Themes > Current Issues
17.11.2007
Too Much of a Good Thing
Jayati
Ghosh
There
was a time, not so long ago, when both Indian policy makers and a significant
section of the Indian public viewed large capital inflows into the country
as inevitably positive, providing much-needed additions to domestic investment.
They also viewed consequent increases in the exchange rate almost as a
badge of honour, a sign of economic strength.
Of course such a position always had its detractors, especially among those who realised that what matters is the use to which capital inflows are put relative to their costs to the economy, which would determine their actual impact. Similarly, more sane analysts have generally noted that a rising rupee is generally positive only from a simplistic macho perspective, since it would adversely affect domestic producers of both export goods and import substitutes. It could thereby even reduce any positive impact of more external resources available for domestic investment.
The period of unqualified celebration of capital inflows appears to be over. Now it appears that even the central government, which has so far gone out of its way to attract capital inflows of all varieties, has realised that it may not all be manna from heaven for the domestic economy, that it can create tendencies which adversely affect domestic production and employment, and that it can even be fiscally expensive.
Of course, it has taken them some time to realise this. In the last few years India has become a favoured destination not only for those seeking to create or expand production facilities, but even more for those engaged in speculative investments at the international level. As a result, India is now experiencing an unprecedented surge in capital inflows.
In recent years, the trade deficit has grown as demand for imports has expanded rapidly. But the current account deficit on India's balance of payments has remained almost constant in 2005-06 and 2006-07 at just above $9 billion, largely because there have been very large inflows of remittances from Indian workers abroad, in oil-exporting countries and in the US. But in this period two years net capital flows into the country have nearly doubled from the already high level of $23 billion in 2005-06 to $45 billion in 2006-07.
And this tendency has intensified in recent months, such that the current year already marks all-time highs of capital inflows. Net inflows of foreign institutional investments into India's stock and debt markets start to rise significantly in 2003, and averaged just under $9 billion a year during 2003 to 2006. But in the first ten months of 2007, it has exploded to reach $18.6 billion. It is this which has driven the Sensex and other stock market indicators to crazy levels, creating illusions of wealth that briefly made some of our large capitalists among the richest men in the world as the value of their personal share holdings shot up.
But the inflow of largely speculative portfolio capital has been only one part of the recent surge. This has also been a period when Indian corporates have been exploiting the recently liberalised rules for external commercial borrowing policy and India's currently good international credit rating to borrow massively from abroad. This allows them to benefit from much lower interest rates abroad, but also adds to the country's external debt, which has suddenly shot up again, this time led by the private sector. In the period January to May 2007, external commercial borrowing was as much as $15.3 billion, compared with $10.8 billion and $3.4 billion during the corresponding periods in 2006 and 2005 respectively.
Note that these are net inflows, and that the gross inflows have been even higher. The Reserve Bank of India has liberalising rules governing capital account expenditures by domestic corporates and residents, and some companies have taken advantage of this by investing quite substantial amounts abroad, including in purchasing expensive assets.
Despite this, the massive surge in net capital inflows has put substantial pressure on the rupee, which has gone up in nominal value quite a lot vis-à-vis the struggling US dollar but has also appreciated in real terms. And this has clearly begun to hurt exporters of goods and services. Complaints are becoming louder from the textile and garments industries and from software exporters, all of whom find it harder to ensure export orders at rates that will allow them to recoup their costs. Domestic producers who are adversely affected by import competition are too diverse to form a strong lobby, but they too are certainly affected.
Trying to manage this within the liberalised framework is proving to be a difficult task that is creating all kinds of paradoxes and further problems. In such a situation, faced with an unwanted surge of capital that is not being used for productive investment but is associated with a rising exchange rate, the obvious thing to do would be to put some limits and constraints on the capital inflows.
The most obvious move of all would be, in the first instance, to reinstate the capital gains tax in the stock market, which would act as a dampener on unwanted capital flows and bring in much-needed revenues into the government's coffers. Other forms of flexible capital controls could easily be devised that would prevent undesired inflows without impacting upon domestic investment.
However, the current ruling ideology does not allow for such creative thinking, and instead insists upon not just maintaining the existing liberalised rules but relaxing them further to allow international and domestic investors unregulated free play. This means that the only instrument in the hands of the hapless central bank to prevent excessive rupee appreciation is direct market activity. Over the past few years, the Reserve Bank of India has been buying up foreign currency and expanding its reserve of foreign assets to adjust domestic demand for foreign currency to the autonomously driven inflow of foreign exchange.
As a result, foreign exchange reserves have gone up dramatically, from $76 billion in March 2003, to $152 billion in March 2006 and $199 billion in March 2007. The rise in reserves continues apace even now – in early November the value of the reserves was $266.5 billion.
But such holding of reserves is not costless for the government. Under the Market Stabilization Scheme launched in April 2004, the Reserve Bank of India is permitted to issue government securities to conduct sterilization operations, the timing, volume, tenure and terms of which are at its discretion. The ceiling on the maximum amount of such securities that can be outstanding at any given point in time is decided periodically through consultations between the RBI and the government.
As far as the central government is concerned, while these securities are a capital liability, its "deposits" with the central bank are an asset, implying that the issue of these securities does not make any net difference to its capital account and does not contribute to the fiscal deficit. However, the interest payable on these securities has to be met by the central government and appears in the budget as a part of the aggregate interest burden.
When the scheme was launched in 2004, the ceiling on the outstanding obligations under the scheme was set at Rs. 60,000 crore. Over time, this ceiling has been increased to cope with rising inflows. On August 8 it was increased to Rs. 150,000 crore for the fiscal year 2007-08. But it had to be raised again to Rs.2,50,000 crore on November 7, with the proviso that the ceiling will be reviewed in future when the sum outstanding (then placed at Rs 185,100 crore) touches Rs.2,35,000 crore. It is only too evident that the capital surge has resulted in a sharp increase in recourse to the scheme within a very short period of time.
And as this scheme is used more and more, it results in larger interest burden of the central government, for funds which it cannot actually use! One current estimate places the interest cost to the central government at Rs. 12,400 crore for this financial year, at the current level of the scheme. It would obviously be more if the scheme is expanded. And this is only the straight fiscal cost – it still leaves out the broader cost to the economy of allowing external commercial borrowing by companies at much higher interest rates than are received by the RBI for its reserves held as safe assets abroad.
So the country is paying heavily for the dubious privilege of receiving capital flows which it is not using, and which carry the potential of possible destabilisation in future at the hint of any financial crisis. Is any more evidence required of the irrationality of our current economic strategy?
Of course such a position always had its detractors, especially among those who realised that what matters is the use to which capital inflows are put relative to their costs to the economy, which would determine their actual impact. Similarly, more sane analysts have generally noted that a rising rupee is generally positive only from a simplistic macho perspective, since it would adversely affect domestic producers of both export goods and import substitutes. It could thereby even reduce any positive impact of more external resources available for domestic investment.
The period of unqualified celebration of capital inflows appears to be over. Now it appears that even the central government, which has so far gone out of its way to attract capital inflows of all varieties, has realised that it may not all be manna from heaven for the domestic economy, that it can create tendencies which adversely affect domestic production and employment, and that it can even be fiscally expensive.
Of course, it has taken them some time to realise this. In the last few years India has become a favoured destination not only for those seeking to create or expand production facilities, but even more for those engaged in speculative investments at the international level. As a result, India is now experiencing an unprecedented surge in capital inflows.
In recent years, the trade deficit has grown as demand for imports has expanded rapidly. But the current account deficit on India's balance of payments has remained almost constant in 2005-06 and 2006-07 at just above $9 billion, largely because there have been very large inflows of remittances from Indian workers abroad, in oil-exporting countries and in the US. But in this period two years net capital flows into the country have nearly doubled from the already high level of $23 billion in 2005-06 to $45 billion in 2006-07.
And this tendency has intensified in recent months, such that the current year already marks all-time highs of capital inflows. Net inflows of foreign institutional investments into India's stock and debt markets start to rise significantly in 2003, and averaged just under $9 billion a year during 2003 to 2006. But in the first ten months of 2007, it has exploded to reach $18.6 billion. It is this which has driven the Sensex and other stock market indicators to crazy levels, creating illusions of wealth that briefly made some of our large capitalists among the richest men in the world as the value of their personal share holdings shot up.
But the inflow of largely speculative portfolio capital has been only one part of the recent surge. This has also been a period when Indian corporates have been exploiting the recently liberalised rules for external commercial borrowing policy and India's currently good international credit rating to borrow massively from abroad. This allows them to benefit from much lower interest rates abroad, but also adds to the country's external debt, which has suddenly shot up again, this time led by the private sector. In the period January to May 2007, external commercial borrowing was as much as $15.3 billion, compared with $10.8 billion and $3.4 billion during the corresponding periods in 2006 and 2005 respectively.
Note that these are net inflows, and that the gross inflows have been even higher. The Reserve Bank of India has liberalising rules governing capital account expenditures by domestic corporates and residents, and some companies have taken advantage of this by investing quite substantial amounts abroad, including in purchasing expensive assets.
Despite this, the massive surge in net capital inflows has put substantial pressure on the rupee, which has gone up in nominal value quite a lot vis-à-vis the struggling US dollar but has also appreciated in real terms. And this has clearly begun to hurt exporters of goods and services. Complaints are becoming louder from the textile and garments industries and from software exporters, all of whom find it harder to ensure export orders at rates that will allow them to recoup their costs. Domestic producers who are adversely affected by import competition are too diverse to form a strong lobby, but they too are certainly affected.
Trying to manage this within the liberalised framework is proving to be a difficult task that is creating all kinds of paradoxes and further problems. In such a situation, faced with an unwanted surge of capital that is not being used for productive investment but is associated with a rising exchange rate, the obvious thing to do would be to put some limits and constraints on the capital inflows.
The most obvious move of all would be, in the first instance, to reinstate the capital gains tax in the stock market, which would act as a dampener on unwanted capital flows and bring in much-needed revenues into the government's coffers. Other forms of flexible capital controls could easily be devised that would prevent undesired inflows without impacting upon domestic investment.
However, the current ruling ideology does not allow for such creative thinking, and instead insists upon not just maintaining the existing liberalised rules but relaxing them further to allow international and domestic investors unregulated free play. This means that the only instrument in the hands of the hapless central bank to prevent excessive rupee appreciation is direct market activity. Over the past few years, the Reserve Bank of India has been buying up foreign currency and expanding its reserve of foreign assets to adjust domestic demand for foreign currency to the autonomously driven inflow of foreign exchange.
As a result, foreign exchange reserves have gone up dramatically, from $76 billion in March 2003, to $152 billion in March 2006 and $199 billion in March 2007. The rise in reserves continues apace even now – in early November the value of the reserves was $266.5 billion.
But such holding of reserves is not costless for the government. Under the Market Stabilization Scheme launched in April 2004, the Reserve Bank of India is permitted to issue government securities to conduct sterilization operations, the timing, volume, tenure and terms of which are at its discretion. The ceiling on the maximum amount of such securities that can be outstanding at any given point in time is decided periodically through consultations between the RBI and the government.
As far as the central government is concerned, while these securities are a capital liability, its "deposits" with the central bank are an asset, implying that the issue of these securities does not make any net difference to its capital account and does not contribute to the fiscal deficit. However, the interest payable on these securities has to be met by the central government and appears in the budget as a part of the aggregate interest burden.
When the scheme was launched in 2004, the ceiling on the outstanding obligations under the scheme was set at Rs. 60,000 crore. Over time, this ceiling has been increased to cope with rising inflows. On August 8 it was increased to Rs. 150,000 crore for the fiscal year 2007-08. But it had to be raised again to Rs.2,50,000 crore on November 7, with the proviso that the ceiling will be reviewed in future when the sum outstanding (then placed at Rs 185,100 crore) touches Rs.2,35,000 crore. It is only too evident that the capital surge has resulted in a sharp increase in recourse to the scheme within a very short period of time.
And as this scheme is used more and more, it results in larger interest burden of the central government, for funds which it cannot actually use! One current estimate places the interest cost to the central government at Rs. 12,400 crore for this financial year, at the current level of the scheme. It would obviously be more if the scheme is expanded. And this is only the straight fiscal cost – it still leaves out the broader cost to the economy of allowing external commercial borrowing by companies at much higher interest rates than are received by the RBI for its reserves held as safe assets abroad.
So the country is paying heavily for the dubious privilege of receiving capital flows which it is not using, and which carry the potential of possible destabilisation in future at the hint of any financial crisis. Is any more evidence required of the irrationality of our current economic strategy?
© MACROSCAN
2007