Jamal Mecklai: Trying to close the capital account

MARKET MANIAC

The nature of politicians is to believe that what's good for them is good for the country. This belief reached its apogee with Indira Gandhi, but the fact is that all politicians believe this, which is why so much policymaking is often directly against the public interest. Anything which could create circumstances that would threaten the gaddi is, almost by definition, off the table.

The government's recent move to close the capital account is a case in point. Making a mockery of the Finance Minister's oft-stated belief that 10% growth is quite readily achievable, the government clamped down on ECBs, ensuring that India Inc's borrowing costs will rise. And, as usual, smaller companies will suffer more than larger ones because the poorly developed domestic debt market hits lower credits disproportionately in terms of pricing. Again, given that supply, and particularly of infrastructure, is the primary constraint on growth, this policy will ensure that wherever growth ends up it will be much lower than potential and certainly lower than the 10% dream.

So, why? Why was this done?

Well, it has become increasingly clear that India's attractiveness to global investors has been threatening the RBI's efforts to do the impossible""viz. manage inflation and the exchange rate in the face of a relatively open capital account. That the government chose to simply try to close the doors on the capital account is evidence that it is unable to do its job effectively. Making the central bank independent and giving it the exclusive task of managing inflation, for instance, would, in the current political environment, take a long time. Ditto for increasing the pace of deregulation of the financial sector, retail, real estate, what have you.

So, since the government can't do what it should, it does what it can "" no matter that this is not in the best long-term interest of the economy.

I mean, it should be clear that a strong rupee would keep inflation controlled, bring borrowing costs down (as wider swathes of Indian business learned how to access international markets), speed up the development of infrastructure, and generally ensure that we could achieve our potential growth "" easily 10%. But, if the rupee shot even higher, and there were job losses in some sectors, many small businesses may go under, providing fodder to the currently-flat-on-its-back BJP?

On the other hand, if the exchange rate were tightly controlled, inflation would certainly get out of hand, leading to perhaps greater political trauma""and, let's not forget that there's a general election in a little over 18 months.

Well, perhaps I am being too judgmental. Perhaps discretion is the better part of valour, and these curbs will turn out to be temporary and will be lifted as soon as the economy""or, more correctly, the economy's managers""get a breather.

The tragedy, though, is that, while the government has lost credibility by backtracking, this new policy is unlikely to have much effect. Even if the ECB spigot is completely turned off""which is neither intended nor likely""our capital account surplus will still exceed the current account deficit, maintaining the pressure on the rupee/inflation. The demand for India is strengthening as we speak""over the past four months, reserves rose by over $30 billion.

The only things that these curbs will achieve is to
a) bring about some rebalancing of the net short dollar positions in the Indian market, which is good;
b) increase the cost of borrowing for India Inc, which is bad;
c) increase the use of derivatives to improve borrowing costs, which could turn out to be bad for some companies (who mismanage the risk) and good for others (like banks and ourselves);
d) increase the uncertainty in the market (note I didn't say volatility but uncertainty, which I define as volatility of volatility), which is bad.

However, the biggest negative for the central bank's market management is the VERY LOUD statement this makes that the "free market" value of the rupee at today's productivity levels is higher "" and, perhaps, substantially higher "" than the current 40 to the dollar. Speculators will doubtless take note. The price action the morning after the curbs were announced - the rupee opened weaker at 40.80, but quickly reverted to its pavilion around 40.50""shows that the market has largely shrugged off this news. And to reiterate the rupee's fundamental strength, the RBI has had to keep buying dollars to prevent rupee appreciation "" reserves rose by $3.99 bn in the week to August 3 "" even after the global credit crisis forced other Asian central banks (Malaysia, Indonesia, the Philippines) to sell dollars to protect their currencies.

The hope is that as soon as the global crisis subsides, the RBI will take the bit between its teeth, re-open the capital account and move faster on reforms. Trying to prevent the market from achieving equilibrium is like spitting at heaven "" sooner or later, it will fall back onto your face. Far better to face the music today "" whatever the tune "" than wait for it to come back tomorrow, when the flows will be larger and the tune will be louder.