According to the Reserve Bank of India's [Get Quote] Annual Report for 2005-06, the nominal rupee denominated rates of return on India's foreign currency assets for 2005-06 and 2004-05 were 3.9 per cent and 3.1 per cent, respectively.

Foreign currency assets include foreign exchange reserves less gold holdings, special drawing rights and India's reserve position in the IMF. Inflation in India in the last one year has been about 5 per cent. Therefore, the real rate of return on India's FCA for 2005-06 was around minus 1.1 per cent (3.9-5).

The Reserve Bank of India is currently responsible for managing the country's foreign exchange reserves. Since central banks hold gold as a last measure of protection against a balance of payments crisis, the discussion in this article is confined to FCA management.

The real INR rate of return on India's FCA has been negligible to negative in the last two years. These low returns on India's FCA could be attributed to the RBI's cautious policies in which the guiding principles are to maintain mark-to-market value and liquidity by taking minimal credit and market risk.

Effectively, the rate of return is a secondary concern and the RBI's options are accordingly limited to investing in short-dated triple-A rated government debt securities.

How should we measure the performance of the Indian FCA portfolio? For instance, should the numeraire currency be the dollar or INR? The currency in which the rate of return is measured should not matter in economic terms.

It is the currency composition of the benchmark portfolio, against which the FCA portfolio's performance is measured, which needs to be calibrated carefully. Given the potential for disorderly US$ depreciation the benchmark portfolio may need to be tweaked frequently to take into account the exposure of the Indian current account to exchange rate risk.

A traditional yardstick to assess the sustainability of a sovereign's external borrowings is to compare the average cost of such borrowings with the GDP growth rate. By extension, India's FCA earnings should be comparable with the GDP growth rate.

In the last one year, real growth has been 8 per cent plus, making the GDP growth rate 9 per cent [8 - (-1.1)] more than FCA earnings. Another construct, suggested by Dani Rodrik, is to compare FCA earnings with the cost of short-term external commercial borrowings.

At the margin, Indian FCA earnings would be about the same as the yield on 3-month US Treasury bills, currently about three-month LIBOR - 0.40 per cent. The average cost of short-term ECBs for Indian firms is about 3-month LIBOR + 2.5 per cent. That is, the opportunity cost of holding "excess" FCA would be at least about 3 per cent.

Of the Asian countries, which have accumulated significant volumes of FX reserves, Singapore has allocated the responsibility of managing reserves to maintain the stability of the Singapore dollar to the Monetary Authority of Singapore and excess reserves have been assigned to the Government of Singapore Investment Corporation, which manages higher risk-return investment portfolios. More recently, South Korea has followed the same model and set up the Korean Investment Corporation.

Some questions about Indian FCA management need answers. Could the returns be increased significantly without undue risk to the country's ability to service its external debt and sustain current account deficits required for investment purposes?

Is the allocation of Indian FCA management to the RBI conducive to a satisfactory rate of return? Further, if the mandate for FCA management is altered would that necessarily result in a higher rate of return?

Obviously, there are no definitive answers to these questions. In the context of adequacy of FX reserves, Guidotti-Greenspan have suggested that these should be at least equal to external debt maturing in the next one year.

As of end March 2006, India's short-term external debt plus long-term debt maturing in a year was about $15 billion. On the same date, non-resident Indian deposits amounted to approximately $35 billion and external commercial borrowings totalled about $26 billion. The market value of foreign institutional investors' portfolio investments in Indian equity markets is around $110 billion.

That is, total external debt maturing in a year plus 50 per cent of NRI deposits and ECBs and 25 per cent of FII portfolio investments add up to about $70 billion.

How should the RBI maintain an adequate level of reserves for external debt servicing and other requirements while it manages excess FCA separately to maximise returns within acceptable credit and market risk limits? As of mid November 2006, Indian FX reserves amounted to about $170 billion.

One option is for the RBI to manage a highly liquid, low-return portfolio of $70 billion as insurance against capital flight caused by unexpected market developments. The remaining $100 billion could also be managed by the RBI in separate portfolios with associated benchmarks, which carry greater market risk and hence commensurately higher returns.

This proposal for several portfolios with differing risk-return characteristics is not necessarily to take additional credit risk but diversified market risk. For instance, FCA managers could move up the yield curve and take some interest rate risk and invest in highly-rated municipal and asset-backed securities.

They could also diversify out of fixed-income instruments into asset categories such as equity and real estate. Singapore and South Korea have set up separate investment corporations to manage their growing reserves because the skills required for managing investments in equities, asset-backed securities, and real estate are qualitatively different from those needed for managing portfolios consisting of short-maturity government-debt securities.

Lawrence Summers, speaking at an LK Jha memorial lecture in Mumbai on March 24, 2006, remarked that India could expect to earn about 6 per cent in real terms on its FCA if these were invested in global capital markets.'

On balance, it appears that it should be possible to earn an additional 5 per cent, compared to current FCA earnings by investing excess Indian FCA through a dedicated investment platform set up by the RBI/Ministry of Finance.

An additional 5 per cent return on $100 billion is $5 billion, which is about 0.6 per cent of GDP. This number would be lower if the investment guidelines for the higher risk-return reserves portfolios were to be restrictive but it is still likely to be a significant figure.