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Using our Forex Reserves to Fund Our Fiscal Deficit


So, S&P is thinking of downgrading our country based on the increased fiscal deficit and they’re hitting our banks too. This gets me really pissed off, because the people they should have downgraded they didn’t do until it was too late – Enron, Lehman and the “AAA” safe-tranches of subprime CDOs that collapsed. The sheer arrogance. Oh well, it doesn’t matter anyhow. Within a year, all the rating agencies will be irrelevant.

Still, let’s look at the deficit. Right now, officially, we’re short by about 45,000 cr. The government does not want to borrow from the market, which seems to be a colluding-set-of-banks, keeping prices low and yields high so that the government buckles and they can buy good debt at low prices.

What then, are the choices? We could borrow abroad, or use some other unrequired issuances (like the MSS stabilization pool) But why not use our foreign exchange reserves instead?

We have $230 billion of forex reserves. A significant chunk of these have come from NRI remittances, a lot of which is non-repatriable – i.e. it’s converted to rupees and spent here and does not need to be paid back. Another lot from exporters is also not a liability – i.e does not need to be paid back in dollars. Therefore, it’s not required to be kept in US dollars – then why not convert the reserves instead, to finance our fiscal deficit?

Right now, all we’ll need is about $10 billion – that’s about 50,000 cr. Let’s just say it gets worse, and we need $30 billion – that’s still nothing compared to $230 bn we hold.

And, if you think this will do shady things to our imports – our total oil import bill, at current prices, is likely to be $35-$40 billion. We currently have about 6 YEARS of oil imports (versus the crisis in 1992, when we had 15 days). We don’t need 6 years of oil imports in our bank, please.

A quick chat with Ajay Shah, who is far far better at this than I can hope to be, revealed that it’s not as simple as selling some dollars and saying “Ho gaya, ab khana kha lo”. [I can’t translate this]

The RBI balance sheet has this stuff on their asset side. You take away from an asset, you gotta replace it with another asset. In this case the simplest thing to do would be to replace part of the forex reserve with Indian bonds. This means no issuance to the market – so yields don’t HAVE to go up because of supply (the RBI will hold the bonds, and never sell them).

In fact, we could issue special bonds at a lower interest rate – which will reflect the rate we are earning in forex anyhow. These bonds needn’t ever be traded on the open market.

Now how does one get rupees? RBI will have to sell the dollars and get rupees. $10 billion of sales would drop the dollar about 5%? That’s to a level, perhaps, of 47.5, from nearly 50 nowadays. This will tick off exporters – but hey, haven’t we seen 39 recently? 47.5 is good enough. Plus, a weaker dollar helps our imports – and we must stimulate our LOCAL economy more than our exports, because the world outside is destroying itself.

And then, why stop at $10 billion? or $30 billion? Eventually we have to let the rupee float. So take out as much as required, and when the rupee floats, we can buy dollars back when required. Remember, our economy CAN be stimulated because of the enormous capital in black money lying around; but it may require money of the order of $100 bn or so. In doing so, if the economy recovers fast AND we float the rupee, dollars will come in from all over the world – and that is likely to let us keep our dollar liability restricted.

This might have other issues I haven’t thought about. Inputs are much appreciated, of course, as comments or by email.


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