The Hindu Business Line : Rising rupee and curbs on FII inflows

Why do we need FII inflows, when the strongest case is for direct investment that raise real sector growth rates and not for funds that come and go at will and are not often easily traced to their real origins?

Bhanoji Rao

For a small or medium enterprise obtaining a net income of Rs 10 per unit of product, from exporting its output produced at a unit cost of Rs 39 and export price of a dollar, at the exchange rate (ER) of Rs 49 per dollar, the worst disaster is if the rate were to plummet to Rs 39. Its net income is zero per unit of output. If costs can’t be cut, there is not much to celebrate for the enterprise.

Here is a sample set of some of the landmark exchange rate levels: Rs 48.08 on November 18, 2002; 44.06 on November 29, 2004; 46.7 on July 17, 2006; and 39.2 on November 12, 2007. The appreciation has been particularly significant since late 2006. Several enterprises must have been hard hit by the rising rupee.

Policy Options

In an article published in the Economic and Political Weekly (November 22, 2003), Professor Deepak Lal of the University of California, Los Angeles, and Dr Suman Bery and Dr Devendra Kumar Pant, of the National Council of Applied Economic Research, New Delhi, provided an in-depth empirical study of the linkages between the real exchange rate, fiscal deficits and capital flows, on the one hand, and the rates of inflation and economic growth, on the other.

Of particular interest here is the set of policy options in the article, notably those concerning forex reserves and the exchange rate.

Lal, Bery and Pant point out that the foreign exchange reserves available then could finance over a year of imports, short-term debt repayment obligations are under control, and there is no precautionary motive for putting the capital inflows into reserves. They said they would like to see policies that would permit greater absorption of the inflows, which will have a positive effect on the growth rate of the economy, instead of adding them to reserves.

In fact, the former RBI Governor, in his address to the 14th National Assembly of Forex Association of India, did refer to the advice and wondered how the government could “invest” in the real economy, without necessarily increasing the size and stake of government in productive sectors at a time when the rule of the game is the opposite.

The other policy option suggested by Lal, Bery and Pant, one that is very much within the framework of the textbooks, is allowing the nominal exchange rate to appreciate, as has been happening of late. They were quite emphatic that the exporter lobby should not be allowed to come in the way of the exchange rate appreciation.

The renowned scholars agree that short-term external debt on private account needs to be monitored and controlled, but there is no need to limit portfolio equity investment and foreign direct investment, as long as the nominal exchange rate is flexible.

Despite what experts and books might say, no constituency can be ignored in a democracy like ours, where votes count. In July this year, the Central Government announced a Rs. 1,400-crore package to compensate exporters hit by the sharply rising rupee. The package includes increased rates of tax refunds through the duty drawback scheme and availability of pre and post-shipment bank credit on far easier terms.

Exchange rate stability

Markets have merits. So is the case with price stability. The same applies to the exchange rate. Whatever might be the great gains speculators love to obtain from flexible exchange rate regimes it is a fact that the real sectors deeply appreciate stable rates. It is one headache less for the investors when they know for sure that rate fluctuations are likely to be minimal. It is in this context, one must understand clearly the factors behind the recent appreciation of the rupee.

A direct and immediate cause of the appreciation is that foreign exchange reserves have been accumulating rapidly in recent times.

sAs pointed out in the 8th Report on Foreign Exchange Reserves published by the Reserve Bank of India in July this year, over the 16-year period March 1991 through March 2007, the nation has accumulated a little over $192 billion, mainly due to investment inflows — $57 billion direct investment and $52 billion FII investment.

The other important flows have been NRI deposits ($29 billion), external assistance ($14 billion) and external commercial borrowing ($38 billion). India’s foreign exchange reserves were $261 billion as on October 19, 2007, higher by $62 billion over end-March 2007. It is well known that much of this increase too was due to the relatively large inflows of FII funds.

The key question, then, is why and for what benefit do we need FII inflows, when the strongest case is for direct investment and not for funds that come and go at will and are not often easily traced to their real origins.

There is nothing wrong with accumulating reserves via export earnings and foreign direct investment inflows, which will raise real sector growth rates, employment, earnings and imports too. The rupee will appreciate, but at a pace that the common man can feel comfortable with.

Funds come into our stock market, domestic markets boom, for no valid reason some one becomes paper-wealthy, the rupee appreciates, but real sectors suffer. Why should this be our policy stance? Meaningful restrictions are needed on FII investments.

(The author, formerly with the National University of Singapore and the World Bank, is a Member of the Governing Board of the GITAM University, Visakhapatnam and Visiting Faculty, Sri Sathya Sai University, Prasanthi Nilayam. He can be reached at bhanoji@gmail.com. )

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