Why Sonia should thank Chidambaram

Sonia Gandhi should thank Finance Minister Chidambaram for resisting proposals to put part of India’s foreign exchange reserves into a Sovereign Wealth Fund, which would buy equity shares in top global companies. Such a Sovereign Wealth Fund (SWF)—an idea backed by eminent economists, the Prime Minister and the Planning Commission—would have suffered huge losses because of the collapse of global stock markets since January.

Neither Opposition politicians nor the public would have been satisfied by explanations that stock markets yield high long-term gains, notwithstanding short-term fluctuations. The Left Front would have accused Chidambaram of gambling away the country’s precious assets in casino capitalism. Others would have accused top Congress politicians of having been bribed or arm-twisted into making dubious investments.

The government would have protested its innocence, and pointed out that the SWFs of many other countries—from China and Abu Dhabi to Singapore and Norway—had also suffered in the market slump. But Indians are quick to see scams when anything untoward happens. The reputation of politicians is so poor that many voters will believe accusations of manipulation and venality.

The US share price of Citibank, the world’s biggest bank, plunged from $56 last year to a low point of $19 last week. Citibank was hit, along with many other top banks, by the sub-prime mortgage crisis in the US. Now, investment experts will find much logic in all SWFs investing a bit in companies like Citibank, since it is the biggest bank in the world. Yet, had Chidambaram set up an SWF, and had it invested in Citibank, Opposition politicians would have screamed “scam” after the latest price crash. Marxists would have claimed that the US had arm-twisted India into investing in sinking banks as a price for the nuclear deal!

Now, there is indeed an economic case for a Sovereign Wealth Fund. Many countries with surplus forex reserves—mostly oil exporters, but also China and Singapore—have set up SWFs that invest in equities. The total assets of all SWFs are almost $3 trillion. India has experienced a huge inflow of dollars in recent years, raising its reserves to $ 290 billion, vastly in excess of any balance of payments needs.

In a seminal paper two years ago, economist Larry Summers, former US Treasury Secretary, made a strong case for developing countries to put excess reserves into stock markets. He argued that, for balance of payments security, a country’s forex reserves should equal one year’s short-term debt. As an abundant precaution, he assumed that countries would hold reserves of double that amount. Even after that, he calculated, 121 developing countries would have excess forex reserves of $2 trillion, equal to 19% of their combined GDP in 2004.

He further pointed out that these reserves yielded pathetically low yields when invested in short-term gilts—the traditional, safe practice. History showed that investment in equities would yield far more, despite short-term fluctuations. So, Summers proposed that all developing countries should put excess reserves into SWFs that would invest in shares. In India’s case, he calculated that the additional yield from such an SWF would be 1 to 1.5% of GDP (or Rs 40,000-60,000 crore) per year.

This was by no means the only rationale for SWFs. Fast growth had made China a massive importer of raw materials, and so its government invested in commodity companies globally. Indeed, it gave massive sums in foreign aid as an additional sweetener to African commodity producers.

Many in India wanted to follow suit. Their aim was not simply to earn a higher yield on forex reserves, but to secure long-term sources of raw materials—oil, gas, coal, non-ferrous metals, even palm oil. The ONGC invested in several oil and gas ventures abroad. Tata, Birla and Sterlite invested in foreign mines for commercial reasons, unrelated to deploying excess forex reserves.

However, Chidambaram and RBI Governor Y V Reddy opposed any SWF for India. Reddy said SWFs were appropriate for countries with mineral windfalls (such as oil exporters), but not India. Indeed, India ran a modest current account deficit, and so needed to import dollars. Now, the world had flooded India with far more dollars than it could absorb, but this was not a structural surplus.

Chidambaram took refuge in a further technical argument. He said that SWFs made sense for countries with excess savings, reflected in a fiscal surplus. But India ran a large fiscal deficit.

However, these technical economic arguments pale besides the political ones. The stock market is seen by both Opposition politicians and the general public as a dodgy place full of crooked manipulators (remember Harshad Mehta and Ketan Parekh). Making money on the stock market is seen as risky, if not actually sinful. Indeed, the Left front has stymied attempts to put pension/provident fund money into Indian equities.

In these circumstances, Chidambaram has shown sound political judgement in refusing to set up an SWF. This might in the long run yield some financial gains. But it carries short-term risks, as has just been demonstrated by the slump in stock markets. So, it needs to be avoided in the run-up to the next general election.

What do you think?