Monday, May 28, 2007

Should forex reserves be invested in equities?

Paper reports have informed that China has decided to invest about $3 bn of its reserves in Blackstone, a private equity fund. On the face of it, it will look like a communist government doing what capitalists would normally do. But most analysts failed to understand and predict China. This coupled with the fact that India also has been accumulating substantial forex reserves, (though not at levels which are comparable to the Chinese – its forex reserves have crossed the $1 trillion mark while that of India’s are currently at about $200 bn) has brought the question of making more money out of deploying these reserves, to the fore.

First some facts. India’s earnings on forex investments, which are mostly made in US Treasury bills and Gold, were about 3.1% and 3.9% respectively in 2004-05 and 2005-06. Taking into account the inflation rate prevailing in those years, the returns translate to a negative return of -1.86% and -0.75% respectively. The current year is not expected to perform any better.

There are two arguments for and against such use of forex reserves.

China is not the only country that has undertaken such a deployment of forex reserves. Singapore, South Korea, Malaysia and Thailand have been investing their forex reserves in various assets like top-grade corporate bonds, equities and real estate all across the globe.

While that is so, what one needs to look at is:

  1. Can a country like India, which has witnessed comfortable levels of foreign exchange accumulation only in recent times, afford to invest in riskier assets? Those countries have been having comfortable forex accumulations over a much longer period.
  2. On the face of it, China’s deployment appears to be a sound business proposition. Their interest rates are far lower than that of the US. So, if they are investing about $3 bn out of their $1 trillion funds, it is a simple case of testing the waters. It hardly makes up for a paltry 0.3% of their total reserves.
  3. But for a country like India, which in fact is subsidizing exports by costly forex build up operations, does it make sense to invest such reserves in more riskier assets? The answer can be a ‘yes’ and ‘no’ depending on how you look at it. If the risks yield better rewards, then the costs of building them up would be offset, at least to a certain extent. On the other hand, if the risks hand out worse results, it will lead to a further hike in costs for the country. So, only a careful study of the risk-reward ratios should clinch the decision rather than mere copying of what China or some other country does.

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