India's folly: Borrowing abroad to create a sovereign fund

The government seems to be inching steadily forward towards the folly of setting up a sovereign wealth fund. According to The Indian Express, a Group of Ministers chaired by Finance Minister Pranab Mukherjee has agreed, in principle, to set up such a fund to help acquire energy assets abroad.

The “in-principle” phrase is a dead giveaway. It means that the GoM is not really convinced about the idea - which has been opposed by the Reserve Bank of India - but the bad idea is somehow being pushed by some policy-makers who want to show they are doing something about insuring the country’s energy future.

The reality though is that the UPA is destroying the country’s energy future by suppressing the oil and coal companies we do have. By artificially pegging the prices of petro-fuels and coal low for short-term political gains, we have prevented the oil companies from generating enough surpluses to invest in buying energy assets abroad, and the same could happen with coal. Coal India is the world’s largest coal company, but its surpluses are being eroded by short-sighted policies.

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[caption id=“attachment_124081” align=“alignleft” width=“380” caption=“By artificially pegging the prices of petro-fuels and coal low for short-term political gains, we have prevented the oil companies from generating enough surpluses to invest in buying energy assets abroad, and the same could happen with coal. Pawan Kumar/Reuters”]  [/caption]

The key to India’s energy security is profitable and freer pricing of energy, not a sovereign fund. The sovereign fund will automatically get created when our oil and coal companies generate surpluses of their own which they can invest abroad or at home.

In the past, this writer has repeatedly emphasised that India is not ready for a sovereign wealth fund for many reasons.

A sovereign fund is about creating a vehicle to invest surpluses - usually abroad. It presupposes that you have money to invest. You can’t invest money that you don’t have or which belongs to someone else and call it a sovereign fund. China can have a sovereign fund, or Japan or Norway. Not India.

Consider India’s situation.

We are running a huge fiscal deficit that is likely to exceed 5 percent of GDP this year, and may worsen next year if revenues do not rise and the UPA goes ahead with its expensive Food Security Bill. So there’s not even a domestic cash surplus to invest in a domestic sovereign fund.

We are running a huge current account deficit that is around 3.1 percent of GDP. A current account surplus means we are importing and spending more on foreign goods and services than we are exporting. This means we have to deplete national wealth to pay for our overconsumption - unless international capital comes in to bridge the deficit.

RBI Deputy Governor HR Khan recently emphasised at an export conference that “We are a current account-deficit country…We are a balance of payments-stressed country. We have to promote exports to see that this is not going out of hand.”

India’s foreign exchange reserves are comfortable at $318 billion - which is what emboldens the advocates of a sovereign fund to force the creation of one. But this reserve is actually not a reserve and it anyway does not belong to the government. The figure almost exactly mirrors India’s large external debt of $317 billion.

Going ahead, our debt number is sure to exceed our so-called reserves as we have now started inviting more debt inflows - which bring their own risks of capital outflows.

The finance minister raised the foreign institutional investor (FII) limit for investment in infrastructure debt from $5 billion to $25 billion in the last budget. Moreover, Sebi’s latest figures show that FIIs are lapping up debt rather than equity. At last count, FIIs had invested a piffling Rs 821 crore in equity, and a huge Rs 19,174 crore in debt in calendar 2011. The RBI’s next data release on debt will surely show India’s external debt exceeding foreign exchange reserves.

Creating a sovereign fund from forex reserves is thus like borrowing money from abroad to create a wealth fund. Can a wealth fund created from borrowed resources really be a wealth fund? Khan of the RBI says these reserves should be kept for times of “extreme distress”.

Ask yourself: if someone told you here’s a good stock you can buy and simultaneously offered you a loan at market interest rates to enable you to buy the share, would you buy it? What is the risk you are courting if the share falls and you still owe your creditor money? The moral hazard is clear: you can’t invest in risk assets with someone else’s money.

Creating a sovereign fund out of borrowed capital is a terrible idea. We should save the idea for later, when we have a budget more or less in balance, when our reserves exceed our debts, and when our current account deficit is more manageable.