Jaimini Bhagwati: Why have stop-go ECB policies?

Going back and forth on ECB policies may be costly as this may signal that India is ambivalent about capital account convertibility.

In recent months, sharply differing views have been expressed about how the Reserve Bank of India (RBI) should manage the rupee (INR) exchange rate and retain monetary policy autonomy in the face of large FX inflows. Some insist that export competitiveness is an issue and the INR cannot be allowed to appreciate further. Others maintain that continuing with sterilised FX intervention is no longer an option because of mounting costs (i.e. the rates of return on India's FX reserves are lower than rates at which interest is paid on government securities). On August 7, the RBI announced that proceeds from external commercial borrowings (ECBs) higher than $20 million can be used only for foreign currency expenditure. Further, prior RBI approval would be required even for ECBs up to $20 million before these can be used for rupee expenditure. ECB policies have been tightened on several occasions in the past to restrict foreign capital inflows when repeated mopping up of INR to reduce inflationary expectations was considered unsustainable.

The downturn in the credit cycle related to the sub-prime and collateralised debt obligations (CDOs) has not played itself out fully. In the next six months, foreign institutional investors (FIIs) may withdraw significant amounts from Indian markets depending on their requirements of funds to cover losses in other markets. If this is accompanied by growing current account deficits, FX inflows may become attractive again within a year. This article suggests that FX outflows should be actively promoted instead of restricting ECBs to tide over periods when there are "excessive" FX inflows.

ECBs are foreign currency borrowings contracted by private and public sector firms, with minimum average maturities of three years, from external commercial sources. In May this year, the RBI lowered ECB interest rate caps for borrowings with average maturities of 3-5 years to six-month LIBOR plus 150 basis points, and for maturities over five years the spread was capped at 250 basis points. ECB rules provide for end-use restrictions, e.g. such borrowings cannot be used for investments in capital markets or real estate. In practice, these policies are fairly restrictive and a substantial fraction of ECBs are contracted by a handful of well-established firms. In 2006-07, the top 10 ECB borrowers accounted for about 30 per cent of all ECBs.

According to the RBI's August 2007 Bulletin, net ECB inflows increased from $8,223 million in 2005-06 (excluding the India Millennium Deposit redemption) to $16,084 million in 2006-07. Why are Indian firms that do not have a natural hedge through foreign currency revenues prepared to take FX risk by borrowing in international reserve currencies? Some borrowers may view the ECB window as an opportunity for carry-trade since nominal INR interest rates are invariably higher than US$ interest rates and the INR has appreciated in the last few years. It is also likely that prior to August 7, ECB borrowers were using the flexibility of when to convert ECB proceeds into INR to take trading positions on the INR exchange rate. This free FX option on the INR exchange rate was very valuable. If and when ECB policies are relaxed in the future, conversion into INR should be made co-terminus with ECB disbursements. However, if conversion timing flexibility is to be offered again, the RBI should recover the full FX option premium from ECB borrowers.

Most ECB borrowers would be aware that there are no arbitrage gains to be made by borrowing in a foreign currency with a lower nominal interest rate. Such borrowers probably find the sophisticated credit analysis and service standards provided by external creditors very valuable. In overall terms, ECBs provide competition to domestic sources of debt financing and are part of the movement towards the globalisation of the Indian financial sector with associated efficiency gains.

The RBI chose to restrict ECBs rather than FII or FDI inflows. And, the conventional wisdom is that equity inflows are preferable to debt. However, ECBs have minimum maturities of three years and are not necessarily short-lived compared to FII inflows. On average, Indian firms are under-leveraged compared to other jurisdictions, resulting in inefficient use of capital. Although the better credits among large Indian companies are able to tap ECBs relatively easily, the interest rate caps make it difficult for smaller firms to access ECBs. Under the new dispensation for ECBs, proceeds are not readily usable for INR expenditure. This restriction amounts to a step back in the movement towards capital account convertibility. A step forward, which would also enable smaller firms to access ECBs, would be to eliminate interest rate caps on ECBs.

In the last two years, net inflows from official and multilateral sources were $1,682 million in 2005-06 and $1,770 million in 2006-07. These borrowings were much lower than ECB inflows but it is unfair to private firms that public sector companies can borrow from external sources even on a non-concessional basis (IBRD and ADB loans) while the private sector's access to foreign debt capital is restricted. At the margin, larger companies will now crowd out smaller firms' access to debt from domestic sources.

Most of the recent attention appears to be focused exclusively on curtailing FX inflows. An alternative approach is to increase FX expenditures including through higher imports without adversely impacting on duties collected or on domestic employment. Specific proposals could be identified if officials from the Departments of Revenue and Economic Affairs in the MoF, RBI and Ministry of Commerce are charged with co-ordinating their efforts with the private sector since the latter would need to be convinced about commercial feasibility.

On balance, if FX inflows had to be curtailed, cutting down on use of ECBs for INR expenditure is preferable to restricting FII or FDI inflows. However, in a hierarchy of options, concerted efforts to increase FX expenditure should come before tightening ECB policies. This is particularly so since net FX inflows, which are large enough to create inflationary pressures and cause INR appreciation, come in phases. There are real costs to going back and forth on ECB policies as this may signal that India is still ambivalent about capital account convertibility. Except if FX reserves were to drop precipitously, the direction should be steadily towards relaxing capital account controls even as the pace has to be necessarily slow.

j.bhagwati@gmail.com