purchases of imported military aircraft, ships, tanks, and other large-ticket defence systems.
The PC's well-intentioned proposals for special modalities for public infrastructure financing could invite enthusiastic attention from the nation's service chiefs.
They could readily advocate that monetised, debt-financing of defence imports will have no inflationary consequences as the extent of monetisation will be swiftly offset by the decline in forex reserves!
Seventh, the PC's proposed scheme assumes that the public infrastructure investments will yield high returns to the economy. Hence the justification for elaborate special treatment.
But what is the surety for this? Will state electricity boards and public works and irrigation departments suddenly become lean, mean profit centres for government finances just because the RBI bends prevailing rules and practices to accommodate a set of special infrastructure financing government bonds?
Surely, the opposite is just as likely, if not more. Namely, the more the institutions for public infrastructure spending, operation and maintenance are relieved of pressing budget constraints, the more lax they will become in using public funds.
Indeed, is finance the real constraint to higher infrastructure investments? A compelling case could be made (and has been by many, including the PC in the Tenth Plan) that the major obstacles to more high-quality infrastructure investment are embedded in the uncertain regulatory frameworks of key sectors and the rampant populism that pervades policies and practices of major public entities providing infrastructure services.
It is these that have to be reformed to transform the quality and quantity of public infrastructure services in India and nudge the country to a higher growth path.
As for the 'problem of excess reserves,' the real answer may lie with reviving serious economic reforms (of labour laws, banking, privatisation, SSI reservations, taxation, etc) that catalyse a sustained revival of industrial investment, which will generate a rapid growth of non-oil imports.
Until then, the high international prices for oil are doing their bit to contain India's forex reserves.
The author is Member, 12th Finance Commission, and a Professor at ICRIER. The views expressed are strictly personal.
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