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Published on July 6, 2007 By PranayGupte In Current Events
India has wasted three years debating a modest proposal for diverting some of its foreign reserves to plugging the country's abysmal infrastructure deficit. It's only now that China is all set to carve out $200 billion from its reserves into a sovereign wealth fund that India is hastening to reach a decision on what to do with its own low-yielding cache.

Finance Minister P. Chidambaram said in a speech at the London Business School last week that, the government has "persuaded" the Reserve Bank of India to lend $5 billion from its $212 billion kitty.

The money will go to a special-purpose vehicle formed last year to enable long-gestation projects to raise funds cheaply.

India's benchmark Sensitive Index rose to a second straight record yesterday. Larsen & Toubro Ltd, the nation's biggest engineering company, gained on reports the company plans to sell its stake in UltraTech Cement Ltd.

The Bombay Stock Exchange's Sensex added 142.25, or 1%, to 14,806.51. The index on Monday surpassed the record set on February8.

The S&P/CNX Nifty Index on the National Stock Exchange rose 43.80, or 1%, to 4,357.55, a record.

"Selling the stake will mean ready funds for Larsen, which has an impressive order book," said KK Mittal, who manages the equivalent of $37mn in stocks at Escorts Asset Management in New Delhi.

Grasim Industries gained after cement sales in June, including those at group company UltraTech Cement, climbed 2.2% from a year earlier.

Larsen rose Rs24.05, or 1.1%, to Rs2,258.95. Larsen plans to sell its 11.5% stake in UltraTech Cement, the Times of India said, citing chairman A M Naik. Separately, Larsen announced a special dividend of Rs2 a share yesterday.

Grasim Industries, the nation's second-largest cement maker, rose Rs84.05, or 3.2%, to Rs2,702.55. UltraTech Cement added Re0.1, or 0.01%, to Rs884.25. Grasim and UltraTech Cement, part of the Aditya Birla Group, together sold 2.53mn metric tonnes of cement last month, Aditya Birla Group said in a faxed statement on Monday.

Overseas investors bought a net Rs58.4bn ($1.4bn) worth of Indian shares on Friday, according to the latest figures available on the Securities and Exchange Board of India website.

The rupee advanced for a fourth day to the highest in almost a month on optimism that overseas funds will buy more local equities to benefit from accelerating economic growth.

Global funds bought a net $4.35bn of shares in the six months through Saturday, compared with $2.6bn a year earlier, according to the regulator. It helped the benchmark Sensitive Index rise to a record for a second day.

"India's growth is attracting committed overseas investors," said K Raghunathan, chief currency trader at state-owned Union Bank of India in Mumbai. "We could see dollar supply sustaining and that will help the rupee."

The rupee rose 0.3% to 40.54 against the dollar as of the 5pm close Tuesday in Mumbai, according to data compiled by Bloomberg. That is the highest since June 5.

The south Asian nation's economy expanded 9.4% in the year ended March 31, a pace only behind China among major world economies.

Commerce and Industry Minister Kamal Nath expects foreign investment to double to $30bn this fiscal year.

Share sales by companies may double this year to an all-time high, buoyed by demand from investors attracted by the fastest pace of growth in almost two decades, JPMorgan Chase & Co said last week. Reserve Bank of India Governor Yaga Venugopal Reddy said on Monday the monetary authority may need stricter policies as the rising capital flows may help quicken inflation

India urgently needs to raise investments in roads, ports, airports, power stations and railways. The latest official estimate puts the amount of funds required in these areas at a massive $475 billion over five years.

Those who oppose using reserves for infrastructure investments highlight two key risks: The economy may overheat because of additional domestic liquidity, and the country may lose hard-currency cover in the event of a run on the rupee.
Neither of these arguments holds much water.

After four years of 8.5 percent compounded annual growth in gross domestic product, there is a danger that the economy is exhausting its productive capacity.

Bloated order books bear testimony to serious supply constraints. Bharat Heavy Electricals, India's biggest maker of power equipment, has a three-year order backlog. Pakistan's cement makers are hoping to benefit from a shortage of building materials in India.

All of this provides a perfect setting for spending a few billion dollars from foreign reserves to import turbines, railway coaches, port equipment and air-traffic control systems.

With adequate leverage, even $5 billion can have an amplified impact on a $1 trillion economy. India Infrastructure Finance, the special-purpose vehicle, can then have a significant corpus to provide credit lines to companies that will import capital goods.

So while spending foreign reserves at home may shore up domestic liquidity and inflation, utilizing the funds overseas will help the economy achieve a better balance between strong demand and tepid supply.

At $65 billion, the annual trade deficit is both large and widening. However, that shouldn't deter the country from accelerated machinery imports.

India's basic balance of payments, or the sum of net exports of goods and services and foreign direct investment, is quite healthy. The minuscule $1.2 billion shortfall in the year that ended March 31 was only a third as large as in the previous year.

Those who support the plan to make use of reserves emphasize the low returns on the central bank's foreign assets, rupee vs us dollar forex trade, which are financed by selling high-cost local debt.

The Reserve Bank of India recently issued three-month treasury bills at a 7.2 percent yield to mop up some of the excess local liquidity created by its purchase of U.S. dollars.

The central bank is buying dollars to stem the pace of appreciation in the rupee, Asia's second-best-performing this year after the Thai baht. However, it isn't making much on the assets it's acquiring with those dollars. In the year that ended June 2006, the Reserve Bank earned 3.9 percent on its reserves.

The domestic economy - especially infrastructure - promises significantly higher returns. National Thermal Power Corporation, the country's biggest power producer, sold a 10-year dollar-denominated bond last year, paying a coupon rate of about 5.9 percent.

The higher returns from domestic infrastructure lending, skeptics say, will only be a reward for sacrificing safety and liquidity, the two essential features of reserve assets.

In this view, lending to Indian companies will compromise the Reserve Bank's balance sheet, leaving it unprepared for a currency crisis. This argument, too, is an exaggerated one.

India's reserves exceed short-term debt by a multiple of 16, providing a much greater cushion than mandated by the Guidotti-Greenspan principle.

That rule of thumb, named after Pablo Guidotti, a former treasury secretary of Argentina, and Alan Greenspan, the former U.S. Federal Reserve chairman, says that countries should hold reserves equal to foreign liabilities coming due within a year.

Even if India were to pay off its entire foreign borrowings - short-term and long-term - it would still be left with $44 billion. So, even by a conservative estimate, a fifth of India's reserves are surplus. Out of this, the current proposal only envisages using $5 billion. How big a risk can that pose?

Using reserves to finance the acquisition of foreign-made capital goods is undoubtedly a roundabout way to achieve a goal that may be as easily reached if the central bank were to just stop buying the incoming dollars. An appreciating rupee will automatically make imports cheaper.

That will be an altogether more satisfactory solution than creating a new layer of state interference.

However, after witnessing New Zealand's helplessness against carry traders who are pushing its currency too high, the Indian central bank isn't likely to leave the rupee entirely to market forces. So it will acquire dollars even when further reserve accumulation doesn't make economic sense.

From this perspective, putting a small part of the treasure trove into infrastructure will at least be a second-best alternative to laissez-faire.

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