Large capital inflows in last few years have posed extraordinary challenges for the conduct of monetary policy for the Reserve Bank of India (RBI). Appreciating rupee, increasing sterilization cost, overheated asset markets, increased potential of crisis are some of the direct consequences of these flows. Capital inflows into India have skyrocketed in the last year. Portfolio flows have picked up strongly on account of Foreign Institutional Investors (FIIs), amounting to Rs.70940 crore during 2007 as compared to an inflow of Rs.31289 crore in 2006. During the period of April-July 2007 FDI inflows were placed at US $ 6.6 billion as compared with US $ 3.7 billion in 2006. Also, there has been a 63 per cent increase in external commercial borrowings made by Indian companies during the first seven months of fiscal year 2007-08. Though large proportion of inflows are non-debt creating they are dominated by Portfolio flows which tend to be volatile and short term.
Exchange Rate
One of the most visible impacts of the flows has been rupee appreciation. The Indian Rupee has appreciated 16% since July 2006 against the US dollar (from 46.85 to 39.33 per US dollar). The 36-currency NEER and REER of the Indian rupee, on an average basis, appreciated by 12% and 12.86%, respectively, between July 2006 and September 2007. This indicates that Rupee has appreciated not only against the dollar, which has depreciated against almost all major currencies, but also against currencies of many of India's trading partners.
Export Competitiveness
Exchange rate appreciation is affecting the export competitiveness of Indian Industry as Indian exports become expensive in foreign markets while imports get cheaper. Some initial indications of the slowdown are reduced growth rates of exports (18.2% in 2007 vs. 27.1% last period) and increased growth rates of imports (non-oil increasing 44% in 2007 vs. 10.9% last period). The Mid-Year Review presented by the Finance Ministry shows that sectors such as textiles, handicrafts and leather, that have low import intensity, have experienced low export growth. The current account which saw a surplus from 2001-04 is predicted to face a deficit of 2.1% in 2007 and 2.6% in 2008 as per the IMF World Economic Outlook, 2007.
Reserves
The biggest challenges in the management of capital flows are the attendant implications for liquidity and overall economic stability. In order to limit the rupee appreciation due to the inflows RBI has been mopping up dollars in the foreign exchange market through interventions. In 2007, the Indian Foreign Currency Reserve accumulation was more than US $100 billion, making India's reserves fourth largest in the world at $266 billion after Japan, China and Russia.
In order to control inflation caused by the increased liquidity RBI uses several monetary instruments. These include issuing bonds under the Market Stabilization Scheme (MSS), absorbing liquidity through net reverse repos under the Liquidity Adjustment Facility (LAF) and increasing Cash Reserve Ratio (CRR). The total amount of issuances under the MSS has gone up by 159 per cent over the March 2007 level. In addition, liquidity absorbed in the form of net reverse repos under the LAF in 2007 was five times the amount in the corresponding period of 2006. The Cash Reserve Ratio (CRR) was raised by 150 basis points during April 2007-October 2007 to 7.5% over and above the cumulative increase of 100 basis points during December 2006-March 2007.
All these instruments have both direct and indirect costs; either as direct fiscal costs due to interest payments on the bonds or as indirect costs due to inefficiencies they introduce in the banking system. The interest rate paid on the MSS bonds is far higher than one received on the foreign currency reserves, which are mostly invested in US treasury bonds. This interest rate differential is a rough estimate of the cost borne due to MSS. As per Mid-Year Review 2007-08 estimates, the fiscal cost of sterilization would be around Rs. 8200 crore for fiscal year 2007-08.
Equity Markets
FII investments in equity markets have lead to a whooping increase of more than 200% in the BSE sensex since January 2005. Last year also saw the highest-ever mobilization of Rs.45,137 crore through public equity issues, comprising both IPOs and FPOs, according to Prithvi Haldea,CMD of PRIME, the premier database on the primary capital market. This is 83 per cent higher than the previous year. Though markets have sky-rocketed, the volatility in markets has increased.
Source: Security and Exchange Board of India (SEBI)
As seen in the corresponding graph, FII investments fell abruptly in Feb 2007 along with the collapse of global markets caused by drops in the Chinese markets. The end of summer and late December FII flows turned negative due to renewed concerns about the US financial crisis. Although there was no fundamental change in or related to the Indian economy, each of the aforementioned occasions have resulted in a nose-dive drop in the Indian stock markets. A shock in an unrelated emerging market economy or shocks in developed countries, that makes investors reassess risk and flee to safety, can cause inflows in India to dry up. Given the prolonged rally in the Indian markets and financial crises in developed countries, such risks have increased exponentially. Such a halt in inflows can lead to higher exchange rate fluctuation (even a significant depreciation of the Indian currency), stock market collapse, current account imbalance and affect India's long term growth prospects.
In the 1990’s East Asian countries like Malaysia, Thailand, Indonesia experienced high growth rates and huge capital inflows. Despite a lack of significant or fundamental change in the economies of these countries in 1997 the inflows suddenly stopped and even reversed, resulting in severe recessions in these countries. Several Latin American countries have witnessed similar episodes of sudden discontinuation of inflows and recession. There is no evidence suggesting that India is immune to similar events. To avoid such economic depressions and tribulations, India needs to manage its flows carefully.
The Reserve Bank of India and the Government of India have tried unsuccessfully to reduce capital inflows. In its Annual Policy Statement for 2007-08 and Mid-term Review of Annual Policy, RBI announced a host of measures to liberalize overseas investments such as; enhancement of the overseas investment limit for Indian companies to 400 per cent of their net worth from the existing limit of 200 per cent; increase in aggregate ceiling on overseas investment by mutual funds to US $ 5 billion from US $ 3 billion; enhancement of the limit for individuals for any permitted current or capital account transaction from US $ 50,000 to US $ 200,000 per year. In August, 2007 RBI also put end use restrictions on External Commercial Borrowings (ECB's), which required borrowers raising more than USD 20 million to park the ECB proceeds overseas for use as foreign currency expenditure. However, none of the measures have helped. Outflows remain a small fraction of the inflows and ECB's continue to rise.
Given the increasing cost of inflows indicated by lower export competitiveness, rising fiscal costs due to sterilization and increased risk of crisis, the Finance Ministry and RBI should take more concrete measures to manage India's inflows. In the Mid-Year Review and various public statements, the Finance Minister has acknowledged the costs and risks to growth due to the inflows. However, the Ministry has been reluctant to impose any form of capital controls or limits on inflows. RBI Governor Y.V. Reddy has hinted that he would be ready to take a more flexible approach and even consider some controls.
While some Latin American countries that have faced similar patterns in capital inflows have experienced recessions in the past due to sudden stops, others have found better ways to deal with such inflows. For example, various economists, including Nobel Prize winner Joseph Stiglitz have praised the Chilean government for managing its flows by using reserve requirements. Chile's strategy of has been succesful at discouraging short term flows, with no affect on long term flows. Chile accomplished this by placing reserve requirements on all inflows for a short time period (a percent of inflows were deposited with the central bank, with no yield or returns to the investors). The reserve requirements’ then were changed depending upon the amount of flows.
India should learn about the cost of its capital inflows, from other countries that have witnessed similar patterns of growth and the unforeseen decline that tends to follow. At the least, India should learn from countries like Chile and figure out ways to manage its inflows in order to avoid similar economic catastrophes.
