The rupee has depreciated considerably and suddenly in the last few weeks. It stood at 45.665 against the US dollar on August 22 and depreciated to 52.3753 on November 22 this year — all in a span of three months (https://bsmedia.business-standard.comwww.x-rates.com/d/INR/USD/data120.html). Though the Reserve Bank of India (RBI) has intervened to some degree, it seems reluctant to go beyond a point. This is because the foreign exchange reserves ($314.339 billion) cannot be viewed as being exceptionally large in light of the uncertainties surrounding us (in India and Europe, and even in the US). Finance Minister Pranab Mukherjee said the rupee depreciation may be due to the foreign institutional investors (FIIs) selling stocks in the market, and buying dollars and selling rupees in the market. Are we helpless then?
It may help to provide a background before we come to the solution to the problem at hand. Domestic savings in India are high. We also have considerable foreign direct investment (FDI). However, the need for investment in India seems to be higher than the sums that we can, and would like to, get from these two sources. It is here that the inflow of funds by FIIs is important. While there is a positive side to this in the form of more capital and, hence, potentially more development in the economy, there is a possible negative side too. Some or even all of this money can be volatile. It can leave suddenly. The worst possible example is the East Asian Financial Crisis in 1997-98. “Indonesia, Korea, Malaysia and the Philippines were hit the hardest — by December 1997, their currencies had depreciated (on average) by about 75 per cent.’” (Kaminsky et al, 2003). It is this apprehension that makes even liberal minded people reluctant to accept large inflow of FII funds in the financial markets in India. This fear is genuine. Is there a way out? Yes, to an extent. Let RBI buy an international credit line.
An international credit line with RBI is a facility by which one can ensure in advance that one is able to borrow in hard currencies up to some pre-specified amount, should the need arise. Like any other facility, it has a price. It is somewhat similar to an insurance policy and the price paid for buying a line of credit is comparable to the insurance premium. It is comparable to insurance because it provides an assured supply of credit in the event of a crisis when international liquidity tends to dry up otherwise. One can also compare a credit line with an option — one may choose or not to choose to borrow at a future date in the event of a bad state of the world.
At present, RBI can fall back on foreign exchange reserves alone to tackle the sharp fall in the value of rupee (we are not considering the extreme step of capital controls). With an international credit line facility, RBI has one more instrument available. This can supplement the foreign exchange reserves.
An international credit line facility is available from the International Monetary Fund (IMF) in two forms. One is called Flexible Credit Line (FCL) and the other is called Precautionary Credit Line (PCL). Three countries (Mexico, Poland and Columbia) have bought FCLs. One country (Romania) has bought PCL. Some data regarding the FCLs is shown in the table. India should have no difficulty in meeting the eligibility criteria since the conditions are not stringent if we go by the data. It also shows that the price of the facility (24-27 basis points) and the interest rate charged for any possible borrowing (2.7 per cent) are reasonable. Though the macroeconomic conditions in India are not unambiguously better than those in Mexico, Poland and Columbia, we have our strengths to be eligible to purchase a credit line facility.
The basic premise on the basis of which we are looking for a safeguard in the form of a credit line is that financial inflows are important and that the implications of a sudden financial outflow, in case it occurs, are extremely serious. If that is the case, then we are indeed justified in spending on line(s) of credit. One more point is that a credit line works out cheaper than foreign exchange reserves under some conditions. So, in any case there is a need to hold a mix of foreign exchange reserves and international credit lines for a given total amount of safeguard against a mishap in the balance of payments.
Did we hear somebody talk about stigma in the context of IMF? This is a genuine concern given IMF’s history. However, there is a need to distinguish between actual borrowing and an option to borrow. The bad experience has been with actual borrowing and not with the option to borrow. Consider an analogy. Many Indians are conservative and do not like to borrow on their credit cards but they do hold credit cards (and not just as a means of payment for which they could in any case use debit cards). Observe that a credit card is like a credit line facility. It can be a good option for emergency funding if utilised properly. Similarly, at the all-India level, an international credit line can be part of macro-prudential policy.
| FLEXIBLE CREDIT LINE EXTENDED BY THE IMF | |||
| Date of approval | Mexico 17 Apr, ‘09 | Poland 6 May, ‘09 | Columbia 11 May, ‘09 |
| Maximum amount that can be borrowed (US$ billion) | 47 | 20.3 | 10.4 |
| FCL as a percentage of the country’s quota with the IMF | 1000 | 1000 | 900 |
| Interest rate under the FCL in % | 2.7 | 2.7 | 2.7 |
| Length of the FCL (in months) | 12 | 12 | 12 |
| Upfront fee (basis points) | 24-27 | 24-27 | 24-27 |
| Real GDP (annual % change, 2008) | 13 | 5 | 3 |
| Gross international reserves (end year 2008, US $billion) | 95.3 | NA | 24 |
| Fiscal deficit as % of GDP | 2 | 3.9* | 0 |
| Public sector debt as % of GDP | 43.3 | 44.9 | 32 |
| Current account deficit in billions of US | 16 | 20.1 | 6.765 |
| Current account deficit as a % of GDP | 0.1 | 2.3 | 3.6 |
| Consumer price index % change | 6.5 | 4 | 7.7 |
| Rating (foreign currency) (Standard & Poor’s) | |||
| Long term | BBB | A- | BB+ |
| Outlook/watch | Stable | Stable | Stable |
| Date | 8 Oct, ‘07 | 27 Oct, ‘08 | 12 Jun, ‘07 |
| Source: Singh, Gurbachan, 2010, Financial Stability Report (FSR), Reserve Bank of India (RBI), March, 2010 and December, 2010: A Critical Review with a Long Term Perspective, Forthcoming in Margin - The Journal of Applied Economic Research) *General government balance | |||
We may add one caveat to the whole argument. Foreign exchange reserves or an international credit line needs to be used sparingly. There is a need to intervene if there is not only a sharp nominal depreciation of the rupee, but also a sharp real depreciation of the rupee (after adjusting for higher inflation within the economy compared to that outside). This is consistent with the view expressed by Subir Gokarn, the deputy governor of RBI, on central bank intervention in the forex market.
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Returning to the main theme on credit line, it is well established that “the [potential] borrower should not wait until the liquidity shock occurs to secure funds to withstand it” (Jean Tirole, The Theory of Corporate Finance, 2006, pg. 200). This is in the context of corporate finance but the argument is more general. In fact, it applies even more in the case of a country than a corporation. So a credit line facility is very useful. An international credit line is not a panacea for all open-economy macro-economic problems. However, it is important enough.
The author is visiting faculty at the Indian Statistical Institute, Delhi Centre