FX Reserves & Infrastructure

Shyam Ponappa / June 16, 2005

The most important criterion for investments is cash flow.


The proposal to use India’s mounting foreign exchange reserves for investing in infrastructure or in capital goods seems to have been given up.

Should it be revived as an attractive idea? Maybe, but this is where we need hard-nosed financial management and not reliance on broad-brush economics. The difference is the emphasis on cash flow, execution, and sustainability.

There is an impression that reserves represent government funds that are available for the asking, regardless of a sustainable yield. Understanding the nature of reserves, infrastructure needs and project returns is a good place to start.

First, foreign exchange reserves are not all India’s own capital: they also represent money that the Reserve Bank of India (RBI) owes investors abroad, parked temporarily with us as the equivalent rupees are invested in India through the primary or secondary markets, in corporate and individual accounts, or in assets such as real estate.

Second, from a financial perspective, investing reserves is all right provided (a) cash outflow needs are met, (b) the value of the invested capital is retained, and (c) the returns are reasonable.

Taken together, this amounts to investors seeing their capital not only preserved but enhanced in what they view as a reasonable timeframe: dicey for equity in infrastructure.

Third, there is no doubt that improving infrastructure to excellent standards improves both productivity and the quality of life, and India is at present very far below these standards.

The problem with investments in roads or airports, however, is that the payback period can be very long: instead of three to six years, it may take 20 to 30 years, or more. This is untenable for most investors, who want returns much sooner.

The economists’ argument is that some portion of a (large) reserve will remain as a stable deposit, like the portion of aggregated savings that stays in the banking system, and can be used for long-term investments. The problem with this reasoning is that such assumptions fail in a crisis.

No stable base can be assumed, and money that flowed in because of perceived opportunities can as easily flow out again in a rush, like a run on a bank, while inflows dry up because of a changed perception of heightened risk.

Invest Reserves In Good Projects And Stop Subsidising US Consumers

So where can reserves be invested, other than in supporting US consumer spending through investment in US treasury instruments? The latter, unfortunately, is what many countries, including Japan, Taiwan, China, and India, have tended to do.

The answer: in productive investments that (a) yield good returns and (b) are of reasonable risk, measured by expected cash flows and their perceived certainty.

A number of country funds do this: search for sound opportunities, not necessarily in their own countries, and invest in them. Their criteria are the soundness of the enterprise, and the capacity to repay with returns. Examples are country funds of Kuwait, Singapore, Norway, Finland, the Netherlands, and of course, China.

How To Fund Infrastructure Without Using Forex Reserves

So how should infrastructure projects be funded if not by reserves? By using available capital (preferably not reserves) to structure attractive opportunities for participation by external capital.

This means augmenting available capital by sourcing capital from third parties who are attracted by the intrinsic project attributes, and encouraged by equity invested by the government or state-owned enterprises.

The effective but difficult way to do this is by setting the terms for each sector, i.e. the framework of (a) policies, (b) laws [primary, secondary, etc.], (c) regulations, (d) rules and procedures, (e) institutions, and (f) customary practices, which effect successful project execution, so that investors (foreign and domestic) find it advantageous not only in theory to invest, but profitable in practice.

Even with perfect hindsight, it must appear to have been a good decision. Investors and prospective investors should feel (a) they can get their money back (b) with satisfactory returns (c) in a time frame that they consider reasonable.

For foreign investors, it is perhaps 5-6 years for India; it is preferable if they invest for a longer period, but this is not something one can persuade investors to do by argument. People who have worked with/for serious investors in India (like me) must be able to conclude after an objective assessment, not tricky wordplay, that the rules are transparent, and that the chances of success are high for projects with good attributes.

Ground Rules

Build the policy framework right from inception

The odds of success in a sector can be improved by setting the policies, processes, and practices, so that good projects ordinarily succeed.

This means rebuilding the policy framework in each sector (except IT) from scratch, using unconventional methods for India: the government working with expert consultants AND industry, as in many well-run countries, in a collaborative mode.

No ivory-tower pronouncements by one or more luminaries, and no special-interest-induced distortions. Otherwise we will get a reprise of the 1990s, with investments of hundreds of millions of dollars in power and telecommunications mired in our muddled policies, with the resulting fall-off.

As for the pernicious practice of road shows to invite investment when the ground rules are at best muddled or dysfunctional, and no objective assessment is possible to indicate reasonable chances of success, what could be more counter-productive than to waste resources on “luring investment” by government and industry bodies? Far better to focus our resources instead on setting the right objectives [see (a) below], and then the ground rules [see (b) below]. Then, investment will follow.

(a) Setting the right objectives: To set proper ground rules for any sector, we must start with clear and reasonable objectives in the context of our history and circumstances [see (b) below].

Our essential need is to achieve and balance markets that function well (because they are open and competitive?) with the policy goals of social equity, environmental sustainability, and security (energy, food, and of the political economy as a whole).

These could be reasonable objectives for us as a nation. For example, in the power sector, the objective could be: reliable and adequate supply at reasonable prices for all users.

(b) Institutions, systems, and procedures—legacies versus building anew: We have inherited a colonial administration that is ill-suited to the pursuit of nation building with a good quality of life. Once we accept this, two things can follow.

One is that the traditional, adversarial—often predatory—stance of the government towards citizens, with its legacy of emphasis on collecting taxes, can be cast off.

Instead of maximising tax collections, the government can concentrate on (a) nurturing long-term capacity and (b) conserving/building the quality of life for citizens—attributes that together may be termed as “the public interest”.

Second, we can start devising constructive policies, institutions, and practices in earnest, instead of ad hoc efforts to bypass our administrative architecture (the “baad mein dekha jayega” [we’ll-see-later] approach).

This is best done with experienced advisors (e.g. for telecom, a firm like Squire Sanders and Dempsey, which has done extensive good work in this area) working with the government and with good domestic consultants, over 18-24 months, aiming at stabilisation over several years. There are no short cuts.


Shyam Ponappa