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| Akash Prakash: The capital inflow conundrum | | RBI shouldn't try disincentives on capital inflows, which could backfire and disrupt markets |
| Akash Prakash / New Delhi Oct 23, 2009, 00:43 IST |
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A few days ago the investment community globally was surprised by the announcement that the Brazilian authorities were planning to re-introduce the IOF levy (a tax on foreign financial transactions). A measure clearly designed to reduce appreciation pressures on the Brazilian currency. This tax used to exist and was only abolished in 2008 (when the global financial system was on the verge of collapse, and all emerging market, or EM, countries were seeing huge capital outflows). The new avatar of this tax is likely to cover more types of transactions (including equities) and have a higher peak rate of 2 per cent as compared to 1.5 per cent. As investors had seen this animal before, beyond an initial hiccup and mild sell-off in regional currency and equity markets, they seemed to have shrugged off the re-introduction of this levy as only a minor irritant.
However, given a global environment of surging risk appetite, extremely low OECD (Organisation for Economic Cooperation and Development) interest rates, a collapsing dollar and widening growth differentials between EM and OECD countries, the risk is that more EM nations may be forced down this path.
Jonathan Anderson of UBS in a recent article highlights some of these issues. He points out that Brazil was forced to act due to intense pressure on the real to appreciate. Since the beginning of the year, the Brazilian real has strengthened more than any other currency in the emerging world (source: UBS).
He makes the additional point that this rapid appreciation occurred despite Brazil not being an outlier in terms of capital inflows as a percentage of GDP or pace of reserve accumulation. Other countries have actually had faster reserve accumulation, or higher implied capital inflows. In those other cases of strong inflows, however, the respective central banks were able to continue intervening, mopping up the inflows and preventing significant currency appreciation. These central banks were able to handle the inflows without having to contemplate capital restrictions or taxes like Brazil has just announced.
He also makes the point that Brazilian policy-makers, despite their concerns about currency appreciation, were unable to intervene more aggressively due to the level of local interest rates. With short-term interest rates at nearly 9 per cent and long-term bond yields at 10 per cent plus, Brazil has some of the highest rates in the EM world. This is the critical difference, and accounts for Brazil having to adopt some type of capital inflow disincentives to control appreciation pressures.
It is much easier for a country like China to run huge current account surpluses and accumulate massive reserves when their interest rates are not much different from those in the US and the EU. In this case, the implied cost of sterilisation is minimal, and thus Beijing can keep the renminbi at whatever level it wishes to.
It is much harder to maintain a stable currency and allow in unencumbered capital flows, when there is a 700-800-basis point interest rate differential. This positive carry will attract huge capital inflows and make the implied costs of sterilisation prohibitive as the central bank has to bear this rate differential.
Even though Anderson’s article is based on Brazil, many of the points he makes are applicable to India as well. Already long bond yields in India are near 7.5 per cent, and will only rise. As inflation begins to spike towards the beginning of 2010, the Reserve Bank of India (RBI) will have to commence tightening and raising short-term rates. RBI, therefore, finds itself in a similar dilemma to Brazil. How should it handle strong capital inflows with a large and growing negative interest rate gap against it?
To my mind, these problems will only get compounded as flows increase in their ferocity. I along with many others believe that this whole cycle will ultimately end with a huge bubble in the asset markets of large EM countries. Thus financial flows into India are only likely to accelerate. The current spate of huge equity capital issuance from Indian corporate houses being a case in point.
To handle large inflows, RBI has basically four choices:
It can let the rupee appreciate.
It can intervene strongly, without sterilisation, to protect the rupee but let local asset markets inflate due to strong liquidity in the system.
It can intervene to protect the rupee from appreciation, sterilise the liquidity impact domestically but bear the costs.
And finally, it can try and dampen inflows through capital controls, taxes and other restrictions.
While the simplest and cleanest solution to handling large inflows is to let the rupee appreciate, this is not as simple as it looks. Our export sector is already badly hit with the OECD slowdown, and the employment intensity of exporters like textiles and gems & jewellery, and SMEs cannot be ignored. We will also be loath to let the rupee appreciate when our competitors in the region are unwilling to follow suit. Even today, policy-makers across Asia are unwilling to let their currencies appreciate.
If we intervene but do not sterilise, we run the risk of stoking an asset bubble locally and fanning inflationary pressures. With the Consumer Price Index (CPI) already in double-digit territory, and all projections of the Wholesale Price Index (WPI) showing a strong upward trajectory, this approach does not seem tenable.
The third choice has the issue of the cost of sterilisation in an environment when the spread between local interest rates and those of the US and the EU are at extremes. Who will bear this cost of sterilisation?
Thus one can see the attraction from an RBI perspective of moving down the road of some type of capital controls, inflows tax etc. Policy-makers may logically feel this is the best approach to handle a possible deluge of capital inflows if the EM asset class is the epicentre of the next asset bubble. While logical, it would be a mistake in my humble opinion.
We still run a current account deficit and, as an economy, are very sensitive to external capital flows. India is probably the most leveraged EM country (of size) to foreign capital. If capital flows are strong, we are able to fund both the government and our corporate sector, as large borrowers move offshore and we are able to avoid a crowding out of the private sector. With healthy capital inflows, interest rates stay stable and economic growth robust, leading to revenue buoyancy.
In an environment of negative capital flows, the India story tends to fall apart. Interest rates spike, economic growth slows, the private sector gets crowded out and liquidity dries up. Post the Lehman collapse, outflows of a mere $25-30 billion shook our economy, almost causing our own financial system to choke.
Being a capital deficient economy, and very vulnerable to external capital flows, we must not attempt any measures which could disrupt these flows. There is a very fine balancing act in designing measures, which are punitive enough to slow capital inflows, but not stop them entirely.
We must also recognise that given the volatility in oil/commodity prices, and the still fragile external financing environment, we must have a greater margin of safety in terms of our forex reserves.
RBI was very innovative in introducing the MSS bonds to handle the surge in capital inflows in 2006-07. It would be better to once again go down this type of route instead of trying to introduce some type of capital controls or disincentives, which could severely backfire and disrupt markets.
Given our dependence on external capital, let us not play with fire.
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