ABHEEK BARUA

T

The ultimate victims of macroeconomic shocks are “micro” entities – banks, corporations and individuals. Both practitioners and policy-makers are equally interested in insulating them from the potential risks that the unbridled transfer of capital across borders can entail. Hence, practitioners – at least the majority of them in India – would rather that the government continue with its measured changes in the degree of capital mobility than go in for “full” capital convertibility in haste.

However, there is a consensus within the practitioner community that the government could take advantage of the continuous improvement in economic conditions to open up some more sluices for the flow of capital. Simultaneously, the kinks and anomalies within the current regime of convertibility (which work effectively as capital controls) need to be ironed out. Some of these may not technically fall in the traditional CAC domain. However, since they impede the free flow of capital, it is useful to review them. These initiatives are not exclusively in the central bank’s domain but need coordinated action by the central bank, the finance ministry and other agencies of government.

Reviewing CAC

One critical aspect of CAC in the Indian context needs to be clarified right at the outset. The general perception that CAC is essentially about allowing larger outflows of capital is incorrect. The move towards capital convertibility is as much about removing the barriers to inflows as much as it is about allowing greater outflows. This is important since it relates the need for CAC to imperatives of funding India’s growth. It also means that the central bank must rethink its entire paradigm of currency and interest rate management. For instance, if capital inflows indeed pick up, the central bank might want to reconsider its policy of sterilised intervention that it follows in the currency and money markets. The costs of sterilisation are well known and it is also established that sterilisation often works to attract higher capital flows, pushing the monetary system into a spiral.1

It might be useful, at this stage, to do a quick review of some of the improvements in the fundamentals on which the case for CAC is based. A number of the preconditions for convertibility that the Tarapore Committee (TC) of 1997 (Tarapore-I as it is commonly referred to) had specified, have either been met or are close to being met. Importantly, the “soundness” indicators for external balances are significantly better than the thresholds set by Tarapore-I. Foreign exchange reserves, for instance, cover about 13 months of imports – the committee had asked for a minimum of six months. The Tarapore Committee had specified a maximum ratio of external debt servicing to current receipts of 20 per cent – the ratio currently stands at 7 per cent. The improvement in domestic fundamentals is less dramatic, but nonetheless encouraging.

Most practitioners would argue that these highly aggregated “top-down” indicators do not fully reflect the improvement in more “microeconomic” spheres in India. Indian companies, for one, have seen significant improvement in productivity and governance standards. There has been considerable consolidation in industry and a number of Indian companies operate at global scales. The quantum jump in the activity and output of the knowledge-based industries, such as information technology has helped the process of integration of the Indian economy with the external world.

From a capital account perspective, these changes have translated into an increase in foreign investor interest in Indian industry. This has been in the form of direct investment and portfolio investment. The average inflow of portfolio and

Economic and Political Weekly May 13, 2006 foreign direct investment in the period 2004-05 to 2006-07 is likely to be $ 13.25 billion compared to an average of $ 5.7 billion in the five preceding years. This shift in investment trajectory appears to be sustainable going forward.

There is also a visible diversification of the source of these capital flows. The pattern of foreign institutional investor (FII) inflows into Indian equity markets is a good example. Foreign investments into the Indian equity markets have historically been dominated by the US and Europe. However, over the last three years, Japan, South Korea and west Asia have emerged as significant investors in Indian equity. Informal estimates put the flows from far eastern economies into the Indian equity markets at $3 billion in 2005 and the first quarter of 2006.

How can greater CAC match this appetite for Indian paper with the needs of local companies, financial institutions and individuals? It might be prudent to start with the case for liberalising flows into and out of the domestic banking system. Banks are permitted to raise only 25 per cent of their tier-I capital within their open position and maturity mismatch limits. They are not allowed to raise external commercial borrowings (ECBs) either or sell securitised paper in the international market. Their investment in overseas money markets is limited to $ 10 million and $ 25 million in debt paper.

This gives rise to a number of problems. First, the absence of freer short-term flows from and into the banking system works against aligning Indian interest rates with global rates. This effectively leads to large arbitrage opportunities that have to be tackled with another set of barriers and controls. It also abets the development of semi-official markets like the non-deliverable forwards (NDF) market which is seen to reflect more “realistic” implicit interest rates. While the Indian central bank has no control over the NDF market, critical asset markets like foreign currency market have started to take cues from the NDF rather than the local forward market. This is certainly an unhealthy trend.

The curb on ECBs starves banks of longterm funds and the effect spills over to the real sector. This could be a binding constraint when the economy is going through an investment upsurge. While larger companies can circumvent the domestic banking system and access foreign loans directly, small and medium scale enterprises (that are perfectly creditworthy) often do not have direct access to global markets and have to turn to local banks.

Again, while the domestic market for securitised debt (non-distressed loans), the appetite for this paper remains confined really to short tenor debt. However, there is a growing supply of longer tenor paper in categories such as mortgage and car loans. Access to international markets would go a long way in developing the market for securitised assets at the medium and long ends of the tenor spectrum. In short, there appears to be a strong case for allowing banks to borrow more both for short term and the long term.

There are certainly legitimate concerns about “weak banks” being exposed to additional risks that access to foreign markets engender. This strengthens the case for greater consolidation of Indian banks in the long term. An interim solution is to introduce a liberal cap on borrowings for the banking system as a whole and then ask banks to approach the RBI for individual limits on the basis of the strength of their balance sheet. This would automatically weed out the weaker banks. The central bank is also likely to have concerns about the end-use of the funds borrowed abroad. As far as these are concerned, the combination of prudential norms for bank exposures to different sectors and restrictions on end-use of external borrowings should guard against possible “misuse”.

Greater short-term debt on banks’ books might potentially breed more volatility in interest and exchange rates. Thus, the RBI might want to raise the limits on banks in a more phased, measured manner than the limit on, say, ECBs. However, greater volatility is perhaps desirable to a degree and will encourage prudent practices such as “hedging” in the exchange market by Indian companies. Differential limits for different banks based on their balance sheet strength would mean that those best equipped to handle volatility are exposed to it. One must recognise that equity flows are perhaps more volatile than short-term debt and the monetary and financial system has learnt to live with the absence of any curbs on these flows. If greater volatility (stemming from freer flows in the banking system) is the price to be paid for stronger alignment with the international interest rates, it is perhaps a “transaction” worth considering.

Indian companies operate in a fairly liberal environment for external borrowings. The aggregate cap on external borrowings is high enough and known to be reasonably flexible. At the end of December 2005, ECBs stood at $ 22.4 billion, roughly 19 per cent of total external debt. There are restrictions on the use of these funds and the tenor but this has not been cause for major quibble between Indian industry and the regulators. However, some of the norms for commercial borrowings warrant immediate correction.

First, there is a glaring asymmetry in the way domestic as well as overseas acquisitions are treated under the ECB guidelines. While ECBs are permitted for overseas direct acquisitions or joint ventures, they are not permitted for domestic acquisitions (except for participation in disinvestment). This is an implicit capital control and results in severe financing constraints for domestic acquisitions. This needs to be removed, if indeed the government is interested in fostering a more efficient industrial structure.

The withholding tax regime also works as a selective capital control and skews the incentive structure for borrowing. The average withholding tax on syndicated bank loans works out to 10 per cent, given that most international banks that lend to Indian borrowers are domiciled in countries with which India has tax treaties. However, the withholding tax on debt issues by Indian companies is significantly higher and jacks up the coupon rate. This leads to a bias against bond issuance and a preference for bank loans. The problem with this incentive structure is that most banks are unwilling to lend for more than five years while the funding needs of most Indian companies are typically longer term. The appetite for longer-term debt is really confined to the international debt market. As the infrastructure investments pick up and the appetite for longer-term debt intensifies, the impact of this bias could intensify. It is imperative that the withholding tax rate be reduced and a market for long-dated Indian bonds be allowed to develop globally.

The financial market practitioners argue for using enhanced CAC to foster institutional development in the domestic capital markets. The case of the equity markets is a useful precedent. Few can doubt the

Economic and Political Weekly May 13, 2006

fact that with the development of a robust derivatives market, comprehensive dematerialisation of equity holdings, etc, India is on a par with the most developed international markets. One cannot also deny the fact that the presence of FIIs has helped accelerate the pace of market development and structural reform in this market.

Rupee Debt Market

The clear laggard among the domestic capital markets is the rupee debt market, particularly the corporate debt market. The number of actively traded securities in this market is minuscule, volumes are low and institutional improvement virtually absent. One of the notable differences between the equity markets and the local currency debt market is the low ceiling on foreign investment in the latter ($ 2 billion in the government securities market and $ 1.5 billion in the corporate debt market).

The central bank’s discomfort with greater foreign holdings of domestic debt is understandable to a degree. Most crisis-hit economies share a common feature – the presence of large foreign liabilities on their balance sheets. However, given the current level of foreign exchange reserves, the discomfort should have eased a little. In fact, issuing local currency debt has one critical advantage – it does not lead to the dollarisation of liabilities unlike dollar debt contracted through ECBs or NRI dollar deposits.

In short, unlike dollar debt, the currency risk on rupee debt is borne by foreign investors. This itself can work as a safeguard against a sudden flight of capital.2 In fact, the literature on currency crises shows that it was not just the quantum of foreign holdings of debt that was the culprit

– it was the large fraction of “dollarised liabilities” that played an equally critical role. Following this logic, the extreme view would be that foreign currency loans such as ECBs should be discouraged and rupee debt holdings stepped up.

Given this analytical case for taking on more “non-dollarised” foreign liabilities, most financial market practitioners would counsel a very careful, nuanced approach to opening up the corporate debt market. Experience has shown that the existing limits have been used by pure arbitrageurs who have chosen to periodically park their funds at the short end of the yield curve to exploit transitory arbitrage gains. They have not contributed to the development of a more robust trading environment, nor are their investment decisions based on the need to take a larger exposure to India’s domestic fundamentals.

A sensible strategy to use FII investments to develop the fixed-income market would increase not only the limit on investments, but also the minimum tenor of bonds that they can invest in. Thus, foreign investors could be excluded from treasury bills and other short-term instruments like commercial paper. If much larger flows are allowed into medium- and long-term bonds, it would help improve the trading environment in the secondary market and also the liquidity in primary issues. This could be the first step towards creating a market in rupee bonds where foreign companies could also list their securities. This ties in with the plan for developing a regional financial hub in India.

Of course, foreign investors would be interested in these products only if they could hedge both currency and interest rate risks. The FIIs are now allowed to hedge their risk to a large extent through currency swaps, options and other derivative instruments. Their alternatives in hedging interest rate risk are considerably more limited and confined to the Overnight Indexed Swaps. Instruments such as interest rate futures will have to be introduced quickly if this market is to develop fast enough.

Finally, the new policy3 on special economic zones (SEZs) envisages the creation of international financial centres (IFCs) within the SEZs. Banks, through their offshore banking units (OBUs), are expected to play a critical role in developing these centres. These OBUs have been given considerable freedom on the liabilities side of their balance sheet and are free from statutory obligations (cash reserve ratio, statutory liquidity ratio and priority sector obligations). On the asset side, however, they are restricted to being bankers to the production units within the SEZs since 75 per cent of their loans have to go to these units. If the IFCs are to develop as global or regional hubs, the OBUs must be given greater freedom to do business in international markets. It is quite likely that the entities within the SEZs will be some of the key clients of the OBUs but the choice must be left to the banks.

Conclusion

This essay will conclude with the issue of allowing higher outflows of capital under a freer CAC. The focus of CAC until now has really been on increasing flows of capital into the domestic markets (through equity flows, commercial borrowings, etc) and then recently on giving Indian companies greater degrees of freedom for operating in international markets. The policy-makers have perhaps consciously de-emphasised the role of CAC in allowing portfolio diversification of domestic individuals and companies. However, the upswing in economic activity has translated into substantial wealth generation in the domestic economy. In the absence of greater freedom to broaden their asset portfolios, a large fraction of the newly created wealth has been channelled back into local markets, leading to “overheating” and creation of asset bubbles. Thus, even from the perspective of mitigating risk in the domestic economy, more freedom for outflows is desirable.

Some investment channels have, no doubt, been opened up, but have not seen an overwhelming response. For instance, the facility for individuals to hold foreign currency deposits of up to $ 25,000 has hardly been utilised. Individuals have also not come forward in large numbers to invest the $ 25,000 permitted in foreign shares or immovable property. One clear reason is that the mismatch between the needs of the profile of domestic individuals who would potentially invest in this. The central bank should also recognise the fact that it is essentially high net worth individuals who would potentially utilise these channels. Given their income and wealth profiles they are interested in bigger ticket transactions. Thus, if indeed, the objective is to encourage risk diversification, the limit on these outflows should be raised to at least $ 1,00,000.

As far as mutual funds investment in foreign debt is concerned, the 2006-07 budget has announced some critical changes. The most critical change comes in the form of the removal of the apparently innocuous condition of the reciprocal limits of 10 per cent on investments made by the domestic mutual funds in securities abroad. This would enhance the prospect of portfolio diversification considerably. The current limit on investments overseas is $ 2 billion. Some escalation of this limit going forward is desirable.

The majority of practitioners support the measured pace with which the capital account has been opened up in India and would, at best, counsel a moderate acceleration of this pace. However, they would argue for a rationalisation of the existing system of controls to remove the “inefficiencies” within the system. The move to CAC need

Economic and Political Weekly May 13, 2006 not be a grand policy gesture – but a steady and focused approach is.

mrn

Email: abheek.barua@in.abnamro.com

Notes