Why Gadkari's plan to use forex reserves for infra will not find favour with RBI

Union Road Transport and Highways Minister Nitin Gadkari has reignited an old debate of using foreign exchange reserves for infrastructure financing. Gadkari has suggested formulating a policy for using a part of the $620 billion foreign exchange reserves of the Reserve Bank of India (RBI). “We have a surplus of dollar reserves in the country," said Gadkari, who is also planning to meet RBI Governor Shaktikanta Das. But Gadkari's idea is unlikely to find favour with the Central Bank. Here's why?

Forex Reserves not sufficient to meet external shock

India's foreign exchange reserves at $ 620 billion have pole-vaulted India in the list of top five in the world after China, Japan, Switzerland, and Russia. The foreign exchange reserves stock is currently enough to cover over 18 months of imports. However, a  month ago, the RBI's Deputy Governor Michael Debabrata Patra, in a research paper wrote that  India's forex reserves of over $ 600 billion might not be sufficient as it falls short on certain parameters including import cover and liability outflow. Patra's paper highlighted that India’s liabilities owed to foreigners are higher than its assets. In fact, India's net international investment position is negative at 12.9 percent of GDP.

US interest rate hikes to slow down foreign fund inflows

The exit from easy monetary policy in the world's largest economy, United States, is expected to push up interest rates, which would result in the flight of capital back home for higher returns and safety of capital. The US Federal Reserve has already indicated a  likely rise in short-term interest rates by 2023. Retail inflation in the US is also on the rise, which could bring an interest rate hike earlier than 2023.

The retail inflation or the consumer price index (CPI) in the domestic market is also over 6 percent plus, with RBI's expectation at 5.7 per cent for the entire year 2021-22. A rise in the interest rate would impact the returns in the stock market. This would mean an outflow of dollars from India thereby impacting the rupee value against the US dollar. In such a scenario, the RBI will have to intervene (sell dollars)  to protect the value of the rupee from depreciating beyond a certain level. A depreciating rupee also means higher imported inflation via crude oil and commodity prices. The RBI will need the foreign exchange reserves to fight back in any extreme scenario.

Also read: India needs forex buffer reserves to beat exchange rate volatility: Raghuram Rajan

Risk of investing in infra financing

The RBI invest its foreign exchange reserves in the US treasuries, gold, and other safe assets where it earns a very low interest of around 2.60 per cent per annum. The RBI is already considering diversifying its investment in a basket of currencies to earn higher returns. But the idea of investing foreign exchange reserves for financing infra projects in the domestic market is quite risky. In the past, commercial banks have burnt their fingers in financing the infra sector. The RBI is also not in the business of taking credit risk and that, too, by investing its precious foreign exchange reserves.

Also read: Nitin Gadkari pitches for using RBI's rising forex reserves to fund infra projects

Tax foreign inflows if govt needs money

Why not tax the foreign inflows, especially the inflows into the stock market, if the government needs money? The tax revenues would be at the disposal of the government to invest in nation-building assets. Currently, the RBI is accumulating the foreign exchange reserves by releasing rupee liquidity in the market. The rupee resources always carry higher costs, which the RBI is foregoing. The taxing of foreign inflows will also have collateral damage as it will impact the booming stock market, but the policymakers will have to find a balance.

Also read: Forex reserves soar by $9.42 bn to all-time high of $620.57 bn

RBI needs a stronger balance sheet

The government balance sheet is already broken with higher borrowings and higher fiscal deficit post the pandemic. The RBI had stepped in with a whatever-it-takes approach to support the government. In fact, the RBI has been at the forefront of keeping surplus liquidity in the system as well as low-interest rates despite inflationary pressure.

The country's Central Bank needs a strong balance sheet to support the growth of the economy. Similarly, in the event of an external shock, the RBI needs a strong balance sheet in terms of foreign exchange reserves to fight off any adverse currency spillover. Ideally, the RBI could help the government in providing some liquidity support to the new Development Financial Institution (DFI), which is already set to make its debut in infra financing.