A V Rajwade: Managing capital flows - II

WORLD MONEY

If inflows are to be taxed, the preferred channel should be short-term credit on imports.

In the last article, I had commented on some of the points in the recent papers on the subject of management of capital flows, authored by Arvind Virmani and Y V Reddy. I had concluded by arguing that the "problem" of capital inflows has been exacerbated by the monetary and exchange rate policies followed by the central bank. There are several other points in the two papers, in particular the solutions suggested, which are worth taking note of. For instance, Virmani's paper attributes the slowdown in growth between 1997-1998 and 2002-03, to the elimination of quantitative restrictions on imports. One would submit that the monetary policy of 1995-96 also had a role to play.

As for the exchange rate per se, Virmani has argued, "There is, therefore, we believe, merit in moderating the appreciation of the rupee (as measured by the 36-country REER), arising from excessive capital inflows (net inflow in excess of current account deficit if any)." One is somewhat intrigued by the reference to "moderating" the appreciation, as the date from which the appreciation should be moderated, has not been specified.

For example, is the suggestion that further rupee appreciation should be moderated? Or is it that the appreciation during the current fiscal year, needs to be moderated, through depreciation of the rupee from the current levels? One hopes that it is the latter and not the former. On the other hand, Reddy quotes (approvingly?) from Barry Eichengreen's paper titled "The Cautious Case for Capital Flows". Eichengreen's recommended solution for the appreciation of the domestic currency is: "The main tool for countering appreciation of the currency will be fiscal policy ... If currencies are too strong for comfort, then Asian governments need to raise taxes and cut public spending."

One does not know how deflationary fiscal policies would "counter" appreciation of the currency. They would surely slow down growth and employment creation. Is it the argument that deliberately slowing growth will reduce the attraction of the economy for foreign investors and thereby reduce capital inflows and the upward pressure on the currency they exert? Virmani also makes a somewhat intriguing argument on the point, namely that "Sterilisation would also have to be increased if the growth in NDA (that is, net domestic assets of the RBI) is positive or the GDP growth falls short of 9 per cent." The first part may be fine in certain circumstances, but is he advocating tighter money when growth slows? Whatever the academic rigour of the argument, surely, given the number of people coming in the job market every year, and the need to reduce the number of people below the poverty line, tightening fiscal policy as recommended by Eichengreen, or monetary policy as apparently preferred by Virmani, is hardly an optimal solution.

But coming back to the topic of capital flows, Virmani argues that "excess capital inflows now impose a cost on the economy (an externality) that needs to be corrected through an appropriate tax". His preferred candidate for taxing inflows seems to be external commercial borrowings (ECBs): a "more flexible way of achieving the same objective would be to auction the right to undertake ECBs. The auction could be held on a quarterly or monthly basis with the annual ceiling appropriately divided into quarterly or monthly tranches. The bid variable could be the unit price per Rupee crore of borrowing....This has the added advantage that the auction cost per annum declines with term of the borrowing thus giving an incentive to long term borrowing/debt."

Personally, if any inflows are to be taxed, one's preferred channel would be short-term credit on imports: taxing or auctioning ECBs is not the optimal solution, as much of such borrowing is used for real capital investment, and increasing the cost of capital for investment is not a very welcome prospect, given the huge investment needs of the economy. Again, the distinction between short-term credit and ECBs is one of maturity, end use and the regulatory treatment, but both are capital inflows and have the same impact on money supply, exchange rate, and so on.

In the last few years, short-term credit on imports has been extremely lucrative for the importers "" in fact, a free lunch! And, as I have argued earlier in this column, the actual scale of such short-term credit is still unknown, but could well be bigger than ECBs or FII inflows. Again, such short-term credit is directly or indirectly financed by the banking system and, therefore, inevitably subject to the herd instinct of banks. It should not be forgotten that the balance of payments crisis in east Asia was triggered by the refusal of the banking system to roll over short-term credit; capital flow in the form of portfolio investment did not turn negative, for the region as a whole, even during the crisis.

avrajwade@gmail.com