Summary: The Reserve Bank of India (RBI) and the government recently revealed India is working on plans to auction rights to corporates to borrow via external commercial borrowings (ECBs). The policy makers’ thinking is aimed at better management of capital inflows and is in line with our expectations for India as well as broadly for Asia [1]. Here we elaborate on the central bank’s and government’s thinking on capital inflows and controls and implications for future policy direction. In brief, we think the RBI’s long-standing view that restricting the volume of capital inflows to manageable levels, preventing extended periods of currency overvaluation and using macro-prudential norms to prevent buildup of asset price bubbles, is only strengthened by the current global crisis. At the same time, given the government’s burgeoning borrowing program, both the RBI and the government are cognizant of the need to attract productive foreign capital. Taken together, we expect the authorities to contemplate only targeted controls on inflows, rather than sweeping controls that would damage investor sentiment. Measures would likely be targeted at debt capital inflows and may be in the nature of controls on volume rather than outright taxes that alter net returns. Furthermore, we rule out controls on capital outflows, as the RBI’s key concern is not excessive currency depreciation, but rather, prolonged currency overvaluation as a result of large capital inflows.
The rationale behind contemplating controls when ECB flows are still low
There are many reasons why the RBI has begun contemplating controls on ECBs again. First, while ECB flows have not recovered yet, foreign exchange reserves have surged by USD 20bn since February and the rupee has appreciated by 10% against the dollar. As such, total capital flows have seen a turnaround and it is only a matter of time before overall inflows may become difficult to manage. Second, in the backdrop of the global meltdown post-Lehman, the RBI eased regulations on ECBs, specifically lifting restrictions on rupee capital expenditure from USD 50mn per entity per year to USD 500mn per year. With financial markets and economies recovering, the RBI has to consider the impact of the relatively liberal ECB regime. Third and importantly, given prospects for early rate hikes in India, and the probable future increase in demand for foreign borrowing as the recovery takes hold and capacity utilisation rates rise, it is only natural that the central bank contemplates ways to manage the likely future increase in ECB inflows.
Where the RBI stands on the controls debate and FX management styles
We think it is clear which side of the ‘capital controls’ debate the Indian central bank sits on. We believe the RBI has long been of the view that capital flows can be temporary and can flow into unproductive assets and investments if not properly regulated. Also, the RBI doesn’t believe capital flows would necessarily stay in line with the fundamentals of the real sector or as it noted recently, the ‘absorptive capacity’ of the economy. The policymaker probably views this long-standing stance as vindicated by the recent global crisis in addition to the many emerging market crises of the 1990’s. Therefore, the approach it takes is to regulate the quantum of inflows as well as the degree of appreciation of the currency.
Sweeping controls unlikely; targeted measures probable
At the same time, the central bank and the government are cognizant of the need to ensure adequate availability of capital for the private sector and is concerned that high government borrowing would crowd-out private investment. For this reason, we believe the policymakers are themselves wary of hasty or ill-designed controls that might send the wrong signal and drive foreign investors away. For example, India is unlikely to follow in the footsteps of Brazil that imposed a 2% tax on short-term flows and a 1.5% tax on ADRs. While the reaction to the Brazilian measure was muted and short-lived (Brazilian real is broadly unchanged from Oct 20 when tax was first imposed and also from Nov 19 when taxes were imposed on ADRs), if India did the same, the reaction could be very different – after all, the policy action doesn’t take place in a vacuum and is interpreted in the context of the existing policy and rhetoric. Such (low) taxes on flows also do not materially alter quantum of flows as they are small relative to overall expected returns.
To read the full report: CAPITAL CONTROL
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