The Hindu Business Line : The year of borrowing dangerously

The increase in capital inflows is frequently cited as yet another indicator of the current economic success of the country. Yet it reflects a very rapid increase in External Commercial Borrowings by corporates, that are being used not so much for domestic investment as to acquire assets abroad. In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh examine the external accounts and consider how it may increase future financial fragility.

During the first two months of 2007 external commercial borrowing has already touched $4.5 billion. - Bijoy Ghosh

Several indicators currently point to the boom in the Indian economy. Both aggregate GDP growth rates and investment rates have been increasing; the foreign exchange reserves keep on increasing, to almost embarrassing levels; and despite this, the exchange rate has been appreciating, largely because of capital inflows.

Over the year ending May 4, 2007, foreign exchange reserves rose by close to $42 billion, to touch $204 billion. Two-thirds of this 26 per cent increase in reserves occurred over the first four months of this year. This galloping rise in reserve levels reflects the effort being made the Reserve Bank of India to mop up the large inflow of foreign exchange into the country. Indeed, by filling the gap between the demand for foreign exchange and its availability within the country through its own market intervention, the central bank has in the past ensured a degree of stability of the rupee.

Rising rupee

However, more recently the rupee has been gaining in strength, despite the RBI's efforts. Chart-1 shows this very clearly with respect to the two major currencies, the dollar and the euro. Over the period ending May 11 this calendar year, the rupee appreciated by 8.2 per cent vis-à-vis the dollar, 6.8 per cent against the pound, 5.7 per cent vis-à-vis the euro and 9.2 per cent against the yen.

Such appreciation over a short period of time is bound to affect the competitiveness of India's exports. The Cotton Textiles Export Promotion Council (Texprocil) has already called on the Government to stop and reverse the rise of the rupee, as have many other industry associations. Recently, even the Commerce Minister joined the chorus.

There is a view that this appreciation is because of a growing unwillingness on the part of the RBI to mop up more foreign exchange through market intervention, because of concerns about inflation. But this is simply not true, as evident from the increase in official reserves. The RBI has indeed been intervening vigorously in foreign exchange markets and purchasing foreign currencies, resulting in a sharp increase in the reserves of foreign exchange assets it holds.

The problem seems to be that the inflow of foreign exchange into India has been so massive that it has not been matched by even this enhanced intervention by the central bank, resulting in an excess supply of foreign currencies and a consequent appreciation of the rupee.

The forex surge

What accounts for this surge in foreign currency inflow? Is it attributable to India's export success, especially in the areas of software and services? It is indeed true that India's net earnings from the exports of software and other IT-enabled services rose by a massive $10 billion from $23.7 billion to $33.7 billion between calendar years 2005 and 2006. Moreover, net inflows on account of private transfers, consisting largely of remittances, rose by an additional $3 billion from $23.2 billion to $26.3 billion between these years. A significant share of such inflows is on account of remittances from those providing software services onsite in foreign countries. Thus, services exports have been a factor explaining the rise in India's invisibles income from $39.4 billion to $55.0 billion between 2005 and 2006.

However, this close-to-$16 billion increase in the surplus from the invisibles trade was more than exhausted by a widening of the deficit on India's merchandise trade account from $47.2 billion to $64.1 billion or by almost $17 billion. As a result, the deficit on account of all current transactions of the country (the current account deficit) increased by $1.2 billion from $7.8 billion in 2005 to $9 billion in 2006.

So, while India's services trade success did help to shore up the current account of India's balance of payments, it cannot explain the increase in the availability of foreign exchange within the country.

This is confirmed by an examination of the detailed BoP statistics for the period April-December 2006 described in Table 1, which shows that the current account balance remained negative at nearly $12 billion, similar to the same period in the previous year.

Table 1 also shows that the net capital account was strongly positive, so a second possible explanation could be the growing attractiveness of India as a destination for foreign investors. Foreign Direct Investment into India, according to the RBI's BoP statistics, rose sharply between 2005 and 2006 from $6.7 billion to $16.9 billion or by more than $10 billion. Much of this is in the form of new equity inflows. Moreover, portfolio flows, which were earlier the dominant form of inflow into the country, actually declined from $12.2 billion to $10.6 billion. Thus, India seems to be witnessing a new phenomenon of greater inflows of FDI as opposed to portfolio capital, with inflows of foreign investment rising by more than $8 billion in the aggregate.

However, this does not necessarily mean that foreign investors have shifted from seeing India as a destination for short-term inflows seeking capital gains to an arena for long-term engagement in productive activity. The distinction between direct and portfolio flows is arbitrary, with inflows involving a single investor acquiring an equity stake of 10 per cent or more being characterised as fixed investment.

As the ceiling on acquisition of shares by foreign investors is relaxed and share acquisition occurs through the private placement route, a number of purely financial investors tend to acquire an equity stake of 10 per cent or more with capital gains in mind. Thus, FDI figures need not reflect investments by investors with a long-term interest.

Further, even though FDI flows have increased substantially, they are also not the prime explanation for the surge in foreign currency inflows, because the rise in foreign investment flows has been accompanied by a sharp rise in investments by Indian firms abroad. One of the ways in which the RBI has been seeking to cope with the increased inflows of foreign capital is by relaxing restrictions on acquisition of foreign exchange by resident individuals and corporations for acquisitions of assets abroad.

This facility has been substantially enhanced in the RBI's recent Credit and Monetary Policy Statement. As Business Line noted in its editorial of April 26, 2007: "Indian corporates can now invest a lot more overseas than what they were allowed to earlier. The retail investors too are being told that they can indulge little more their fancy for overseas stocks. More significantly, resident entities have now been enabled to take speculative views on future exchange rate movements even when there is no immediate/direct exposure to foreign exchange risk. The RBI is evidently counting on the participation of even those who had until now viewed it as something remote to their interests so that a vibrant two-way movement gets established in the market for foreign currency as people with divergent views back their judgement with money."

Even before this recent announcement, the liberalisation of rules and a growing appetite for bigger-ticket acquisitions abroad had raised the outflow of foreign investment from the country from $2.5 billion to $9.7 billion. This more than $7 billion outflow consumed a large part of the incremental foreign currency coming into the country on account of enhanced inward investment. As a result, net inflows of foreign investment into the country increased only marginally from $16.3 billion to just $16.7 billion between 2005 and 2006.

So neither the current account, nor net FDI nor foreign aid, which has actually declined, have contributed to the observed excess supply of foreign currency within the country in recent months.

ECB zooms

Instead, the main cause is a huge increase in commercial borrowing by private firms. With caps on External Commercial Borrowing relaxed and interest rates ruling higher in the domestic market, Indian firms seem to be taking the syndicated loan route to borrow money abroad at relatively lower interest rates to finance their operations, investments and acquisitions.

Net medium-term and long-term borrowing increased from $1 billion in 2005 to $13 billion in 2006, or by a huge $12 billion. Table 2 indicates that even in the first nine months of the previous financial year, total External Commercial Borrowing (including NRI deposits which are also essentially just that) was more than $13.6 billion.

Furthermore, this tendency for increased foreign borrowing by private firms is increasing rapidly — figures from the RBI indicate that during the first two months of 2007 external commercial borrowing had already touched $4.5 billion.

Thus the real change in India's balance of payments is a growing presence of debt in the capital account, driven not by official borrowing but private commercial borrowing and non-resident Indian deposits.

This is a noteworthy phenomenon for several reasons. First, it is occurring in a context in which domestic corporates are apparently already flush with funds and seeking investment outlets internationally, as evidenced by the spree of recent acquisitions abroad by Indian conglomerates. Second, it creates a number of problems for macroeconomic management. Third, it implies a wasteful and macro-economically expensive build-up of external reserves.

Thus, to the extent that such external debt is used to finance expenditures within the economy it increases the domestic supply of free foreign exchange, thereby worsening the RBI's exchange rate and monetary management problems. To the extent that such borrowing is used to finance spending abroad, encouraged by the RBI, it increases India's future foreign exchange commitments with attendant risks.

Above all, in the short run these funds involve much higher interest payments than those obtained from assets in which India's reserves are invested, imply a loss of revenue for the central bank and a loss of net foreign exchange for the country. The external reserves necessarily have to be invested in "safe", low risk and, therefore, low return assets (such as US government treasury securities, which currently account for around 10 per cent of reserves). The net returns from investments of external reserves made by the RBI are currently only between 1.5 per cent and 2 per cent, whereas the interest rate on ECBs by Indian firms are around three times these rates.

This means that that are serious questions relating to the external macroeconomic management of the country, with the current policy being both wasteful and risky and creating the potential for future financial crisis. It is therefore imperative for the RBI to rethink its position on capital inflows and for the Finance Ministry to enforce a stricter ceiling on External Commercial Borrowing.

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