Welcome back, inflows

Written by Rajesh Chakrabarti | Updated: Jun 1 2008, 03:38am hrs
What a difference seven months can make to a countrys economy It has been a roller-coaster ride for Indias external finances. The rupee shot up over 8% in 2007-08 and many (including yours truly) feared that resisting the rupees climb even up to 35 may prove to be a challenge for regulators. Now the rupee is down by more than 6% in the last couple of months, there has been a slacking of foreign funds inflow and there is already talk of a liquidity crunch in the economy with SBI recently making record repo borrowings. The result: a reopening of the foreign funds inflow tap on Thursday. The government raised the caps of External Commercial Borrowing (ECB) up from the seven-month old clampdown of $20 million to $50 million for all and $100 million for infrastructure companies. Limits on all-in costs on ECBs have also been loosened significantly. Caps on FII investments in government securities and corporate bonds have been raised more than 50% and doubled respectively. So, foreign funds are now welcome. At least till we change our minds again.

Will it work Likely yes, at least in the short run, though, to what extent is anybodys guess. Worries over oil prices and a possible further weakening of the rupee can discourage borrowers from using the new limits to the maximum. The rush for ECBs in the past was, in large part, driven by the almost one-way bet on the rupee appreciation.

The problem lies elsewhere. Capital controls appear to have become yet another lever to be adjusted as the reading of the economic tea changes. If interest rates can be altered to bring about desired changes between the money market and the real economy, and if quantitative controls like CRR and SLR can aid in that task, whats wrong with adjusting the sluice gates of foreign funds as the tide turns In fact, if it is impossible to serve multiple objectives with a single instrument, rather than cut down on the former, why not expand the latter

The trouble is that quantity-based controls rather than price-based oneslike interest rates and exchange rateshave negative efficiency implications, particularly with regard to allocation. Someone ends up subsidizing someone else. In effect, ECBs are a special window for large firms to access cheaper foreign funds. As the quality borrowers head out and the loan portfolio of Indian banks suffer, it is quite likely that the small and medium borrowers actually face a stiffening of borrowing terms rather than an improvement from the increased liquidity.

Perhaps more importantly, fiddling dynamically with the levels of such restrictions poses questions about policy credibility and, in the long run, can cause expectation problems and speculation, blunting their effectiveness. It will soon be open betting season on which government regulation is to go next with the punters including the foreign investors themselves. Also, a miscalculation of global trends and faulty timings of such moves can make significantly worse for the economy.

The move to give FIIs greater access to the debt markets, particularly the corporate debt market, is perhaps less problematic. To the extent it can help breathe any life into this market, it would have served a public good quite apart from its impact on the exchange rate. Whether this will stimulate FII flows from their recent anemic levels (and reverse the sizeable outflow in May), is, of course to be seen.

Finally, inviting foreign funds with inflation, by some estimates, already touching double digits, may seem counter-intuitive. Conventional wisdom tells us that more money into the system is going to make matters worse. Most probably the logic here is in terms of lags and sectors. In other words, the real sector seems to be responding to monetary cues with a delay and we are probably suffering the real hangover of the 2007 financial highs, which is likely to decline on its own since we already know the financial sector developments since then. In that case, allowing further money into the system may not aggravate matters. Lets hope the projection is right.

A curious aspect of much of the discussion about the current inflation in India is that it is focused on specific sectors rather than on the general economy. If foreign funds help appreciate the currency and that reduces the oil bill, it may save the government from having to raise fuel prices in an election year and avoid further inflationary pressures.

In many ways, Thursdays move was one whose time had come. Used to assiduous wooing by foreign investors, Indian markets have been feeling rather neglected in terms of investor attention in recent months. So the seduction is on again. The question is, will the suitors return

The author teaches finance at the Indian School of Business, Hyderabad