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Jaimini Bhagwati: BRICS and the coming crash

In the event of major capital outflows from India, a BRICS Bank and reserves-sharing agreement would be a big help

Jaimini Bhagwati 

Jaimini Bhagwati

On 15 July 2014, the five BRICS countries - Brazil, Russia, India, China and South Africa - agreed at their sixth summit meeting in Fortaleza, Brazil, to set up a New Development Bank (NDB) and a Contingency Reserve Arrangement (CRA). The NDB is expected to fund development projects as does the World Bank and the CRA is to address balance of payments difficulties on the lines of the International Monetary Fund. Although the summit's decisions cover political and other issues, this article limits itself to discussing the viability and significance of the proposed NDB and CRA.

International print media has dwelt on the perceived incompatible nature of the BRICS grouping. The sceptical tone of the reporting reflects discomfort with India, Brazil and South Africa teaming up with Russia and China to set up multilateral financial institutions (MFIs). Separately, developed countries have persistently delayed reducing their equity-quotas in existing MFIs to reflect the growing economic weight of larger developing economies. Now that the volumes of capital flows to developing countries from private sources have overwhelmed those from MFIs, it could be argued that MFIs have lost their earlier significance. On balance, MFIs retain their importance because they provide much longer maturity and lower cost loans.

A number of preparatory steps will be needed to set up the NDB and the CRA. For instance, the Articles of Agreement and the conditions and pricing of loans have to be agreed upon. The NDB and the CRA should begin by limiting their lending activities to BRICS members backed by central-government guarantees as is the case with World Bank loans. However, unlike the World Bank, the NDB could fund its loans by borrowing from member governments. The five BRICS countries have invested significant proportions of their foreign-exchange (forex) reserves in debt securities of G7 governments. Ironically, never in recorded history have so many of the world's poor lent so much to the rich.

The BRICS members could lend to each other rather than to the richest countries. A fraction of just the short-term investments of BRICS countries in the United States Treasury bills (T-bills) could fund loans to BRICS members. Effectively, the NDB's opportunity cost of borrowing would be the rate of return that BRICS countries receive on their United States T-bill investments.

The six-month United States T-bill spread against six-month London Inter-Bank Offered Rate (the LIBOR indicates the cost of borrowing for double-A rated banks) is currently 0.28 per cent. Six-month dollar LIBOR is at 0.33 per cent and the yield on six-month United States T-bills is 0.05 per cent. Even as United States T-bill and LIBOR interest rates keep changing, the spread between the two remains relatively stable as it reflects the difference in borrowing cost for a triple-A credit versus a double-A credit.

The International Bank for Reconstruction and Development (IBRD)'s current average cost of borrowing is a little below the LIBOR and its lending rates are about LIBOR plus one per cent. The NDB could lend at lower interest rates than the IBRD at, say, LIBOR plus 0.5 per cent. As the NDB's cost of borrowing would be LIBOR minus 0.28 per cent, the spread of 0.78 per cent between its lending rate and cost of borrowing could be shared between lending countries and the NDB. Consequently, the BRICS members that lend to the NDB would receive a higher rate of return on their investments than on United States T-bills and interest rates charged from borrowers would be lower than what is charged by the World Bank. If lending is confined to the BRICS countries, the NDB is a superbly viable financial proposition.

The NDB's subscribed equity capital would be $50 billion, of which $10 billion could be paid in equal amounts of $2 billion by each BRICS member. That is, the BRICS countries would not need to contribute large amounts to set up the NDB. The currency-swap mechanism that would fund the CRA would be supported by $41 billion from China, $18 billion each from India, Russia and Brazil, and $5 billion from South Africa. Member countries would need to contribute to the CRA only if there is any disbursement out of this fund.

After the financial-economic meltdown of 2008, the central banks of the United States, Japan and the United Kingdom and the European Central Bank have resorted to unprecedented levels of expansionary monetary policies leading to extremely low and even negative nominal interest rates in their currencies (the table provides nominal government debt interest rates from one- to 10-year maturities as of August 19, 2014).

However, despite the low interest rates, longer-term lending for greenfield ventures has not increased in developed economies, as banks are still repairing their balance sheets. Instead, fund managers seeking higher returns have invested in lower credits, including junk bonds. Bloomberg's global non-investment grade bond index is at present yielding 5.9 per cent. It follows that the probability of a global crash in asset markets has grown. This is another compelling reason to make the NDB and the CRA functional urgently.

Even as we wait for the NDB and the CRA to be in a position to lend, it would be prudent for India to increase its stock of forex reserves. Clearly, holding higher forex reserves is costly, as returns are negligible to negative even in nominal terms, as shown in the table. However, forex reserves do provide a measure of insurance cover. Of course, raising forex reserves cannot be the only strategy that the Reserve Bank of India (RBI) and the government follow to protect against future forex outflows caused by one or more of the following: pricking of asset bubbles; rise in G7 interest rates; a West Asian conflagration leading to higher oil prices; and reduction in remittances from the Gulf. Obviously, India needs to rein in its fiscal imbalances, as also its trade deficits. This will take sustained effort and time, as will bringing down inflation. Hence, increasing forex reserves has to be part of the risk-management policies that the RBI and the government follow.

In the event that a global crash is triggered by bursting of asset bubbles, there would be substantial private capital outflows from India. In such a scenario, it would be helpful if the NDB and the CRA were already up and running for us to have additional sources of emergency funding. To sum up, it would be prudent for India to work post-haste with its BRICS partners to set up these two institutions.

The writer, a finance professional and former Indian High Commissioner to the United Kingdom, is currently RBI Chair professor at ICRIER

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First Published: Thu, August 21 2014. 21:50 IST