A letter urging the RBI governor to use his forex reserves to buy undervalued assets like foreign commercial banks and investment banks.

Dear Sir,
Recently, I spent some time going through your most recent report on how you manage your portfolio – which you call 'official reserve and other foreign currency assets' but commonly referred to as forex reserves. Your asset base of over $250 billion is huge, more than the combined wealth of the top-5 richest Indians. Even if you set aside $100 billion to manage the short and medium term requirements of your business, you have $150 billion to invest.

Being a good citizen mindful of his responsibilities, I decided to offer you some 'tips' on managing your portfolio. Even if I can help you earn a 10 per cent net return, you will make $15 billion annually. As the size of your portfolio can only increase, absolute returns will also be higher in future.
 
I do admit that I have no prior experience in portfolio strategy development or fund management. But, if anything, I consider that to be my major selling point. As you might have observed, the performance of most portfolio strategists and analysts is always directly correlated to overall market performance. They do well when the market are doing well and flop when the markets slip. Their problem is they don't think out of the box. Having absolutely no experience, I am perfectly capable of doing that.

Current Portfolio Review
I am sorry to say this, but your current portfolio sucks. You have parked most of your money with your friends who have similar business as yours, but in other countries. I do appreciate the fact that you know their businesses very well – mostly printing currency notes, deciding the cost of money and publishing voluminous reports.

You very well understand the risks involved. But I am sure the recent behaviour of some of these friends would have made you a bit nervous. We don't know as yet if your friends would have to keep repeating their recent efforts like giving away $100 billion to rather shaky borrowers. As a business sector, they sure seem to be headed for tougher times.

You have also invested a substantial sum in paper issued by foreign governments. In this category, I presume, your biggest holding is debt floated by a sovereign entity whose status as the world's only super power is being steadily eroded. Its finances are in shambles, partly a result of ill-advised violent adventures in foreign shores in a futile effort to retain the remaining vestiges of power.

This entity's shareholders, commonly known as citizens, are a profligate lot who believe in consuming way beyond their means and who depend on increasing amounts of debt to plug the difference. There is an old saying, 'it is foolish to bet on an ageing lion, even if he is still king'. Sorry, I made that up, but you got the drift.

Your next major holding is deposits with what you have described in your report as 'top-rated foreign commercial banks'. I am sure you will correct this in your next report, as there is no such thing as a 'top-rated' commercial bank anymore. All of them are being downgraded as junk by rating agencies who themselves have been downgraded for doling out top ratings in the first place.

And what have you made over the last three years for sticking with your friends, their bosses who are the sovereign governments and their clients who are the commercial banks? Nominal returns of 3.1 per cent, 4.1 per cent and 4.7 per cent for 2004-05, 2006-06 and 2006-07 respectively! Net of inflation, you lost money during 04-05 and 05-06 while barely broke even in 06-07. Your returns would have been even worse, if not for your investments in the yellow metal – like a true Indian.

Now that you have fully understood the truly pathetic performance of your portfolio, I am sure you will be receptive to my advice.

Portfolio Strategy
I am a big fan of Warren Buffet. Therefore, I believe one should follow some rules while designing the portfolio strategy and have a disciplined approach to fund management. So, here are the suggested rules, straight out of the Buffet school of investment, for your portfolio:

• Never cross your circle of competency while investing
• If you have to acquire whole entities instead of only parts, never hesitate 
• Buy assets only when they are on fire sale

I would add one more principle to the above, 'the assets you acquire should meet the long term strategic objectives of your businesses'.

Sector Allocation
The first rule listed above makes sector allocation very difficult for you. If you must restrict yourself to businesses you understand very well, you will have to buy out your friends in other countries. But they are not for sale and you have no competitors in this country to acquire either.

The next best bets are the clients – both yours and your friends' – who are in businesses related to lending money, investments or other financial services. Since you control all the money available in this country, you must have a good understanding of other businesses which are mostly derived from your business.

Now that we have zeroed in on the sector broadly known as 'banking and financial services', your portfolio can easily meet the third rule and the fourth one I added. Banking and financial services businesses in most markets, except places like China and India, are now quoting at very low valuations. Yes, much of the decline in value can be attributed to the insane business practices they used to follow.

But, they claim to have put an end to such behaviour – at least until the beginning of the next boom. Also, these businesses have the potential to do well in future and their intrinsic values should now be close to their market values.

As far as the fourth rule is concerned, you have only one long term goal. You have no competitor in your core business of central banking, so your only long term interest is in perpetuating control over your clients who are the commercial banks in this country. Now, it is no secret that you don't want those foreign banks buying out your domestic clients after 2009 – though you have promised to allow them to do so.

One of your deputies remarked last month that some of your domestic clients like ICICI and HDFC should be treated as foreign clients as they have already become predominantly foreign owned.

Everyone knows that you are a man who keeps his word, so there is no way you can take back your promise.  There is only one way out – buy out, or have substantial stakes in, those foreign banks who are planning to gobble up Indian banks. That should be the strategic objective of your portfolio investments.

Picking your ideal targets
My first pick for you happens to be the world's biggest commercial bank, with strong presence in related businesses as well. Yes, you guessed it, Citibank. It is struggling now, which is a good thing for an investor as the valuation has declined by more than 40 per cent. It has a very strong brand and is present in most countries you can visit.

Citi holds a strategic stake in HDFC, one of your major domestic clients, and has declared its intention to acquire that business after 2009. Now that the bank is headed by our own boy Vikram Pandit, you don't have to worry about any management opposition to your buy out attempt. I am sure he would prefer to have you, rather than those Arab oil sheikhs, as the dominant shareholder.

How much would Citi cost? If you want to buy out the entire thing, you will need slightly more than $150 billion. But, if you go in for a full acquisition, you would exhaust all your money and it is very risky to put all your billions in just one basket. Therefore I suggest you take only a strategic stake in Citi, say 26 per cent, which will cost you less than $40 billion. That is enough to make you the biggest and most influential shareholder.

I know you would prefer to retain effective control over ICICI, which would soon become your biggest client, rather than HDFC. But the major ICICI shareholders, government investment companies of Singapore and Dubai, are not for sale. I suggest you start buying ICICI from the open market whenever prices correct, and start negotiating with Singapore and Dubai to buy out their stakes. Yes, ICICI is richly valued. But, in this case, your long term strategic goal is more imperative. You don't have to make any allocation for this acquisition now; you can manage with the future accretions to your kitty.

You should now allocate around $50 billion to acquire 10 per cent each of your large foreign clients like HSBC, Bank of America and Royal Bank of Scotland which just bought ABN Amro. Valuations of all these banks have declined, though not as much as Citi. 10 per cent stakes should get you board representations at each of these banks and that would mean sufficient influence over them.

As we all know, our economy is booming and is likely to boom for many more years. One of the big beneficiaries of fast growth is investment banks. Every time companies, investors and traders do stupid things with their own money, the investment banker takes a cut. Investment banks are constantly in touch with all economic agents and have insider knowledge of what is going on in the economy, something very useful for you. Therefore, you must buy a large investment bank.

Which one? Ideally, you should buy Goldman Sachs. It will cost you $80 billion, which is low for a company which earns more than $12 billion annually. But, it is unlikely that partners of that firm would sell out easily as they are now on a high. That limits your choices to Morgan Stanley and Merrill Lynch – both of which are valued at around $50 billion each. There is nothing much to pick between the two, so the final choice would depend on which is more desperate to have you as the boss. Also, using your future cash inflows, you should look at gradually building some positions on smaller investment banks like Lehman Brothers and Bear Sterns – currently valued at $32 billion and $13 billion respectively.

After buying out Citi, either Morgan Stanley or Merrill Lynch, and 10 per cent each of HSBC, Bank of America and Royal Bank of Scotland, you will be left with around $10 billion. You should use part of that money to promote an exchange, which will offer currency and currency derivatives trading in this country. Such an exchange will do well with just your business and help you have better control over currency price movements.

Potential troubles
There could be some critics who argue that you should not take up ownership positions in banks as you also happen to be their regulator. I understand that was the logic you yourself gave when you sold your SBI stake to the government. Though many did, I never bought that argument. What is the point in transferring ownership to the government, which is in turn your regulator? Yes, all it achieved was add one more level in the chain of ownership.

By the same logic, the government should not own any companies as it regulates everything. As long as there are public sector companies, you can defend your investments in banks.

Your next hurdle is an abstract concept called political will. Even if you want to invest your money the way you want, your government may not allow you to do so. I am sure you will be able to convince the prime minister, who was in your business earlier. But, you should spin a good story when you make your pitch to the comrades. My suggestion is to tell them that acquiring these multinational beasts is the best way to reform them and convert them to socialist ways.

I am confident that I have presented you with the most appropriate portfolio strategy. If you need any further assistance, I am more than willing to help.

Yours truly,

Vivek Sharma