Shankar Acharya: Midsummer Madness?

A PIECE OF MY MIND

TABLE 1 INDIA'S SUMMARY BALANCE OF PAYMENTS
(US $billion)	2005/6	2006/7	Change
Current Account (net)	-9.2	-9.6	-0.4
Capital Account (net) :	24.2	46.2	22
of which:
Foreign Direct Investment	4.7	8.4	3.7
Portfolio Investment	12.5	7.1	-5.4
External Commercial Borrowing	2.71	16.1	13.4
Short-term Trade Credit	1.7	3.3	1.6
External Assistance	1.7	1.8	0.1
NRI Deposits	2.8	3.9	1.1
Addition to Reserves2	15.1	36.6	21.5
Notes: 1. Net of IMD redemptions of $ 5.5 billion. 2. Balance of payments basis (excluding valuation changes). Source: RBI's "Macroeconomic and Monetary Developments,  First Quarter, 2007/8", July 2007.

 Reams have been written on this subject in all the pink papers, some of it sensible, quite a lot of it not. I will not rehearse the well-worn arguments. Instead let me focus on what I see as the two main proximate causes of this major policy failure and suggest solutions. First is the hugely counter-productive policy of MOF to enhance the annual external commercial borrowing (ECB) limit for domestic borrowers in each of the last two fiscal years, thus aggravating enormously the underlying problem of managing the surge in external capital inflows. Just how serious this policy error has been can be gauged from the recent BoP data in Table 1. In round numbers, while the current account deficit stayed almost constant between 2005/6 and 2006/7, the capital account surplus increased by $22 billion, of which ECB accounted for over $13 billion, or 60 per cent of the increase! To prevent unwanted rupee appreciation, the RBI had to purchase the extra $22 billion into reserves in 2006/7, compounding massively its liquidity management challenges. The $13 billion of additional ECB corresponds to over Rs 55,000 crore of reserve money injection (at prevailing exchange rates). To put that into perspective, a 0.5 per cent CRR increase only "sterilizes" about Rs 15,000 crore. 
 

TABLE 2 TOP 10 ECB BORROWERS FOR THE YEAR 06/07 (by approvals/registration)
S.No.	Company	ECBs/FCCBs  (in $ million)	Share (%)
1	Reliance Petroleum Ltd.	2,000	7.89
2	Reliance Communications  Ltd	1,000	3.94
3	Tata Steel Ltd.	755	2.98
4	Reliance Industries Ltd.	750	2.96
5	Reliance Energy limited	650	2.56
6	Air India Ltd.	560	2.21
7	Export-Import Bank of India	550	2.17
8	Reliance Ports & Terminals Ltd	500	1.97
9	Reliance Communications Infrastructure Ltd	500	1.97
10	Reliance Telecom Ltd	500	1.97
	Sub- total	7,765	30.62
	Total for year	25,353	100.00
Source : www.rbi.org.in/scripts/ECBView/aspx

 Against this background, several analysts (aside from myself) have called for a reversal of ECB policy to moderate the (self-inflicted?) capital surge problem. Of these, Rajeev Malik of J.P. Morgan (not usually identified as a fount of socialist control policies) has been the most trenchant advocate in a series of articles in this newspaper since spring of this year. More recently, the PM's Economic Advisory Council has lent its considerable weight to this view. All of us are careful to avoid any significant negative "signaling effect" on foreign investment, either direct or portfolio. Temporarily constraining domestic borrowers' access to ECB is a limitation, but seems well worth the benefits of containing capital surge and allowing a more competitive exchange rate policy, without spawning excess liquidity or unduly high fiscal costs from sterilised intervention. Any qualms should be assuaged by the interesting fact that some 20 or so corporates have accounted for over half of all ECB borrowings in recent years (Table 2 lists top 10 borrowers in 2006/7; they accounted for over 30 per cent of total approvals). Needless to say, these corporates have done rather well financially from the recent rupee appreciation and will deploy their considerable clout in resisting any reversal (a clout magnified by approaching elections?).  The second, principal proximate cause of the recent rupee appreciation appears to be the "conversion" of MOF (and the RBI?) to a pro-appreciation set of arguments peddled in recent months by some IMF staffers and a small group of younger domestic economists. A common characteristic of both these sets of bright, well-trained economists is a notable lack of hands-on, policy-making experience in a world of real political economy constraints and real uncertainties. Incidentally, during the previous episode of capital surge in 1993-95, IMF staffers had proffered the same recommendation of rupee appreciation (in those days they didn't publish in our pink papers!). Despite having just emerged from an IMF loan programme, we (in MOF) listened politely and ignored the advice, thus protecting the emerging booms in exports and industry. Alas, the present MOF appears to have been more receptive to the pro-appreciation nostrums. Perhaps this is because these arguments are anchored in textbook views of open economy macro policy, which have deeply (and perhaps appropriately) influenced policies in advanced industrial nations. The textbooks are fine; it's just that their domain of greatest relevance is restricted to $20,000 (plus) per capita, mature industrial economies with well-developed financial markets and "deep integration" of domestic and external markets in goods and services. The textbook policy recommendations have to be carefully screened and calibrated to our rapidly transforming, $1,000 per capita economy, with massive rural underemployment, semi-developed financial institutions and markets, bad physical and social infrastructure and substantial labor market dualism.  Let me illustrate with a few "textbook propositions" (favoured by the pro-appreciation folk) and my comments on them:  Proposition 1: Central banks (notably the RBI) should focus on the single objective of inflation control.  Comment: Wrong. At our stage of development, the RBI is quite right to weigh and pursue several objectives, including inflation, economic activity, financial stability and institutional development.  Proposition 2: The RBI should not concern itself with the level or volatility of the exchange rate.  Comment: Nonsense. The exchange rate is the single most important price in the economic domain, which deeply influences the rate of economic development, the degree of openness and the balance between tradables and non-tradables. It would be criminal for the RBI (and MOF) not to have clear strategic goals and instruments for exchange rate management, within the limits set by its objectives and the external payments system.  Proposition 3: Inflation is a purely monetary phenomenon; so monetary policy is all that really matters.  Comment: Wrong again, at least if you examine carefully the empirical evidence in developing economies. Supply shocks, market rigidities, expectations and openness all matter rather a lot.  Proposition 4: As productivity increases in the economy the appropriate exchange rate should appreciate commensurately.  Comment: Not quite. Yes, productivity growth is an important variable in calibrating exchange rate policy but a lot depends on what's happening in key competitor countries (China and others).  Proposition 5: Sterilised intervention (purchase of dollars by the RBI, offset by sale of rupee securities) always leads to higher interest rates.  Comment: Rubbish. It is quite feasible to calibrate the intervention so as to leave interest rate and liquidity conditions roughly where they were before the specified dollar purchase-cum-sterilisation.  I could go on, but you get the picture.  To sum up, our exchange rate policy since March 2007 has erred seriously and imposed significant, rising and avoidable costs for exports, output and employment. Given my view of the proximate causes, the solutions are clear enough: sharply tighten the present ECB policy and...get real about macroeconomic policy in the real world. At this juncture, global uncertainties may also help correct our faulty exchange rate policies.  Postscript: This article was submitted just before the government's announcement tightening ECB norms. This policy correction is welcome; let's hope it's enough.  The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal