A V Rajwade: Capital account and the exchange rate

WORLD MONEY

In "Current account and the exchange rate" (January 13), I had argued about the uncompetitiveness of the exchange rate and the increasingly unsustainable deficit on the current account it seems to be contributing to. If the exchange rate for IMD repayment and the political sensitivity of the petro-product prices have, perhaps, influenced the exchange rate policy recently, increasing capital inflows, particularly in the form of portfolio investments in the equity market, have also contributed to the strength (swelling?) of the Indian rupee. One recent, major review of the issue of FII flows is contained in the Report of the Expert Group appointed by the ministry of finance (the Lahiri Committee). The Reserve Bank of India representative on the committee has dissented on most of the Committee's major recommendations. This is not the first time that Mumbai and Delhi have differences about capital flows and reserves: using reserves for infrastructure investment and the possible need, at some stage, to look at measures to control capital inflows, were others.

Capital inflows have been large "" in 2005, FIIs have poured in $10 billion, and Indian companies have raised $17 billion (including ADR/GDR, debt and FCCB issues; source, Barclays Capital) in the overseas markets. (One is not quite clear whether private equity flows are included in either number.) And real estate investors are waiting in the wings. Whatever the economics of foreign funds for individual companies for reducing the cost of capital, the economy as a whole can use them only to the extent of the deficit on current account, given the macro-economic identity between domestic savings and investments. This apart, foreign funding has been instrumental in giving a lot of qualitative gains to the systems in the secondary market, disclosure and corporate governance and so on. It is difficult to believe that we would have had a secondary market in equities as efficient as any in the world, but for the presence of FIIs.

This apart, one major issue in the Lahiri Committee report is whether such flows could be volatile "" that is, subject to quick reversal "" and, therefore, potentially damaging for financial market stability and integrity. Both economics and empirical evidence argue against a mass exit by the FIIs. Given the level of current investment, they surely know that a mass exodus would lead to huge losses as equity prices and the exchange rate would crash. The best empirical evidence comes from south-east Asia. During the 1997-98 balance of payment (BoP) crisis, the flight of capital was much more on the part of banks and residents, rather than foreign portfolio investors. Incidentally, one of the points in the RBI's note is that "a special group may be constituted to study measures to contain large volatility". One does not really see the need for this, given the existence of enough studies on the South-east Asian experience.

The second issue is the continuation, or otherwise, of participatory notes. The Committee recommends that "the current dispensation for PNs may continue". This envisages that PNs can be issued/transferred only to regulated entities, and that the existing PNs, not conforming to this, should be wound down within five years: this rule has been prevalent for almost two years now and does not seem to have caused any problems. The RBI would like PNs to be banned as "the nature of the beneficial ownership or the identity of the investor will not be known". Admittedly, there is some force in RBI's point "" but it carries a reduction ad absurdum Can RBI, or even the account-holding commercial banks, claim to know the beneficial ownership of all the funds deposited in every account? Should, therefore, account opening itself be banned? There are enough genuine and legitimate reasons for the use and popularity of participatory notes, and their complete banning would be like throwing the proverbial baby with the bath water.

The third point is about FII investment in the debt market. The Committee favours a quantitative restriction on annual flows while the RBI would like the stock to be controlled. One would, perhaps, recommend a via-media "" the Committee's proposal but with a lock-in period for bond market investments.

The RBI's suggestion about the constitution of a special group is also aimed at examining the impact of capital inflows on the exchange rate and "fiscal vulnerability": by the latter, one presumes the RBI is referring to the cost of intervention in the forex market. For one thing, this has come down substantially after the rise in dollar interest rates. To my mind, this cost is well worth the jobs and GDP growth which an uncompetitive exchange rate will endanger. As for managing the exchange rate itself, if necessary, we should go to Beijing to find out how China keeps a competitive exchange rate and low inflation, despite a huge current account surplus and far bigger capital inflows.

Email: avrco@vsnl.com