Get real about the impossible trinity

Financial Express, 24 May 2007

Late last week, in order to check capital inflows into India, the Ministry of Finance modified the rules for external commercial borrowing. It lowered the ECB interest rate ceiling over Libor and banned the use of ECBs for integrated townships in the real estate sector. This has been done to keep the ECB policy "in tune with the evolving macroeconomic situation, changing market conditions, sectoral requirements, the external sector and the lessons of experience." In other words, it has been done because of the challanges India faces in trying to achieve three conflicting objectives, the impossible trinity. We cannot keep the capital account open, AND have an independent monetary policy AND manage the exchange rate. Gross ECB flows this year are expected to exceed the USD 22 billion ceiling by about a couple of billion dollars. Net inflows are, of course, much smaller as repayment of earlier ECBs is continually taking place. As domestic interest rates rose throughout the year, Indian companies borrowed abroad. No, the government has not reduced the total amount that can be borrowed, but by making it less attractive for foreigners to lend to Indian companies, it is hoping the total amount of borrowing and thus total inflows will come down. This would ease the pressure on the rupee.

The attempt to reduce ECB inflows have not come as a surprise. Indeed, it was a surprise that this move did not come with the credit policy. The credit policy appeared to focus on allowing greater outflows as the instrument for easing pressure on the rupee. For example, the RBI raised the limit on the amount individuals can remit abroad every year from USD 50,000 to USD 100,000 per year. It seemed as if the policy was to continue to liberalise the capital account. Soon, however, it was clear that capital outflows were not going to be the mechanism through which pressure on the rupee would be eased. In a circular to banks the RBI barred remittance of foreign exchange for the purpose of paying margins to overseas exchanges. The money remitted for margins allowed overseas investors to take positions on derivatives markets outside the country. The RBI will allow individuals to buy stocks on foreign stock exchanges but not trade in derivatives. Such micro-management of how citizens of India utilise USD 100,000 a year is likely to help ensure that not much capital leaves the country. As it is, since 2004 only USD 53 million have left the country under this scheme.

The change in the ECB policy suggests that the policy consistency that people had perhaps hoped to see in the form of continued liberalisation of the capital account is not here yet. The sharp volatility of the rupee in April had appeared to indicate that either rupee appreciation is going to be used as an instrument to control inflation, or that the government is going to allow rupee appreciation to give priority to the interests of the millions of firms and households who are suffering from a sharp rise in interest rates that resulted from RBI's attempts to sterlise its intervention. However, the move to reduce ECBs shows that the attempt to manipulate the rupee continues, and to turn the clock back in terms of capital controls. Today it is being done through ECB policy, but tomorrow it could be back to more forex intervention and higher interest rates. A sustainable solution, which could have come only by abandoning one of the three objectives, has not been reached.

What lies ahead? There are two options. One is to genuninely move towards greater capital account convertiblity and to prepare the economy for it. This would mean giving up the objective of rupee manipulation while developing financial markets so that firms could become more resilient and be prepared for the policy change. The other is to linger on with the dying days of the old regime - to try to bring back more capital controls and continue to manipulate the currency market. The first would require an understanding of where we are going, how to get there and how to make the transition smooth. It would entail developing currency futures markets in India rather than preventing Indians from hedging their currency exposures in the Dubai market for rupee dollar futures.

The Percy Mistry report on Mumbai as an International Financial Centre has recommended changes to the financial system that would be required if India's path towards capital account convertiblity is to be a smooth one. The present difficulties and challanges presented by the impossible trinity make it clear that it is becoming enormously difficult for India to continue to keep fine tuning the three objectives in an attempt to find the right balance. The sharp increase in the turnover on the foreign exchange market, with gross flows of foreign exchange moving in and out of India rising to more than 90 percent of GDP, no longer makes it easy to do this fine tuning. It is time that India turn to other countries for "lessons of experience".

The most disappointing part of the present situation is the lack of vision on part of the government and RBI. RBI's public pronouncements give confused signals and do not offer a consistent policy framework. RBI continues to claim there are no difficulties with the erstwhile monetary policy framework nor have there ever been any difficulties. This lack of effort on crafting a path for coping with a complex future will not help us face these challanges any better.

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