Rajeev Malik: Few steps to checkmate

Inaction promises that capital inflows will again overwhelm policymakers. Scaling back ECBs is the least painful option and will also make monetary transmission more effective.

The current bout of increased global risk aversion offers some breathing room to take stock of the policy inconsistencies between growth, capital inflows, inflation and exchange rate dynamics. Policymakers could be pushing themselves in a corner owing to these inconsistencies. The current tactical shifts in market positions do not alter the medium-term attractiveness of India's economic rise, the fundamental attractiveness of the rupee, the expected surge in capital inflows, and the government's unsustainable band-aid approach of fixing the symptoms rather than the causes of economic excesses.

A large number of people find it puzzling that policymakers are having difficulty in dealing with capital inflows despite the significant financing needs of the economy that can be met only by foreign savings. Actually, the case is rather simple: an economy's need for overseas funding is not the same as its ability to absorb those funds without creating macroeconomic imbalances, such as inflationary pressure and asset bubbles.

The current dilemma in dealing with capital inflows owes to conflicting objectives about growth and inflation and the ill-timed""but probably well-intentioned""policy measures that boosted capital inflows which, in turn, exacerbated the monetary challenges for the RBI. Also important is the role played by the government's inability to implement faster reforms that will increase the economy's absorption of capital inflows and push up the speed limit on non-inflationary growth.

By now, the short-lived hands-off approach by the RBI toward the rupee should have emphasised one important point to even the fanatics pushing the no-intervention-by-RBI view: the appreciation pressure from capital inflows is immense. If left unchecked, the flood of capital inflows could possibly quickly take the rupee to even, say, 35 or lower against the dollar.

A simple economic point appears to escape the government: capital inflows over and above what the economy can absorb productively and without fuelling inflationary pressure will spill over to asset markets and push up prices.

There also appears to be a misguided notion among those who should probably know better that more funds from overseas would ease the pressure on demand for domestic funds and hence ease inflationary pressure as these funds are being spent to expand capacity or to improve infrastructure. The pressure on domestic financial resources will surely be eased, but the investment activity generated by these overseas funds will still add to demand-driven inflationary pressure at a time the economy is already bursting at the seams. Thus, the proposed disinflationary benefits of additional capacity will come only after inflationary pressure is initially exacerbated.

Managing elevated expectations in an economic boom is not an easy task, as policymakers are now realising. We undoubtedly need more capital inflows for infrastructure (never mind whether existing funds are being utilised more efficiently), and more FDI. Lobby groups will also stress that corporate India should be able to raise cheaper funds overseas as investment plans should not be adversely affected by the rising cost of credit domestically.

Each of the above makes good sense when viewed individually from the perspective of a particular industry or business. But the aggregate outcome will flood the economy with more overseas funds than what can be absorbed without exacerbating inflationary pressure or fuelling asset bubbles. What is good at a micro level for individuals and businesses may not be necessarily appropriate for the aggregate macro policy framework, especially when the government is unable to ease the structural rigidities rapidly to allow greater non-inflationary absorption of capital inflows.

Unfortunately, the conflict between capital inflows and their incomplete domestic absorption is poised to again take a toll on the exchange rate. Last year's overall balance of payments (current account balance minus capital account balance) probably posted a massive surplus of around $35-40 billion. This year's outcome will probably be similar, and could easily blow away the rupee, if no preemptive actions are taken.

Admittedly, an increase in global risk aversion and/or a dollar rebound could save the day. But our policy setting should be prepared to absorb such outcomes, not be only reliant on their occurrence. Additionally, the recent improvement in inflation offers more flexibility to the RBI for intervention in the foreign exchange market. But with the benefits of capacity enhancements still some time away and demand conditions still strong, an acceleration in the pace of monetary expansion could come back to haunt us.

The RBI has already repeatedly expressed its reservations about the magnitude of capital inflows. There are also constraints on how much the RBI can intervene in the foreign exchange market, the fiscal costs of sterilisation, and the limited flexibility for additional hikes in the cash reserve ratio that the banking system can absorb without asset quality deterioration becoming a bigger problem.

Investors in financial markets thrive on macro policy inconsistencies, and the current Indian economic framework provides a host of such mismatches, with the current status quo over dealing with capital inflows being the most egregious.

The government needs to decide on the likely combinations of the magnitude of capital inflows and the additional rupee appreciation that are palatable. A lasting solution for greater absorption of capital inflows is an accelerated move towards removing supply-side constraints and structural rigidities and inefficiencies that keep inflation high. But these are not short-term solutions and, in any case, progress on these remains tardy and uneven.

There are no easy options partly because capital account liberalisation should be a one-way street. Also, significant rupee appreciation does not appear to be politically feasible, and the economy's absorptive capacity cannot be increased overnight. We are already encouraging more outflows, and restrictions on foreign portfolio and direct investment should be a firm no-no.

However, there is one option: scale back external commercial borrowings (ECBs) by Indian companies, which reportedly hit $25.4 billion last fiscal year compared to the cap-that-cannot-be-enforced of $22 billion. ECBs probably surged to around 24 per cent of the increase in the dollar value of non-food credit (a similar share was recorded relative to the increase in nominal GDP). And some were wondering why monetary tightening was not having the desired impact!

The bottom line is that not doing anything is not an option, and restricting domestic usage of ECBs is the least painful option. It will also make monetary transmission more effective, and won't hurt foreigner investors' confidence. The ball is in the government's court.

The author is executive director at JPMorgan Chase Bank, Singapore. The views expressed are personal