Sensible but stop-gap

On Tuesday, the government announced a cap on the amount of money that Indian companies can borrow abroad. This channel of capital inflows""external commercial borrowings, or ECBs""had contributed substantially to the increase in domestic liquidity, which, in turn, was making it rather difficult for the Reserve Bank of India (RBI) to maintain its anti-inflationary stance. Provoked by the sharp appreciation in the rupee, which was induced by the RBI's decision to stop buying up surplus foreign exchange, there was mounting opinion that, regardless of whatever else needed to be done, a cap on ECBs was a vital short-term measure. This newspaper had endorsed such a cap several weeks ago. Even though it has come with a significant lag, it remains relevant as an instrument of liquidity management, even as the RBI tries to balance the conflict between managing domestic liquidity and the exchange rate all at once.

However, it must be emphasised that this is only a "breathing space" measure, giving policy-makers some time to grapple with the longer-term implications of a persistently appreciating rupee. While it is true that an under-valued currency itself stimulates capital flows""foreign investors need not worry about currency depreciation diluting their returns""there is also little question that capital inflows into the country are significantly motivated by the more fundamental factor of sustained growth. These flows are likely to persist regardless of the currency regime. Whether they come in as debt or as equity investments is secondary. Given the widely held view among global investors that the Indian growth story is enduring, a balance of payments surplus induced by large capital inflows is a structural phenomenon. To the extent that it complicates domestic macro-economic management, it requires a structural response.

One of these is to simply let the currency float. In fact, this is an eventuality which will emerge along with full convertibility, for which there is a roadmap with four years remaining. Perhaps that process can be hastened, but it is constrained by the state of preparedness of the financial sector. The real question is how the regime should transit from a managed exchange rate to a largely market-determined one. Too rapid a transition can be disruptive, as has already been seen in the performance of exports, many of which are relatively employment-intensive. On the other hand, too slow a movement intensifies the problem of large capital inflows, while exacerbating the risks of a drastic response to domestic or external shocks.

It is this transition which needs to be rigorously but quickly considered in the current scenario. Recent upheavals in global equity markets should heighten the sense of urgency. Of course, part of the adjustment required has already taken place with the recent appreciation of the rupee. It is now, clearly, much closer to its true market value, whatever that may be. By imposing the cap on ECBs, the government appears to be signalling that it now wants to hold course for a while and let the various players impacted by the appreciation adjust to it. Under the circumstances, stopping for a breather is all very well, but the opportunity it provides will go to waste if the requirements for a currency regime more appropriate to the state of the economy and its future course are not decided and acted upon.