Change of mind?

Last year the government decided to clamp down on external commercial borrowings (ECB), as a part of its bid to slow down capital inflows and stop the surge in the rupee's external value. Now, it would be a strange twist if it were to happen, the government is reported to be getting ready to do the opposite, and allow more ECBs. The logic of such an about-turn is not clear, since little in the current economic context has changed to warrant an fresh opening of the tap. In a situation where the problem is said to be too much (rather than too little) money coming in, the fear that foreign exchange inflows may rise beyond levels of comfort is still there, especially given the rising interest rate differential between India and the US and the euro area. As for the excess domestic liquidity that the inflows created and can create in the future, and their inflationary impact, the picture is worse than before because inflation levels have climbed quite sharply in recent weeks.

It is important to note that it was ECBs rather than portfolio investment by overseas institutional investors which were responsible for the upward pressure on the rupee last year. Vidya Mahambare of Crisil, the credit rating firm, has examined the relationship between the rupee-dollar exchange rate, FII inflows and the stock market index by using rolling correlations. Her study has shown that FII inflows did not have a strong correlation with either the Sensex or the value of the rupee. As it happens, net FII inflows during this period were relatively small at $1.4 billion. So it was probably ECB inflows ($10.8 billion during March-May last year) that got diverted to the stock market, causing both the currency and the stock market to spiral upward. Relaxing controls on ECBs, then, would put fresh upward pressure on the rupee "" which the government would presumably want to avoid.

If the government does decide to relax the curbs on ECBs, so that the tap can be opened a little more, it would be a sign that business is keen to get access to cheaper capital overseas, since the cost of capital in India is high. Admittedly, there is a currency risk that comes with overseas loans, but the cost of hedging this is smaller than the interest rate differential. Also, many of the large companies have a recurring dollar income stream, thus giving them a natural hedge against dollar loans.

Even if the larger issue of liquidity management is sorted out, there is the issue of equity, for it is mostly the larger firms who will get access to ECBs, giving them a significant cost advantage over smaller companies, who in the normal course will find it more difficult to access international finance. And if, in order to manage liquidity, the government has to mop up funds and thereby drive up domestic interest rates even further, it increases the disadvantage for the smaller companies.