There are three different issues involved in this question which need to be addressed and answered separately before putting then together into a single package. The first issue is that of lending external reserves for domestic investment. By definition external reserves have to be kept in safe assets not affected by BOP shocks to the economy as they are held to reduce risks in such an eventuality. The Asian crises showed that external borrowing by domestic banks for the purpose of domestic lending increases systemic risk of crises. “Using” FE reserves for domestic purpose has a similar effect. If reserves are seen as ‘excessive,’ this indicates an implicit judgements that the risks are low and will remain so even with lower reserves. They are two sides of the same coin.
The accumulation of our reserves is the outcome of a BOP & foreign exchange management policy designed to meet external and domestic shocks and promote growth. If this results in “excessive” reserve accumulation the policy needs to be modified. Though the build up of reserves till September this year has roughly halved to what it was last year because of industrial recovery and higher oil and raw material policies there is scope for slowing it further. ICRIER studies have shown the positive effect of the tariff reductions since 1992, on intra-industry trade and specialization, productivity and exports. Reserve accumulation can be efficiently stopped or perhaps reversed by a sharp reduction in tariffs. A reduction in peak tariffs to 10% by 2006 and to 5% by 2008 budget and the lowering the excessively high agricultural tariffs will enhance productivity, increase exports and accelerate industrial growth.
The second issue is that of infrastructure investment and development. Experience with Telecom sector reform has shown that efficient and effective development of infrastructure requires a policy framework that promotes entry and supports competition (particularly with the government supplier). This requires isolation of natural monopoly elements through unbundling and a professional independent regulatory framework to regulate monopoly elements and ensure fair competition with the incumbent. In the case of electricity the so-called ‘Theft & Dacoity’ (T&D) losses would also have to be tackled head on if competitive pricing is to be fair and equitable to honest users. As roads are a classic ‘Public good’ policy reform is not enough and most of the burden has to be borne by the government, policy reform can be helpful high density National highways.
The third issue is that of public investment in infrastructure and its financing. In theory public investment in infrastructure, financed by money creation or by debt can be undertaken as long as the social benefit of the former (in terms of growth/productivity) is greater than the social cost in terms of inflation and/or crowding out. The former depends on the institutional structures for undertaking such expenditures, and institutional reform (of which the National Highway authority is the best example so far) is required to reduce leakage and enhance social productivity. The latter depends on unused capacity in the economy, which was very high from 1998 to 2002, but has tightened since mid-2003. External supply side (e.g. oil) inflationary pressures have also increased over the same period. Thus the conditions for both monetary and debt financing have worsened over the last 18 months. It may therefore not be wise to increase monetary expansion and thus add demand side pressure to supply based inflation nor to crowd out rising private investment with higher government borrowing. Nevertheless, if the social benefit is higher than the social cost, perhaps a financial package can be devised to get round the constraints imposed by the FRBM.
Though the package has been put together as one to “use FE reserves to finance public infrastructure,’ the following restatement/revision would appear to achieve the same objectives more efficiently: Increase government infrastructure investment in concert with, (1) A sharp reduction in tariff rates. Reserve accumulation would slow and perhaps reverse providing greater scope for non-inflationary monetization of the deficit needed to finance infrastructure. (2) A pro-competition infrastructure policy and a professional independent regulatory framework for electricity, railways, ports, airports and dams & canals, (3) Institutional reform of public infrastructure monopolies, like State electricity boards, irrigation departments public works departments (for State highways and village roads). The last two measures would enhance the benefit from increased public investment in infrastructure and thus make the costs of financing them worthwhile.