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Why India should welcome all capital inflows

By Jaimini Bhagwati
May 21, 2010 16:35 IST
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If India can fast utilise currency flows for long-term projects, the regulatory regime could be more liberal, says Jaimini Bhagwati.

In the aftermath of the financial crisis of 2008, several orthodoxies - such as efficient markets, inflation targeting and central bank independence - are being reviewed.

Even the International Monetary Fund (IMF) and the World Bank have revised their views and conceded that capital controls may be necessary at times.

However, for the ideologically blinkered in India, capital account controls in any form are synonymous with "licence and permit raj".

Given the size of India's outstanding stock of internal public debt and projected budget deficits, there are limitations to which the government/public sector can access funds domestically.

This would suggest that India should welcome all forms of capital inflows to plug its funding gaps. However, if foreign capital flows into India are more than its current account deficit, the excess gets added to its forex (FX) reserves, which are warehoused in low interest rate bearing government securities of triple A developed countries.

The governor of the Reserve Bank of India (RBI) mentioned at a conference in Zurich on May 11, 2010 that "problems arise when the (capital) flows are largely in excess of the economy's absorptive capacity".

This article examines available options and corresponding logic to increase or restrict capital inflows against the irony of India having to lend its FX reserves to governments of countries with much higher per capita income.

First, a few numbers. As of December 31, 2009, India's FX reserves stood at $283.5 billion. On the same date, total external debt amounted to $251.4 billion, of which long-term debt with remaining maturities of more than a year added up to $206.2 billion.

Out of this long-term debt component, external commercial borrowings (ECBs) stood at $70 billion and non-resident Indian (NRI) deposits totalled $47.5 billion.

Clearly, there can be no universal rules about optimum levels of FX reserves, which would be applicable to countries such as India with relatively non-convertible capital accounts.

At the same time, it cannot be in India's interest to maintain a capital account which remains perpetually non-convertible since there are significant efficiency losses in restricting capital inflows.

India's FX reserves are not that large in the light of its persistent current account deficits and its total external debt.

Further, the ongoing volatility in currency markets and rising swap spreads reflect growing concern about the creditworthiness of some Eurozone countries. In the event the unthinkable happens, that is a large developed economy defaults on its sovereign debt obligations, cross-border capital flows could freeze.

Therefore, if under these higher than usual sovereign risk circumstances our expectation is that India's FX reserves could prove to be inadequate, we should ease restrictions that impede capital inflows. Accordingly, RBI should mop up incoming FX flows and issue market stabilisation bonds to contain inflationary pressures.

If, on the contrary, the view is that India's FX reserves are adequate because the economic costs of incremental holdings are higher than the perceived risk mitigation benefits, capital inflows should be restricted. It follows that we need to evaluate which measures would be appropriate to reduce capital inflows.

It is generally agreed that foreign direct investment (FDI) is preferable to portfolio inflows and external debt. In the past, portfolio inflows have provided critically needed capital and have had the salutary effect of improving corporate governance.

The latter because foreign institutional investor (FII) flows went preferentially to companies which adhered to better accounting and transparency norms. However, it is not clear that portfolio inflows should be preferred to ECBs any longer. ECBs carry medium to long-term maturities and the redemption outflows are known ex-ante.

Further, ECBs fund incremental economic activity if end-use conditions are enforced. In contrast, portfolio flows can change direction sharply, and if there is a liquidity/solvency crisis elsewhere, FIIs will withdraw funds from India.

Additionally, a sharp rise in portfolio inflows ends up chasing the same limited floating stock of around hundred Indian companies.

One of the measures to limit FX inflows could be to discourage NRI deposits. NRI deposits are attracted by interest rates which are higher than corresponding maturity government securities in dollar/euro or rupee deposit rates for domestic investors.

Indian and foreign banks offering NRI deposit schemes are essentially engaged in carry trade for the shorter maturity deposits and are probably taking some open exchange rate risk on longer deposits.

There is, therefore, no reason to attract NRI deposits by offering subsidies in the form of higher interest rates, if we are confident that FX reserves are adequate and at a sustainable level.

A counter-argument is that the relationship with NRI depositors has to be nurtured since other FX flows can be fickle.

This reasoning is not convincing because NRIs or, for that matter, non-Indian origin foreigners (it is unclear why they are currently not allowed to make deposits at NRI rates) would avail themselves of deposit schemes if higher than prevailing interest rates are offered.

Taking a step back in time, in 2004-05 there were discussions about the use of India's FX reserves for infrastructure projects. More recently, it has been reported that during 2012-17, India will need to invest about $1 trillion in infrastructure projects. It has also been mentioned that another infrastructure fund amounting to $11 billion is about to be set up.

Investors can be expected to be wary about funding long-gestation projects in India. Consequently, every possible domestic or foreign source should be tapped to raise long-term funds.

However, since India's ability to absorb FX inflows is limited, accessing of hard currency financing for the infrastructure sector needs to be linked to the time-bound use of FX for specific projects.

To conclude, there is a lack of plain-speaking on the issue of whether India needs foreign capital or not. It is awkward for us to acknowledge that it is difficult for capital-deficient India to absorb foreign capital inflows fast enough to prevent an unwanted rise in FX reserves.

Namely, we tend to work around rent-seeking elements which deliberately complicate the acquisition of land and cause delays in obtaining regulatory, municipal, state and central government clearances.

The regulatory regime for FX flows could be more consistently liberal and not stop-go if India were able to rapidly utilise incoming hard currency flows to fund long-term projects.

The author is India's ambassador to the European Union, Belgium and Luxembourg. The views expressed are personal.

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