Last week, the Ministry of Finance issued new guidelines for External Commercial Borrowing (ECB). Even though the impact of the guidelines is expected to be small, this decision is important in that it constitutes an important reversal of the market-oriented reforms of the 1990s.
The guidelines have imposed a number of restrictions on external commercial borrowing by firms. ECBs above USD 50 million will be permitted only for "import of equipment" or "foreign exchange needs of infrastructure projects". MoF has put restrictions on the rate at which firms can borrow. It has also tried to micro-manage firms by requiring them to hedge their currency risks. Further, it has restricted the access of companies in one industry (finance) from ECBs, but left escape clauses for a few approved purposes.
It is a remarkable flashback to the 1970s, a display of government fulminating command and control. The new guidelines require MoF staff to allow or disallow each ECB depending on what the firm claims it will use the borrowed funds for. MoF will give the firm a license to access funds if it approves of what the firm will produce. This is not unlike the licensing regime of the 1970s.
This will obviously not end here. MoF will presumably put some inspectors of the dreaded Enforcement Directorate to confirm that firms have used the money in approved ways. Money is fungible: Who can tell what end-use a given borrowing is for? Investigations and penalties could easily endup being as arbitrary and politicised as those associated with FERA.
Why is MoF trying to restore command and controls? It is clearly an attempt to stem capital inflows into India. Foreign capital has become unwelcome. It is putting upward pressure on the rupee at a time when RBI does not like it. As foreign exchange reserves pile up, the RBI sterilises them to prevent money supply growth from increasing.
RBI is coming to the end of its ammunition. The limits to the amount the RBI can sterilise are fast approaching. After another USD 10 billion, when reserves go beyond USD 100 billion, it will become increasingly difficult for the RBI to prevent money supply from rising.
If dollars continue to flow in at current rates even after RBI's kitty swells beyond USD 100 billion, the RBI would have to let money supply rise. In the RBI's framework this is expected to be inflationary. To prevent this from happening, it would like the inflows to decline.
Well, actually, that is not very accurate. The RBI does not have to keep buying up the dollars that flow in. It could reduce its purchase of dollars and then it does not have to worry about the level of reserves going beyond levels it has the capacity to sterilise. But if it does so, then the rupee would appreciate.
It is important to see that in either event, the rupee will appreciate in real terms. In the first case, the nominal rate does not appreciate, but inflation reduces the competivitiveness of exports. In the second case, the nominal rate appreciates and if inflation is the same, it pulls up the real rate.
The key insight is: the current level of openness of India's capital account thus does not allow the RBI to manage the exchange rate and money supply targets at the same time.
Jaswant Singh thus faces a choice between accepting a rupee appreciation (whether through inflation or not), or to roll back the reforms, throw up capital controls, and undo Bimal Jalan's most important achievement. (He could also cut custom duties and reduce the pressure on the rupee as argued in a previous article, but perhaps he is waiting to do that in the budget). The recent ECB guidelines indicate that Mr Singh has chosen the path to capital controls.
The ECB guidelines are not alone. Other such reversals have come about recently. RBI has started micro-managing the interest rates that banks can pay on NRI deposit policies. Investments into bonds by FIIs have been curtailed.Will these outbursts of command and control get the job done? It is unlikely. Policing by the bureaucracy is good for harrassment but not for blocking inflows. Capping the interest rate to 150 bps above LIBOR will restrict ECBs to a few large companies. It essentially means Reliance and Grasim can get loans while smaller companies cannot. But there are enough big firms and so inflows will be unaffected.
Looking forward, if the government is setting out on a capital controls warpath, where will the next controls come? The next steps could come in a large number of small fronts - on FIIs, on banks, on NRIs, each leading to a little more control by the bureaucracy and each adding to the pain and costs of the economy.
The trouble for Jaswant Singh is that at RBI Bimal Jalan had done a slow but serious job of opening up the capital account. So a good deal of reversal of reforms is required to undo his work. Otherwise, closing any one avenue will merely encourage flows through other channels. Even if the capital account is fully closed down, India's vast trade account can be easily used, as in the past, for moving dollars using overinvoicing and underinvoicing. The inspector raj will then need to hit trade.
What is disturbing, therefore, is not the extent to which the new ECB guidelines will close the capital account. The real problem is the direction in which MoF is headed. The move away from administered prices has been slow and painful. The move away from micro-management and controls, from the economic philosophy of the 1970s, has been a long and hard battle. It has involved getting government out of the operation of the economy, reducing the power of the government officials, and it has freed up individuals and businesses in innumerable ways. This display of 1970s vintage policies are a reminder of how little has been achieved, in terms of a new mindset amongst policy makers today. As soon as they are faced with a problem, the instinctive reaction is to move towards administrative controls, even though that is incompatible with the framework of current economic policy.
Today India is quite clear that the economy should not become a closed economy. Let us not fool ourselves that bits of tinkering here and there are going to solve the issues faced of monetary and exchange rate management in an open economy. The impossible trinity is here to stay. We need to re-examine our exchange rate and monetary policies than to attempt to impose capital controls.
The author is at ICRIER. These are her personal views.
ila at icrier dot res dot in