The rupee fell, bond yields hardened and IT stocks shot up as the Reserve Bank of India took steps to ensure that corporates did not use foreign loans for making rupee payments. RBI had, in its recent quarterly review of monetary policy, signalled that it would strive to prevent the rupee from appreciating. The curbs on external commercial borrowings provide more ammunition for that policy.
How severe will be the impact? According to RBI’s balance of payments (BoP) data, ECBs in 2006-07 amounted to $16 billion. Since this amount is reflected in the BoP data, it means that $16 billion has come into the country. And out of a total addition of $36.6 billion (net of valuation effects) to foreign exchange reserves in 2006-07, ECBs accounted for $16.1 billion. In effect, ECBs accounted for 44% of the total accretion to forex reserves. Seen thus, it does seem that the measures will have a significant impact.
But not everybody agrees. Chetan Ahya, economist at Morgan Stanley, says that according to his calculations, around $4 billion or so of inflows will be affected, which is not a huge amount. Points out Gaurav Kapur, economist with ABN Amro Bank, “Quite a bit of the ECB inflows would have been spent on imports of capital goods, so the net effect will not be very large.” The market seems to agree, which is why, although the rupee weakened, it didn’t crash. Moreover, there had been plenty of hints that the ECB policy will be tightened, with the Prime Minister’s Economic Advisory Council calling for curbs on them. Bankers say that’s why a substantial pipeline of ECBs has already been built up and since the new measures will allow loans already contracted to go through, the impact is likely to be muted. Also, with corporates structuring foreign currency loans innovatively, the impact on foreign flows is also not expected to be severe. Foreign direct investment, portfolio flows, private equity and ADRs/GDRs remain strong alternative avenues of foreign capital inflows.
Nevertheless, the measures will result in more local borrowing. Coupled with less need for RBI to intervene in the forex market by buying dollars, liquidity in the money and credit markets will be tighter, leading to higher interest rates.
For corporates, not only will the cost of borrowing increase, but the gains made during the last quarter on account of rupee translation could disappear. Interest-rate sensitive stocks, such as auto and real estate stocks, could be hit. As for the rupee, while most dealers now expect it to be weak in the shortrun, the impact of RBI measures in the long run is far from certain, especially in the context of the uncertainty about risk appetite.
The curbs are also unlikely to impact growth. “The RBI has signalled that it wants to put a stop to speculative inflows, while leaving genuine foreign currency loans for project imports untouched,” says Indranil Pan, chief economist at Kotak Mahindra Bank. As for the higher cost of borrowing, with return on capital being so high, slightly higher interest rates are unlikely to deter investment, although consumer demand may be affected.
RBI’s curbs on ECBs will provide some solace to exporters. Merchandise export growth in the first quarter of FY2008 has been the lowest in the last four years. As the table shows, it was in the first quarter of FY2004 that the rate of growth in exports was even lower than in the current year. In dollar terms, export growth was 14.05% in the April-June quarter this year, compared with 11.06% in the same period of 2003.
In rupee terms the showing was even more dismal, falling to 6.94% this year, while it was 6.75% during April to June 2003. While the slowdown in rupee terms is a measure of the compression in profits that Indian exporters are facing, the slowdown in dollar terms indicates that our exports are becoming uncompetitive on account of rupee appreciation.
The lower rupee rate of growth indicates another trend common to the first quarter of both FY2004 and FY2008—both the April to June 2003 quarter and the current June quarter were marked by an appreciating rupee. While the rupee appreciated against the dollar by around 6.2% over April to June this year, it did so by a much lower 2.4% in the same period of 2003. That could very well mean that there’s more pain to come for exporters. On the other hand, these are early days and much depends on what happens to the US currency and how the current rise in risk aversion plays out. In 2003-04, exports accelerated later in the year and export growth for the full year was 20.34% in US dollar terms and 11.16% in rupee terms.
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