Thinking modalities for a sovereign wealth fund

In a recent lecture, Y V Reddy, the Reserve Bank of India (RBI) governor, rejected the idea of having a sovereign wealth fund (SWF) citing reasons like current account deficit, vulnerability to oil price volatility, fluctuations in food grain production and hot money (portfolio flows).

Should we feel proud of being the fifth-largest accumulator of foreign exchange reserves sitting on $260 billion? And if we cannot stem the accretion in reserves, shouldn’t we at least try to increase the returns on them? Forming a sovereign wealth fund could just be a win-win solution.

SWF is a special purpose vehicle of the government, funded by foreign currency assets, with a higher risk tolerance and higher return expectation.

The management of assets under SWF is separate from the management of the official reserves. Unlike official reserves, which are usually held in short duration US bonds, the SWF portfolio has a product mix of different fixed income, equity, commodity and realty instruments.

Since the funding is being done in foreign currency and also since the investments are done in foreign markets, there can be no inflationary pressures due to sterilisation (which could have been the case if the reserves were being used for infrastructure funding).

So, what is the relevance of SWF to the Indian scenario?

Asian central bankers, including RBI, have been financing the current account deficit of the US and there is absolutely no indication that this will cease in the near future.

The RBI’s intervention in the market to stem appreciation in rupee will just result in further accretion of forex reserves. The calculation of forex reserves adequacy, using any of the theoretical models available, will show that we are well over the prescribed requirement.

I quote two of the most frequently used norms to measure the current forex reserves adequacy in India.

* Import cover: Reserves should be sufficient to cover 3-4 months of import. India has reserves sufficient to cover 15 months of imports (June 2007)

* (Greenspan-Guidotti rule: Reserves should be equal to one-year short-term external debt. At the end of June 2007, the ratio of India’s short-term debt to forex reserves was only 7.9%.

Forex reserves were 129% of the entire external debt, thus exceeding the entire external debt by a whopping $48 billion. Even by the most conservative approach, this $48 billion can be considered as excess reserves.

Meanwhile, RBI has been sterilising the continuous appreciation of the rupee by issuing domestic debt at 7.4% (average yields for dated securities in primary market in 2005-06).

Unfortunately, as per the latest available figures from the Report on Foreign Exchange Reserves-2006-07, the return on the forex reserves was a dismal 3.9% for 2005-06 (July-June).

Thus, sadly, we are earning a return of just 3.9% on assets financed by a debt of 7.4%. Moreover, with rupee appreciating, reserves in national term are actually much less than in dollar term. Is this the right way of managing our country’s assets? 

One of the solutions to this situation obviously lies in actively managing the excess reserves to obtain better yield. That can be achieved by forming a SWF - let’s call it the Indian Wealth Fund (IWF).Let us assume that at the end of October 2007, IWF has strategic asset allocation like a balanced fund, with 60% investment in fixed income, 30% in equities and 10% in cash (or Fed funds).

We create a model case by using different benchmarking indices for the different asset classes (see table). A rough estimate shows that the return could have been 13.78% in the last one year.

Assuming $20 billion of the excess reserve is available for investments through the IWF, the returns (at Rs 39.5 per dollar) alone would be sufficient to finance 90% of health sector expenditure proposed in the 2007-08 budget.

Similar calculations show that the aggregate returns from the investment would have been in tune of 10% and 6.5% for 5 years and 10 years, respectively.

Of course, changing the allocation and time period variables will alter returns, but the point remains that investment through the IWF will indubitably lead to enhancement of returns.

Internationally, there are about 15-20 SWFs. Recently, China came up with an SWF named China Investment Corporation, which had an initial asset size of $200 billion, i.e., around 15% of the country’s forex reserves (excluding gold).

One of the oldest SWFs, Norway’s Global Pension Fund, with an asset allocation of 40% in equities and 60% in fixed income, earned nominal returns of 6.5% with a management cost of just 0.09% per annum.

How do we go about forming an IWF in India? It will be a separate autonomous body under the Constitution, with initial set-up funding from the government. Like any other investment fund, it will have a trustee and an asset management

company (AMC). Trustees will constitute representatives from RBI, the ministry of finance and academicians, and will have fiduciary responsibility for setting

investment objectives and ensuring proper benchmarking and risk management systems. The AMC will draw out professionals from the market, offering them competitive remunerations.

IWF will be responsible for managing a portion of excess reserves transferred from the official reserves. The asset size can be increased from time to time with accretion in forex reserves.

The IWF will have investment objectives (decided by investment trustees), mainly to increase returns on foreign currency assets, and the AMC will work towards achieving those objectives.

It may be mentioned here that presently, Indian forex reserves are held in the form of short duration government securities and deposits with other central banks in four currencies, viz., the US dollar, euro, yen and pound sterling. Such allocation is driven by a low risk appetite and desire for high liquidity.

On the contrary, since the IWF’s strategy would be to enhance returns, one could see a shift towards equities, corporate bonds and derivatives, etc.

In the case of fixed income securities, investment will shift towards longer duration sovereign debt, corporate bonds and asset backed securities.

Meanwhile, the equities’ investment horizon will include both developed markets and emerging markets. Asset allocation can be done like a balanced fund, as illustrated in the table.

Moreover, if dollar continues to lose its dominance further, IWF could diversify its assets further to non-USD currencies.

Since managing a multi-asset portfolio requires a huge initial setup with staffing of highly specialised and
experienced traders, researchers and back office personnel, using external assets managers could help.

Apart from private global financial bigwigs, some supranational organisations are also acting as external managers for many SWFs.

After asset allocation is decided by the trustee, benchmarks could be chosen or specially designed and external mangers who would be actively managing the portfolio would be given the task of beating the benchmarks.

Also, having a robust integrated risk management system with the AMC measuring and reporting all types of risks to trustees on regular basis would be very essential.

This brings us back to the statement of Reddy. Reasons like current account deficit (which is low), vulnerability to oil price, etc do make a case for adequate forex reserves.

But, at same time, they cannot justify having such idle excess reserves. As we have seen by now, formation of the IWF, contrary to Reddy’s view, could be the answer to the problem of suboptimum utilisation of burgeoning forex reserves, without actually putting any inflationary pressure on the economy.