A V Rajwade: Managing capital flows

WORLD MONEY

The appreciation of the rupee has led to much concern over the ways to control foreign inflows.

In the last couple of months, we have had two major papers from people at the highest levels of policymaking, on the issue of capital flows. The first is titled "Macro-economic management of the Indian economy: Capital flows, interest rates and inflation" by Arvind Virmani, November 2007. (Virmani is now the chief economic advisor in the finance ministry.) The second is the inaugural address on "Management of the capital account in India: Some perspectives" by the RBI Governor, Y V Reddy, at the Indian Econometric Society conference in Hyderabad earlier this month. Rajeev Kumar, Director and Chief Executive, ICRIER, in the recent pre-Budget meeting of economists with the FM, seems to have also touched upon the issue, and suggested a tax on foreign inflows in order to check the price of the Indian currency. Recall the storm that was created when the Governor, in a speech a couple of years back, had suggested that something like this may need to be considered at a later date?

But this apart, if all this evidences that there is serious concern about the appreciation of the rupee and the adverse impact it could have on the economy, this surely is welcome.

Let me, however, look at and discuss some of the points made in the two papers. Turning first to Virmani's paper, he argues that, to the extent capital inflows are driven by interest differentials, "we must... remove all policy distortions and market distortions that keep these differentials from narrowing." Two points may be made in relation to the interest differential:

For one thing, inasmuch as interest parity does not rule in the domestic forward foreign exchange market, there is an attractive "carry" even on fully hedged inflows. One manifestation of the scale of distortion the absence of interest parity can create, is the current price of five-year MIOCS swaps: you could swap LIBOR-based dollars for 4.77 per cent rupees for five years.

More of the interest differential-driven capital inflows are probably in the form of short-term credit on imports by resident companies, rather than in the form of either FII investments in the debt market or external commercial borrowings (ECBs).

To my mind, the second point does not seem to be getting the attention it perhaps needs, given the potential size of such capital flows. Currently, annual imports are of the order of $240 billion, and, in terms of stock, this can generate short-term capital flows of the same order, given that supplier/buyer credits up to one year are free of all regulatory restrictions "" so long as you keep the fig leaf of the individual transaction limit of $20 million.

While on the subject of short-term credit, I reproduce hereunder extracts from paragraph 13.72 of the Eleventh Five Year Plan as recently approved by the National Development Council (quoted in Reddy's speech):

"In controlling capital flows it is important to recognise the relative attractiveness of different types of flows. In this regard, direct foreign investment is the most preferred form of flow. Investments in Indian firms through the stock market and by venture capital funds in unlisted companies are also potentially beneficial. ECBs and other short-term flows are areas where one can introduce an element of control to moderate sudden surges."

What the document does not comment on is the irony of our regulatory regime: "the most preferred form of flow", FDI, is the most restricted, and the riskiest, namely short-term capital, is completely unregulated so long as it comes in the form of buyer/supplier credit!

But to come back to Virmani's paper, "it seems that inflation convergence has been much faster than that in nominal interest rates and consequently in real interest rates." He ascribes this to "market imperfections and distortions in capital/ credit markets." With due respect, surely there are at least two other and, in my view, more important, factors which lead to the phenomenon:

The administered interest rates on some small savings (these have come down to some extent but there is still further scope).

Monetary policy and reserve ratios. Over the last year-and-a-half, rupee interest rates have gone up, thanks to the tightening of the monetary screw.

The irony is that, even as we continue to blame the scale of capital inflows for the difficulties they are creating in the conduct of monetary policy, the policy itself has played a role in encouraging capital inflows. Higher domestic interest rates make the economics of short-term credit far more lucrative for the importer, as also for the borrower of ECBs. The exchange rate policy, particularly in Q1 of the current fiscal year, has also played a major role in attracting foreign capital: debt capital at negative cost to the borrower, and FIIs getting a bonus return from the currency appreciation, over and above what the stock market gives them.

avrajwade@gmail.com