The Reserve Bank of India is considering launching a Sovereign Wealth Fund which will effectively allow it to invest its excess reserves in higher yielding assets that are off-limits to it right now. This is on the back of the $5 bn set aside in the 2007 budget for the India Infrastructure Finance Corporation. Critics have quickly pointed to the East Asian Financial Crisis of 1997 as to why this is a bad idea. Here is a quick historical perspective.
For much of human history, the trade of Europe with South-Eastern Asia, particularly India and the countries of the Malay archipelago, has been the most lucrative branch of world commerce. The monopoly and control of this trade route was thus much prized by nations, from the early Roman empire, to the Byzantine empire, and later in the 15th century the Italian cities of Venice and Genoa. Then the Portuguese found the sea route around Africa and spent much of the 16th century swiftly proceeding to become the dominant power in this trade, cutting not just the Venetians, but also the Sultans of Alexandria and Constantinople, effectively cutting the supply chain a few layers. It was a remarkable achievement for a tiny country which had to contend with the Italians and the Sultans, and yet built fortifications along the Indian Ocean rim to protect its trade.
In 1580, Spain annexed Portugal in Europe, and the Spaniards, rather stupidly in hindsight, decided that they were not interested in preserving what the Portuguese had worked so hard and energetically to establish – a monopoly of the most lucrative trade route in human history. The reason is interesting.
While Bartholomeo Diaz and Vasco Da Gama were finding the Eastward trade route to India, Spain dispatched one Christopher Columbus on a misguided Westward journey to India. Now the “India” or “Indies” that Columbus found quickly became the exclusive domain of Spain, where they found that they could simply dig up precious metals like gold and silver. They decided that it was good to keep your gold and silver in the country than to use it. And trade with India virtually meant that gold would leave your country and end up in India.
Without the lure of trade, Spain had little incentive (despite stated intent) to prevent the budding merchant powers like Holland, England and France from entering this trade. From the time Sir Thomas Roe got trading rights from Mughal Emperor Jehangir around 1605, the British East India company spent the next hundred years becoming the dominant power in this trade route.
Note that at this time, India was still just a prized trading partner. Territorial expansion, much less an empire were a distant dream, minus the resources that the Industrial Revolution would bring and the presence in India of powerful rulers like Aurangazeb and Shivaji.
So even while the shareholders of the East India Company were rolling in cash, a powerful backlash was building up against the company in England, on the basis of the same false mercantile theory that had held back Spain a century ago. The company was accused of impoverishing England by despatching bullion to India.
Fortunately for England, she had a strong merchant class who from real experience of distant commerce correctly understood that gold must be allowed to find its own natural price level, or must simply fall in value.
The rest as we know is history. England went on to build one of the largest and definitely most sprawling empire in history, became the most powerful and richest nation in the world. Other European powers achieved similar though modest in comparison successes. Spain went on to lose most of her colonies in the New World and the old, even before the English empire had reached its peak.
And what of the nation that for many centuries bled Europe of its bullion – India? 18 centuries is a long story, but it too was largely hoarded (in different ways and different places). With exceptions like the Cholas and the Marathas, few Indian rulers invested in a navy. Trade with Europe was largely dominated by foreigners, with Indians at best accounting for the first leg of the journey to the start of the land route through the Levant. Moreover the hoarded wealth was easy picking for invaders whether from the Afghan passes or the sea trade routes from Europe.
It must be noted in conclusion that the British Indian Empire was originally built as a commercial venture by a trading entity which would have been a non-starter if the British were paranoid of bullion (or excess reserves) leaving their shores.