A day after the finance ministry announced curbs on external commercial borrowings (ECBs), which will slow foreign capital inflows, the rupee’s appreciation against the dollar saw only a marginal let-up. And even these gains may be short-lived. Unless of course, the finance ministry and the Reserve Bank of India (RBI) together have in store further measures with which they can reinforce such curbs.
So, why did the finance ministry decide to place curbs on ECB inflows?
In 2006-07, there was a paradigm shift in the nature of ECBs. Unlike in the past when these borrowings were primarily towards funding dollar spending, a substantial part was accruing towards funding domestic rupee expenditure. While ECBs aggregated $16.1 billion in the year, borrowings for spending in rupees amounted to $6.3 billion; it is another matter that it allowed companies to raise monies at interest rates substantially lower, albeit with an underlying foreign currency risk, than what they would have borrowed domestically. The finance ministry believes its measures will reduce foreign inflows by choking this route. Last year brought an accretion of as much as $36.6 billion to the country’s foreign currency reserves—thanks to the additional foreign exchange that RBI purchased to stem the appreciation of the rupee—and the finance ministry believes it will succeed in reducing inflows by at least one sixth.
Sadly, the numbers won’t stack up. The current financial year till 20 July saw accretions to foreign currency reserves worth $22.9 billion—double that witnessed in the same period in 2006-07. While this pace may not be sustained for the rest of the year, especially with global financial markets beginning to see volatility, it is also not likely to see a sharp reversal. Either way, the curbs announced on Tuesday will not have the desired effect of a dramatic slowdown in foreign currency inflows.
Worse, the move sends the wrong signal to the markets.
For one, it is probably the first time that India has regressed on its measures for external sector reforms. After effecting a shift in the mindset by allowing Indian companies to borrow in dollars to spend in rupees domestically, it is now forcing a reversal. Second, North Block has conveyed a sense of panic. The fact that foreign currency inflows are posing a macro-economic problem has never been in doubt. By undertaking a measure, which on the face of it will achieve little, the authorities have conveyed to the market that RBI is short on options.
Market players now realize that there is not much that the government can do at this stage. Any further measures to sterilize inflows are not possible, unless the Union government is willing to absorb the fiscal costs. Unless something dramatic occurs, the pressure on the rupee to appreciate will resume. In other words, the authorities would have failed to restore a two-way movement of the rupee. This could be disastrous for the shortterm, as foreign currency speculators will be emboldened to take riskier bets—making it even tougher for RBI to manage inflows.
If there is any lesson here, it is that there is no simple solution. The way forward is for the government to allow greater flexibility to the market, calibrated to account for real-world situations. The market estimates that if RBI stopped all interventions, then the rupee would settle to Rs37 to a dollar, with undoubtedly catastrophic effects on exports. The first step is to develop a vibrant market for foreign currency derivatives that can provide a foreign currency hedge. The Percy Mistry report, submitted earlier this year, has set out the blueprint. But due to internal resistance, matters have begun to drag. It is for the leadership to manage the conflicts among policy wonks within government.
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