Misaligned monetary policies are at the root of the current rot.
By V Kumaraswamy
Even after 28 years of reforms, India is still confused about what market reforms are. There is lack of confidence about their satisfactory working. So, we find a lot of good samaritan interventions, even from ‘not answerable to people’ regulators who tend to arbitrate between consumers and producers instead of working on making markets more functional. Similar confusion on trying to balance savers’ and investors’ interest, pensioners’ and borrowers’, levels of capital account convertibility have led to instability in various monetary metrics. This perhaps is one of the main villains of the current economic logjam. India has near-full capital account convertibility. Quibbles on the definition aside, despite restrictions on tenure, interest rates, security, etc, we are able to raise far more loans than we want in forex. The size of our forex reserve is such that no overseas lender believes that an Indian corporate would default because RBI would fail to provide requisite forex at the time of repayment; default if any would be due to the corporate’s own failure. After 4-5 rounds, many overseas banks have developed confidence about regular borrowers. While the country’s risk premium has gone down (due to better rating and perception), borrower risk premium is also going down. Although there have been some mammoth overseas transactions by Indian corporates, there is still some distance to cover.
As a result, the dollar interest rates commanded by Indian borrowers is at a much lower level than domestic ‘administered’ rates and in line with the rates in world markets. Between two open (capital) markets, the interest rates should converge, and where they will settle depends on the relative size and strength. But, to protect pensioners and the poor, we are stubbornly holding up domestic rates, creating problems for investment, capacity utilisation and jobs.
There are various ways to converge the $ rates and $ interest rates with differing consequences. One way is to let the domestic rates drift to $ interest rates. This will cause lesser accretion to our reserves. Both demand and supply will be more equally distant from the pure trade-account-dollar demand and supply, and, hence, will be unlikely to disturb the latter. This is what our misaligned policies do not permit. The surplus from capital account keeps the dollar cheaper, making imports more attractive and taxing exports. The second way is to make borrowers hedge their exposures fully. Or impose a tax on interest paid overseas. This will increase the dollar loan costs, converging the domestic rates with $ interest rates and reduce the surplus dollar supplies from the capital account. But, the purpose of capital account convertibility is to source cheaper capital for faster growth.
The third way may be to impose physical limits on capital dollar and restrict it to imbalance in trade dollar (plus remittances). RBI may be allowed to accrete only 2-3 months of CAD or trade deficit per annum till forex reserves fall back to six-month’s import cover from the 10.9 months now. This would mean partial roll-back of convertibility or discretionary action by RBI that is not market-based. The fourth, one-time devaluation, may not help by itself since the capital dollar market does not care for absolute levels as much as its movement during the year, which it translates into interest rates and adds to the interest rates exchanged by the parties. It would help if RBI and the government openly declare that they would depreciate the currency as much as the difference between the domestic rupee interest rates and capital dollar interest rates would warrant on a year-on-year basis. In such a case, the players would price it in and the resultant would be equivalent to the ` interest rates. However, this would nullify the beneficial effect of capital account convertibility altogether.
Inconsistent monetary policy, where inflation, exchange rate and domestic interest rates and markets are messed around with, leads to lack of competitiveness and unemployment. Our growth and markets are being gifted to overseas players. There is little else to blame for our misfortune now—fiscal deficit, CAD, reserves, debt/GDP, public investment ratio, are all favourable and should, at better times, be an ideal launch-pad for growth acceleration.
The ideal action for the monetary authorities would be a mix of various alternatives. The trade dollar (without the influence of capital dollar) truly represents the cost competitiveness of the economy. This is what would determine capacity utilisation and employment. As explained here before, capital dollar does not depend on dollar levels. Effort should be made to stabilise $/` rate in the combined market. Capital account should be liberalised on the outbound account as well, so that dollars sitting in reserves and invested in US treasuries earning 1% and 2%, can earn a lot more. Tax on dollar interests and limits on reserves accretion would make the exchange rate converge towards trade dollar levels. The government should also reduce the spread over inflation on domestic interest rates. But to lessen the impact on pensioners, it should target interest ‘subsidies’ by paying them 1-1.5 % extra upto a specified extent. This can be financed out of the tax the capital dollar coming in without imports.
Author of Making growth happen in India