Investment of India’s rising foreign exchange reserves in equity funds, especially index funds, can fetch higher returns as interest rates which have been on a declining trajectory over the last four decades in advanced economies, have touched their historic lows, a Reserve Bank of India (RBI) report has said.
“Investment in equities is considered to be risky, especially for a central bank, which is responsible for safeguarding the reserves. However, investment of a small portion of the reserves in an index fund has the potential to augment the return of the portfolio,” said an RBI report on ‘The low yield environment and Forex Reserves management’. Total forex reserves were $ 639.51 billion as on October 8, 2021. Investment in S&P 500 across various business cycles and financial booms and busts reveal that the CAGR return in 5 years, 10 years, 15 years, 20 years, 25 years and 30 years would have been 13.3 per cent, 11.1 per cent, 7.3 per cent, 5.4 per cent, 7.4 per cent and 8.5 per cent, respectively, it said.
“This implies that if held for a long to very long period of time, despite volatility in the interim, it can not only preserve the capital but also fetch a return much higher than most of the investments,” the report said. Incidentally, in May, the RBI had raised the red flag over the question of a “bubble” in the stock markets. “This order of asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble,” the RBI said in its Annual Report for 2020-21. On August 22, 2020, RBI Governor Shaktikanta Das said there was a clear disconnect between the sharp surge in markets and the state of real economy, as surplus global liquidity was driving up asset prices worldwide.
In a recent interaction with The Indian Express and Financial Times, Das had said, “Globally, there is a surplus liquidity and stock prices are very high, and are booming in almost every market, including India… But I wanted to mention is that there is no evidence of high asset prices, namely the high stock prices, feeding into general inflation or general prices.”
“There is no evidence to show that the high liquidity is feeding into general prices,” Das said. The Sensex has been hitting new peaks and crossed the 62,000 level in intra-day trading on Tuesday. The EME (emerging market economies) stock markets got buffeted in August with China’s regulatory crackdown and continued to fall in September on concerns relating to China and change in monetary policy stance of several AEs. Stock markets in EMEs such as India and Russia, however, notched all-time highs in September and continued to rise in October.
As at end-March 2021, out of the total foreign currency assets of $536.69 billion, $359.88 billion was invested in securities, $153.39 billion was deposited with other central banks and the BIS and the balance $23.43 billion comprised deposits with commercial banks overseas. All these avenues carry very low interest rates. Gold reserves were worth $38 billion.
“The return on the S&P 500 equity index funds is comparable to that on gold over a long period of time,” it said. A number of central banks are increasingly making investment in equities in some form or the other. Swiss National Bank, for example, has an investment of 20 per cent of its reserves in equities. Further, the regional governments of the major advanced economies issue bonds which, in many countries, carry the implicit guarantee of the sovereign, the RBI report said.
“They also yield better return than the sovereigns. Reserve managers could invest a small percentage of their reserves in such sub-national debt securities across the developed countries like Germany, Australia, Canada, etc and US agency bonds,” it said. Similarly, even the best rated supranational agencies yield better than sovereigns in most of the cases. If reserve managers can go further down the credit curve, then they can earn even higher yield.
Reserve managers usually invest in highly rated sovereigns like G10 countries as they have deep bond markets and meet safety and liquidity criteria of the reserve managers. However, there are some countries which are relatively stable financially, are highly rated and offer better yields than some of the G7 countries, the RBI report said.