The Long And The Short Of It

However, some of the points in Tarapores article (Southeast Asian flu immunisation, Business Standard, January 30, 1998) need discussion. It has been argued that the 30 per cent surcharge encourages the tendency to step up recourse to trade credit abroad. Whatever the original intentions, the way it is being levied by most banks is by applying it for one month on the debit pertaining to the payment of an import bill, whether it was on a sight basis or usance.

In that case, it does nothing to either encourage or discourage the use of foreign currency credit for financing imports. All that it does is to raise the cost of imports by less than half a per cent if the rate of interest is say 15 per cent per annum, the surcharge is less than 0.4 per cent (4.5 per cent per annum for one month), which is neither here nor there!

 

I do not believe that this was the intention. Perhaps the banks found that a simple one month formula was an operationally feasible way of levying the surcharge. So operated, the surcharge has become merely an extra 0.4 per cent import duty, albeit going to banks, not the government.

Let me repeat in practice the surcharge is merely adding about 0.4 per cent to the cost of imports; it is neutral to the economics of trade credit; and it adds to banks earnings without benefiting the exporter or the remitter.

The same article also argues in favour of a tax on trade credit: if any importer is not paying for his imports in cash he would be subject to an import trade credit tax, and the shorter the maturity the sharper the incidence of the tax. But if shorter maturities are to attract higher tax, then surely cash imports should attract the highest tax, and not zero tax! If the objective is to discourage people from taking short term credit, tax incidence should be exactly in the reverse order longer the credit, higher the tax. In any case one does not find oneself in favour of the basic idea as it is, the longer the credit, the higher is the exchange risk (if unhedged), or the forward margin (if it is hedged). This itself is a deterrent.

It is of course true that leads and lags, and their reversal when conditions change, do make the demand:supply conditions in the exchange market, as well as in the rupee market, extremely volatile. To my mind, the real long term solution is the development of a liquid, efficient and interest differentials-governed forward market. This in turn requires the growth of a term interbank market, and some freedom to banks to deposit or borrow dollars abroad.

A lot of the current problems arise because the forward margin often differs widely from interest differentials. When the forward margin is too low, a lot of short term credit is utilised; when it is too high, short term credit is quickly reversed through prepayments and suspension of further recourse to credit.

In the development of a term interbank market, the central bank has already played its role by eliminating reserve requirements. When this was done, some of the foreign and private sector banks had in fact started quoting bid and offer prices. But the market failed to take off. To my mind, unless the large Indian public sector banks enter the fray, this market will remain dormant. It seems to be more a question of mindsets and mental lethargy? rather than any major regulatory impediments.

However, let me turn back to the REER and the present exchange rate. The last published number of the bilateral export based index is for September 1997, at 64.70 (RBI Bulletin, January 1998). What should one compare this with? My personal preference would be March 1993, the first time a unified market determined exchange rate came into being. The index then was 56.98 (it was very close to this number in January 1996 as well). So the September 1997 number evidences an REER appreciation of 13.5 per cent over March 1993. No wonder exports have slowed down!

If March 1993 is not to be considered as a reasonable base, let us look at the average level of the index over 1996 it was 59.45. Compared to this, the September 1997 number shows an REER appreciation of 8.8 per cent, which is by no means negligible.

The average Indian rupee/US$ exchange rate in September 1997 was Rs 36.50. Since then to the point of writing, the US$ has appreciated against all major currencies, except the pound. Besides, inflation differential would have enhanced the REER by about 1 per cent. The impact of dollar appreciation abroad and the inflation differential, taken together, is unlikely to be less than 2 per cent. This means that we now need an Indian rupee/US$ exchange rate between Rs 42 (to restore it to March 1993 level) and 40.50 (to restore it to 1996 level). A MERM model would probably evidence the need of an even larger correction.

Take your pick!