No thanks, India does not need a sovereign wealth fund

After several false starts, it seems like the government and the Reserve Bank of India (RBI) are finally on course to set up a sovereign wealth fund (SWF). A sovereign fund is essentially a state-owned mutual fund that invests in assets abroad.

The idea now is to create a corpus of $10 billion to invest in energy assets abroad. The modalities are being worked out, but The Indian Express reports that the fund will be run as a subsidiary of the RBI and the money will be used to buy crude oil, coal and gas fields abroad with the foreign exchange reserves of the country.

The RBI has never been very enthusiastic about a sovereign fund in the past, but the Express assures us that it is now fully on board.

More from Business

Hyundai India’s Rs 27,870 crore IPO oversubscribed by 2.28X, largely driven by institutional investors How Indian fintech startups are driving Malaysia’s UPI-like digital payments revolution

But is a sovereign fund such a great idea? There are good reasons and bad reasons for setting up a sovereign fund, but currently the bad reasons outweigh the good.

[caption id=“attachment_69968” align=“alignleft” width=“380” caption=“The RBI has never been very enthusiastic about a sovereign fund in the past. Reuters”]  [/caption]

Before we get into this, let’s clear a popular misconception. The fact that India has foreign exchange reserves of $316 billion makes it seem as though we are sitting on piles of idle cash which can be invested better.

However, these reserves are not “free reserves” resulting from trade or export surpluses - which is the case with China. Most of our reserves are essentially borrowed money - like non-resident deposits, or loans raised by government and private sector companies. In fact, they actually represent liabilities that have to be repaid at some time in future. Our reserves are thus not really reserves, but temporarily parked capital inflows.

Impact Shorts

More Shorts

Tata Harrier EV vs Mahindra XEV 9e: Design and road presence compared

As Trump weaponises tariff, Fed sees a bigger worry: Not jobs, but rising prices in America

One figure will put this in perspective: as against foreign exchange reserves of $316 billion as on 12 August, the country’s foreign exchange debt was nearly as big at $306 billion.

In any case, when we are running a huge current account deficit (CAD) of 2.7-2.8 percent of GDP, we have to borrow capital or seek foreign equity investment just to pay for our imports. Where then is the surplus to invest abroad? (The CAD is the gap between earnings from exports and expenditure on imports of goods and services that has to be bridged by capital inflows, either debt or equity.)

So, the first fallacy that needs to be debunked is this: sovereign funds cannot be created by countries with big current account deficits. They are usually created by countries with exchange surpluses.

Just as you can become a serious investor only by generating savings and not by borrowing money, India cannot hope to run a sovereign fund with what is substantially someone else’s money. This explains the RBI’s initial reluctance to use its exchange reserves for financing the government’s energy or infrastructure dreams. It cannot invest in a sovereign fund which does not belong to it.

China can. China runs as many a four sovereign funds because its foreign exchange reserves represent genuine surpluses earned by its export machine. Norway runs a sovereign pension fund because its government decided that the temporary national wealth generated by North Sea oil should not be squandered away in current expenditure. It should be invested for the benefit of future generations.

Singapore runs two sovereign wealth funds because that city-state has no natural resources worth speaking about, and needs to invest its surpluses to create income streams for the future. Saudi Arabia, which has oil oozing out of every pore, and dollars spilling out of every barrel of oil sold, needs a SWF to invest its surpluses.

At last count, the Sovereign Wealth Fund Institute had 53 such funds listed in its directory - including many monetary authorities like Saudi Arabia’s SAMA and Hong Kong’s Monetary Authority, which have to manage foreign exchange reserves.

The second fallacy that needs questioning is the assumption that owning energy assets abroad - an oilfield here or a coal mine there - will somehow help India’s energy security. This is a complete misreading of the meaning of sovereignty.

A sovereign fund is sovereign only in name. It’s ownership of an oilfield in, say, Nigeria or Russia, will not mean India will get cheap oil. The price of the oil will still be determined by the oil market, and the sovereign laws of the host country. Just as India would not allow a foreign owner of Indian oilfields to sell the oil at any price he chooses, ownership of foreign energy assets does not guarantee cheap oil or even energy security for India.

In fact, oil security comes from pricing oil at market prices, so that prospecting companies have an incentive to look for more oil and gas reserves within India’s territorial limits.

The third point relates to what kind of risk a sovereign fund can take on. A billionaire can make huge bets on stocks or race horses in the hope that he can make even more billions - and take on big losses, if the bets go wrong. He will just be a few millions short.

But can a pauper bet big on race horses? Can India, with no real export surpluses worth speaking about, afford to be betting on energy or any other assets abroad when their prices can go down? Gold can go up to $2,000 an ounce, and also fall to $1,000 - if the US and European economies revive. RBI Governor Duvvuri Subbarao would have lost his job if that had happened to the gold he bought in 2009.

China can take those risks. It has a problem of plenty of reserves, and hence it is taking big bets abroad since the only other alternative is investment in low-yielding US treasury stocks - which are becoming less of a safe haven after the S&P downgrade.

The Chinese State Administration of Foreign Exchange (SAFE), which has been given one part of the country’s foreign exchange kitty to manage, invests in the UK equity market, and its big holdings include oil companies, banks, and retailers. Among them: Royal Dutch Shell, Rio Tinto, Tesco and Barclays. Its corpus is $568 billion - double India’s entire foreign reserves excluding gold.

However, there are good reasons to create an India Sovereign Fund - and these are entirely to do with the sensible management of India’s existing foreign exchange reserves.

As Firstpost noted earlier, investing most of the reserves in US dollars has been injurious to our financial health. In 2009-10, our foreign currency assets and gold gave us a return of just 2.09 percent. In terms of rupees, our earnings on foreign currency assets actually dropped 50 percent from Rs 50,796 crore in 2008-09 to Rs 25,102 crore in 2009-10. In 2010-11, it was down to an even more abysmal 1.74 percent.

The only redeeming feature is the RBI’s decision to buy 200 tonnes of gold in 2009 - which has given us a huge gain. Gold is now 8-9 percent of our total reserves, having more than doubled in value.

This gives us a counter-intuitive idea: the RBI’s decision to buy gold in 2009 suggests that it has already begun to think in terms of sovereign wealth management. It has taken risks by investing over $6 billion in gold in November 2009, and reaped dividends on it.

The logical and only sensible reason for creating an Indian sovereign wealth fund is for the management of our foreign exchange reserves and our need to diversify away from the dollar . This is what Saudi Arabia’s Monetary Authority does. This is what the RBI should do.

Perhaps a good way to go about it is to create an RBI subsidiary and allot it, say, $ 25 billion to manage. It should also be given an official asset allocation goal so that it does not take excessive risks: it could be 25 percent in safe assets that earn more than 3 percent, another 50 percent in riskier assets like commodities and oil, and the rest on high risk assets like equity or real estate. Based on its performance, more assets can be allocated, while staying within the overall asset allocation range.

The RBI needs a fund manager for its own use. The country doesn’t need a sovereign wealth fund. That’s for richer countries which have surpluses to invest.