Abheek Barua: P-note curbs: another damp squib?

The RBI should at any cost avoid signalling any kind of monetary tightening since that could induce more inflows.

Given the number of column inches devoted to the debate on capital controls in this newspaper and elsewhere, I am a little apologetic about writing yet another piece on it. However, the issue seems far from resolved and I thought it would not be entirely futile to stand up and be counted.

Let me try and address the key question in this debate and make my position clear. Should we lose sleep over the problem of copious capital inflows and an overvalued exchange rate? I believe we should. While it is possible to argue on the basis of past data that a "fairly valued" exchange rate is a neither necessary nor a sufficient condition for sustaining our export growth, there is enough evidence on the ground to suggest that export-driven, labour-intensive sectors like textiles are bleeding. Their future looks particularly grim if the exchange rate problem is coupled with the possibility of a sharp slowdown in demand from the US and other developed markets

Are there other problems? Markets tend to function well when there is a significant number of both buyers and sellers. If you look at the rupee market, you will notice that there is significant deviation from this "ideal". More often than not, the sole large buyer of dollars in this market is the RBI with the rest of the market dumping dollars. This creates virtually a unidirectional movement in the market, interrupted transitorily by central bank invention. Given this one-way movement, market players find it somewhat irrational to hedge their rupee exposures. The large quantum of unhedged exposures in the forex markets multiplies the risk in our currency markets. Besides, hedging costs eat into interest arbitrage margins. In their absence, arbitrage margins expand and encourage more inflows.

Can capital controls work in this scenario? To begin with, we must recognise that these are exceptional circumstances. The rapid currency appreciation of the last few weeks is less a function of the natural, justifiable appetite for the long-term India "story" as it is momentum brought on by a policy-induced surge in liquidity in global markets. This came on the back of the US Fed's decision to pare interest rates to handle their mortgage market led macroeconomic crisis and more cuts are expected. This momentum in the currency's movement has the potential to breed our own crisis "" a combination of highly inflated asset bubbles and an insidious slowdown on the back of weakening external demand, concentrated in the employment-heavy SME segment.

Exceptional circumstances need exceptional solutions, particularly, the jettisoning of all dogma. I would reserve my judgement on whether capital controls are desirable in a "business-as-usual scenario". However, given the abnormal circumstances, some curbs on capital flows are perhaps the only way out.

The imposition of selective capital controls is a great opportunity to change currency market expectations. I must, in this context, congratulate Sebi on so deftly handling the imposition of participatory note curbs. It prevented a sharp decline in the equity markets and a run on the currency (seen in Thailand in 2006) that would have forced it to roll back some of its measures. That said, the "capital control" aspect of these measures seemed to have got diluted considerably since the draft guidelines were released less than a fortnight ago.

I confess to being somewhat naïve about stock-market regulation and the legal limits of hedge fund operations. It is possible that foreign money in the equity markets will reduce going forward. However, given the stock-market's behaviour over the last few days, market participants (including foreign funds) seem to have arrived at the conclusion that the new restrictions would barely dent fund inflows. Was this the desired the objective of these measures? Or was it aimed at perceptible moderation in capital inflows presumably aimed at arresting the rupee's rise? If the rupee was the target, the regulator perhaps should have shown unregistered investors tougher love.

It is being a little unfair to the stock-market regulator alone. Managing currency market expectations is not the stock-market regulator's remit after all. If moderation in capital inflows was indeed the goal, two things could have been done to take the rupee to a new trading range. The government could have kept emphasising that the participatory note curbs were indeed a much-needed control on inflows and not just a measure aimed at greater transparency. A statement that it expected the rupee to halt its uninterrupted climb against the dollar was perhaps in order. That message, which had the potential of altering the currency market views, seems to have got lost somewhere along the way.

Second, the RBI could have stepped in and bought dollars when there was a bit of a dollar shortage and reasserted the fact that it was keen on a weaker currency. This would have induced the currency market that was heavily oversold on dollars to cover their short positions and moved the rupee a little more. Many of the market participants who were keen on buying dollars in the few days of rupee depreciation (right after the Sebi draft proposals) were waiting for a little nudge from the RBI. When it did not come, they reverted to their "shorts" on the greenback.

I have no doubt that going forward the RBI will have to intervene a lot more in the currency market and release rupees into the domestic system. It could perhaps allow the money markets to live with a little more liquidity instead of constantly obsessing over the inflationary consequences. It should at any cost avoid signalling any kind of monetary tightening since that could induce more inflows. Second, the fiscal costs of sterilisation pale in comparison to the costs we might have to bear if the rupee continues to rise. Perhaps a war chest of sterilisation bonds is what the doctor ordered.

The author is chief economist, HDFC Bank. The views here are personal