Foreign inflows may be tightened further3 min read . Updated: 22 Nov 2007, 12:45 AM IST
Foreign inflows may be tightened further
Foreign inflows may be tightened further
New Delhi: India is poised to announce a new policy that will try to stem the growing pressure from foreign capital inflows into the country, potentially reducing the pressure on the rupee from appreciating even more against the dollar.
“Since there is too much inflow of capital into the country, a move is on to prune the inflows and one of the measures may include a cap on ECBs (external commercial borrowings)," said a senior government official who spoke on the condition of anonymity. ECBs are overseas debt raised by Indian firms for their business ventures. The government has already tightened ECB guidelines once this year.
Cause For Concern (Graphic)
Simultaneously, the government and Reserve Bank of India (RBI) are also working on a strategy to introduce currency hedging on exchanges as opposed to the over-the-counter model that is restricted to firms with large foreign currency exposures. RBI has circulated a discussion paper on the subject last week. In the short run, though, both appear to be leaning towards some form of capital controls.
Another government official, who also didn’t want to be identified, independently confirmed that a policy change, in consultation with RBI, was on the anvil. He declined to elaborate because of the sensitive nature of the proposals that are still being finalized.
The government and RBI have already expressed recent concerns about the issue.
“These inflows are a test of the absorptive capacity of the economy," said finance minister P. Chidambaram at an economic editors’ conference on 12 November.
Opportunities to raise debt overseas at a cost lower than in India resulted in a more than five-fold increase in ECBs to 2006-07. The inflows, according to the Economic Outlook for 2007-08 compiled by the Prime Minister’s Economic Advisory Council, through ECBs in 2006-07 made up a significant part of $36.6 billion accretion to reserves in 2006-07. In the first quarter of 2007-08, inflows on account of ECBs were $7 billion, higher by 75% over the corresponding period of the previous year.
The combined foreign exchange inflows through ECBs, foreign portfolio and direct investments eventually show up in the form of higher money supply as the central bank mops up the excess dollars in return for rupees. Because more money is chasing the same number of goods, this is potentially inflationary.
The inflows also cause the rupee to appreciate, making Indian exports more expensive in dollar terms and hence less competitive internationally.
Overseas investors have bought a record $18.8 billion of stocks and bonds this year, according to the market regulator. That helped the rupee gain 12.5% since January and pushed the Sensex, the benchmark index of the Bombay Stock Exchange, to above 20,000 points for the first time, leading to the imposition of capital controls. (The Sensex has since dipped. It fell 678 points, or 3.5%, on Wednesday to close at 18,602.)
RBI has tried to offset the situation by buying dollars in the foreign exchange market. But despite repeated interventions by RBI, the rupee has risen by more than 10% this year.
Some economists, however, don’t see measures to control capital inflows as an effective way to curb the flood of foreign exchange into India. “All these measures will be short-term, and any tinkering will create problems for India in the international market," says N.R. Bhanumurthy, associate professor at the Institute of Economic Growth. The solution, he says, lies in bringing down the interest rates in the economy to reduce the gap between rates in the US and India, which is sucking in foreign portfolio investments.
A senior government official said 95% of India’s investment is funded out of savings, making it tough for policymakers to take decisions based on actions in the US. Forcing a reduction in interest rates could impact savings and thereby jeopardize investments and in turn economic growth.
Ajay Shah, former advisor in the finance ministry, said: “It is fundamentally illegal for the government to say that it knows better than the market." Shah has advocated allowing the market to determine the exchange rate of the rupee.
Using capital controls as a measure to deal with the situation would impose other costs on the economy. “Capital controls have real costs. All capital controls involve distortions," said Shah.
(Bloomberg contributed to this story.)