From talk about creating a sovereign wealth fund we are now trying to build a forex kitty with borrowed dollars. An artificially strong rupee is a recipe for disaster

After much loose talk about creating a sovereign wealth fund, the massive walloping the rupee got after May this year appears to have sobered down the UPA government. But not enough, it seems. It is now heading full-speed in the opposite direction - towards an even more ruinous idea, what we can call a string of sovereign debt funds.

With over $400 billion in foreign debt, and over $170 billion of it due for repayment over the next six months by March 2014, the government surely needs more dollars in the kitty to reassure the foreign exchange markets. Few dollars in the till means the rupee will again take running leap from the Qutb Minar.

However, the right answer to the problem of the current account deficit (CAD) is not to try and build a forex kitty with borrowings from abroad, especially to prop up the rupee. It is to let the rupee find its own level, and use the currency weakness to build exports and compress imports.

According to The Economic Times, the finance ministry is planning to take the wrong road to CAD nirvana. It wants to take up the foreign exchange reserves from around $250 billion now to nearly $300 billion by December-end, largely by borrowings. The report quotes a finance ministry official as saying "the effort is to build a forex kitty" so that it is well-prepared when the US Fed starts tapering down it $85 billion monthly bond purchases from early next year.

The Reserve Bank of India (RBI) and the finance ministry have unveiled an unstated sovereign debt fund(s) plan in stages since August-September this year. These are some of the elements.

#1: Free ride to banks on dollar deposits. Soon after he took over as RBI Governor, Raghuram Rajan offered banks dollar-rupee swaps on fresh three-year (or longer tenure) non-resident dollar deposits at the concessional rate of 3.5 percent. He also allowed banks to raise rupee-dollar swaps on overseas loans at rates that are 1 percent below the current market swap rate.

#2: Arm-twist public sector units to borrow in dollars. Three months ago, Finance Minister P Chidambaram announced that the idea of asking profitable public sector units to raise dollar loans - i.e. quasi sovereign bond issues - was "on the table." So far, barring banks, few PSUs have offered to put their necks on the chopping block, but one can't rule it out if the idea is to build a $300 billion kitty by December-end. We are just two months from that deadline.

#3: Lobby the global bond index builders to include rupee bonds. Fund managers globally tend to invest in sovereign debt based on their index weights. India has been talking to JP Morgan and others to get rupee bonds onto their indices. If this happens, the government is hoping that $20-40 billion will flow in over 12 months.

In short, what the government is really doing is to try and build forex reserves by borrowing - a clandestine string of sovereign debt funds raised by public sector banks and institutions.

It is highly imprudent, and damaging in the medium term. It's like borrowing on your credit card and putting all the money in a fixed deposit to show you have big money in the bank. Some people will be fooled, but not all.

It is also damaging to the real miracle that has begun happenings on the external front, and especially on the CAD front due to the fall in the rupee.

If the rupee has strengthened from 69 to the dollar to just over Rs 61 now, it is because exports are picking up and imports are being compressed naturally. Mr Market, as we noted earlier, is fixing our external problems bit by bit.

The moves to artificially arrange a forex hoard of $300 billion will dampen this gradually improving scenario since the rupee will then rise artificially if dollar inflows build up, making imports cheaper and exports more difficult. The real change on CAD will then be halted in its tracks.

Why would a finance minister do this? That is, hamper real improvements on the external front by artificially propping up reserves and the rupee?

The only answer is the election time-table. Hence the December deadline to build forex reserves. A strong rupee will help bring down imported inflation and the fiscal deficit by making oil subsidies lower. Oil subsidies are the biggest boosters for inflation, and the subsidy bill this year will cost the exchequer nearly Rs 1,40,000-1,50,000 crore. Unless the rupee strengthens.

With food inflation running high despite a bountiful monsoon, runaway oil prices will make matters worse. This is why the finance ministry is choosing to push the rupee up even while claiming it is not targeting any price for the rupee.

The sovereign debt funding initiated through the backdoor is a recipe for medium term disaster - but in election season, this is not what Chidambaram sees.