Don’t stop those flows: Financial Express: October 28 2010

The torrent of FII flows into the country has once again germinated the debate on imposing a tax on capital inflows. We have countries like Brazil and Thailand that have resorted to taxing them and RBI has been trying to make the right sounds, though admittedly the same has not been spoken of as yet. The pressure is palpable, given that the interest rates in the West will remain benign for most part of 2011, which will mean that capital inflows will come for some more time and hence cannot be looked at as being a temporary aberration. What really is the right way to go about it?

We need to separate the two issues here—capital inflows and their impact on the currency. The former has an impact on the latter but they need to be addressed independently. Let us ask the question as to whether we need capital inflows today. The answer is a big ‘yes’ because we are running a current account deficit that will move towards the 3.5% mark this year. This is so because our trade deficit is widening, which is a good sign, since imports of the non-oil variety are increasing. Also with the US or rather some parts of the US talking tough on outsourcing, software receipts will be impacted, leading to a larger current account deficit.

The best way of tackling these deficits is through higher capital inflows. FDI would come in the normal course as would NRI funds. The ECB market is still regulated by RBI, which means that the FIIs have to provide support in some form. This is the beginning part of the Tobin tax story. These funds have been pouring into the country creating problems on rupee appreciation. There are two reasons put forward for controlling these flows. The first is that this is perceived as hot money that could reverse any time, which is destabilising. The second is that they are creating problems on the currency side, which, in turn, has monetary policy implications. In the last two decades or so, there have been only two instances when there were net outflows from the country in FY99 and FY09. Therefore, to assume that these funds, which cumulate to around $114 bn, would dispel smells of paranoia, especially if we believe in the India growth story.

Are these numbers alarming? Getting in, say, around $20 bn in 6 months is not really a large amount, given our balance of payments situation. While our foreign currency reserves are high at $270 bn, we must realise that our import cover ratio (4 months is around $120 bn) is also rising, as is our external debt, which was $273 bn in June 2010. Therefore, we cannot really get smug about these inflows because we need them.

Now the more serious issue for us is the appreciation of the rupee. More capital inflows lead to appreciation of the currency and while the text book says that we should let the rupee strengthen, the world does not operate that way. China has been recalcitrant with the renminbi and our trade competitors are holding back their currency from strengthening, which means that we have to follow suit or else our exports would slide.

Now, if we accept that we need the dollars, which is not hot money, but do not want the appreciation, the best way out is for the RBI to mop them up. Currently, with deposits growing slower than credit, there is a liquidity crunch, which is being made good by these dollars. Assuming that this equation balances, then RBI should buy the dollars to ensure that the currency is stable.

The economic argument here is that money supply increases will be inflationary and a chaotic paradox for RBI, which is hiking rates to control demand-pull-monetary forces. But we have a countervailing move that can be invoked, in the form of issuance of MSS bonds. Our budget included Rs 50,000 crore of such bonds for the year and hence should be used to counter these flows. The cost will be the interest component that the government will have to bear, which at an average rate of 8% would work out to Rs 4,000 crore a year.

The takeaways are that if we believe in the 10% growth story, we should allow unhindered capital inflows. These funds would support liquidity in the system when it is scarce. RBI intervention subsequently is advisable to hold the currency through the MSS sterilisation process. The cost is not really high considering that we get the best of the capital flows as well as a stronger rupee in an imperfect inward-looking economic world.