Subir Gokarn: Dealing with the deluge

We have a plan that involves speeding up the convertibility process along with a commitment to a market-determined exchange rate.

At least as far as foreign exchange is concerned, when it rains, it pours. India's forex reserves crossed the $200 billion mark in the first week of April, up about $46 billion from a year ago. They would have undoubtedly have grown some more, had the Reserve Bank of India not, at least temporarily, decided to stop preventing the rupee from appreciating over the last couple of weeks.

Over the past year, the net foreign exchange assets of the banking system increased by about 28 per cent, the fastest- growing component of the collective balance sheet. By comparison, credit to the domestic private sector (which includes retail lending) grew by about 25 per cent, while credit to government increased by a mere 7.7 per cent.

For a country whose policymakers cut their teeth on dealing with balance of payments crises precipitated by too little foreign exchange, the current scenario might be a little difficult to assimilate. The natural inclination is to treat it as just reward from global investors for doing many things right over the past decade and a half.

But, when we move beyond the realm of self-congratulation and complacency, we will have to accept the fact that, as with many economic phenomena, so with foreign exchange inflow: too much can be as much of a problem as too little. An enduring solution to this will have to combine realistic assessments of the likelihood of their sustainability with policy and regulatory changes.

Let's look at potential macroeconomic scenarios, with their implications for the balance of payments. There is a wide consensus about the sustainability of 8-9 per cent growth in the medium term, even if the 10 per cent aspiration of the government may be viewed with some scepticism. If present patterns are to hold, this will mean the persistence of substantial inflow on the invisibles account, keeping the current account deficit in check under reasonable assumptions about energy prices and global economic performance.

With 8 per cent plus growth and expectations of a relatively healthy current account, investment flows in search of high long-term returns simply cannot stay away. Apart from portfolio investment, funds will continue to come in through the acquisition route, particularly in the form of private equity, which is constantly in search of sunrise sectors that are past the incubation phase but not quite ready for public listing. There are a huge number of such opportunities in India currently. Besides this, there is the increasing capacity of Indian companies to borrow abroad at rates more attractive than they can find here.

All of this means that sustaining the current pace of growth will inevitably be accompanied by a strong balance of payments surplus. We can then begin to examine policy options in terms of the two extremes and the middle ground.

At one extreme is the laissez-faire or market fundamentalist option. Let the forex flow in and let the markets deal with it. The resistance to this option is currently based on fears that left to market forces the rupee will appreciate, hurting export competitiveness. The fears may be justified, but we need to remember that the forex market in India is still not characterised by free entry, which is a necessary condition for any competitive market to work. In the absence of full convertibility, resident Indians, collectively potentially large players in a free forex market, are largely shut out.

Yes, the five-year roadmap is in place and things will pan out pretty much as it says. But, given the virtual certainty of the persistent balance of payments surplus, there is an increasingly strong argument for substantially advancing the deadlines for full convertibility. Some would argue that it wouldn't make much difference, because even if he had the option, why would the average Indian investor want to take his money elsewhere in this environment?

My response to this is that it doesn't matter whether convertibility immediately increases the absorption of forex inflow and reverses the pressure on the rupee. The key contribution that it makes is that a new, credible threat is introduced into the equation for both investors, foreign and domestic, and policymakers.

Expectations can change very quickly and anything could trigger a sharp reversal in the current trend in inflow into India. With that risk in mind, investors and domestic borrowers will have every incentive to hedge their exposures, which they do not really need to do in a regime of restricted convertibility and a managed exchange rate. Even if the costs of hedging are low because of the availability of efficient instruments, they will influence relative returns or borrowing costs between India and the rest of the world. The money may still surge in, but market forces will guide and restrain it.

The challenge for policymakers in this scenario is to ensure that they do not do anything to trigger the reversal in expectations. It is akin to a tightrope walk, but one that will induce enormous discipline in policy statements and actions.

The other extreme is the command and control or sequestration approach. To put it simply, the way in which China has been able to deal with its even larger inflow is by imposing very tight restrictions on the banking system's ability to lend those flows, once they are converted into yuan, onwards. Technically, this translates into an incremental cash reserve ratio on forex inflow into the banking system close to or equal to 1. Can we visualise this solution in the Indian context?

Theoretically, it is feasible, but the key difference between the Indian and Chinese banking systems is the extent of private shareholding in the former. Such a restriction would severely constrain the profitability of banks. The subversion of shareholder rights by the government would send a very negative message to the private sector about its commitment to the smooth functioning of markets.

So, is there a middle ground? Moving inwards from the two extremes, we have a plan that involves speeding up the move towards convertibility along with a commitment to a market-determined exchange rate, and a temporary and discriminatory set of restrictions on inflow and their domestic uses. However, this hybrid carries significant risks. Timeframes may not be adhered to and temporary measures could well become permanent. But, in the current circumstances, it is perhaps the only viable option.

The author is chief economist, Crisil. The views here are personal