Capital controls on external commercial borrowing

At 6:49 PM today, there was a MoF press release with capital controls against external commercial borrowing (ECB). Here's a spreadsheet with facts about ECB. Will these capital controls substantially change the situation on the currency market? Are these initiatives a good idea? I think not, for a few reasons:

1. How big is the benefit for a central bank seeking to manipulate the currency market? ECB is not that big when compared with the overall size of the problem of market manipulation of the currency market. As the spreadsheet mentioned above shows, of the incremental gross inflows into the country in 2006-07, only 5% were on account of incremental ECB inflows. The daily trading volume on the currency market is $38 billion a day. Manipulating such a market is hard - and the change in ECB caused by today's announcement is small. Recall that RBI purchased $12 billion in February alone - while the net ECB in the full year of 2006-07 was $16 billion.
2. The reduction in ECB through this may be pretty small. ECB above $20 million has to be used outside the country for `specified purposes' such as the purchase of equipment. This needn't change the situation on the currency market: pretty much the same outcome on the currency market could come about, while only changing the identity of the firms doing ECB. Consider a firm that was ordinarily going to import equipment anyway. Ordinarily, this firm might have purchased USD on the INR-USD market in order to buy imported capital goods. Instead, this firm will do ECB. It will now be the beneficiary of low cost borrowing and possibly a one-way bet on the rupee. Its orders will now fail to come into the INR-USD market. To the extent that such substitution takes place, the impact of the rule change will be smaller than meets the eye.
3. Capital controls on debt are easy to evade using repos and using put-call parity. It's not hard to disguise offshore borrowing once equity flows are open. See my `pre-31st' text in this blog posting, and this blog posting on the general theme of dodging restrictions against debt. There is a widespread belief in India that equity flows are "good" and that debt flows are "bad" and that the levers of policy should be used to block the latter. But once equity flows are open, no "Maxwell's demon" can favour equity flows and block debt flows, since market participants will just do put-call parity and spot-futures "arbitrage" (i.e. repo) positions so as to achieve debt-style payoffs while using equity-style instruments.
4. Offshore arms of Indian firms will do the borrowing. Many Indian firms are becoming multinationals. When firm X in India owns firm Y outside the country, now, firm Y will do borrowing. The intra-firm trade between X and Y will do transfer pricing so as to move cash to Y. Y will then repay the debt. Once you have a large current account with globalised firms, capital controls lose effectiveness.
5. Loss of credibility and respect for the policy process. These four difficulties raise questions about the policy process that led up to this decision and lead to a loss of credibility. We're still in a stage of denial about an inconsistent monetary policy regime; we're not confronting the fundamental mistakes that lie beneath; we're still looking for palliatives (and we're trying palliatives that won't even work).
6. Capital controls on debt today; where can this go next? Reversing some reforms undermines the credibility of all reforms. When this won't work, where would you go next? A `tobin tax' on FII flows?
7. Poor development strategy. Suppose I am wrong; suppose these capital controls are effective. The deeper question remains: Why do such restrictions? This boils down to industrial policy where a garment exporter is `good' and must be supported with an undervalued exchange rate, while (say) a power plant that wanted to do ECB is `bad' and must finance this subsidy. It is hard for a government to have the information processing required to make such calls correctly. Is there much to gain from `export-led growth' when that growth is based on subsidies? Garment exporters will, of course, export more if they are given free electricity - is this a good way for India to achieve `export led growth'? (This Business Standard article talks about `fake exports').

Update (9 August): The editorial in Business Standard says:

However, it must be emphasised that this is only a “breathing space” measure, giving policy-makers some time to grapple with the longer-term implications of a persistently appreciating rupee. While it is true that an under-valued currency itself stimulates capital flows—foreign investors need not worry about currency depreciation diluting their returns—there is also little question that capital inflows into the country are significantly motivated by the more fundamental factor of sustained growth. These flows are likely to persist regardless of the currency regime. Whether they come in as debt or as equity investments is secondary. Given the widely held view among global investors that the Indian growth story is enduring, a balance of payments surplus induced by large capital inflows is a structural phenomenon. To the extent that it complicates domestic macro-economic management, it requires a structural response.

One of these is to simply let the currency float. In fact, this is an eventuality which will emerge along with full convertibility, for which there is a roadmap with four years remaining. Perhaps that process can be hastened, but it is constrained by the state of preparedness of the financial sector. The real question is how the regime should transit from a managed exchange rate to a largely market-determined one. Too rapid a transition can be disruptive, as has already been seen in the performance of exports, many of which are relatively employment-intensive. On the other hand, too slow a movement intensifies the problem of large capital inflows, while exacerbating the risks of a drastic response to domestic or external shocks.

It is this transition which needs to be rigorously but quickly considered in the current scenario. Recent upheavals in global equity markets should heighten the sense of urgency. Of course, part of the adjustment required has already taken place with the recent appreciation of the rupee. It is now, clearly, much closer to its true market value, whatever that may be. By imposing the cap on ECBs, the government appears to be signalling that it now wants to hold course for a while and let the various players impacted by the appreciation adjust to it. Under the circumstances, stopping for a breather is all very well, but the opportunity it provides will go to waste if the requirements for a currency regime more appropriate to the state of the economy and its future course are not decided and acted upon.

The editorial in Mint says:

Sadly, the numbers won’t stack up. The current financial year till 20 July saw accretions to foreign currency reserves worth $22.9 billion—double that witnessed in the same period in 2006-07. While this pace may not be sustained for the rest of the year, especially with global financial markets beginning to see volatility, it is also not likely to see a sharp reversal. Either way, the curbs announced on Tuesday will not have the desired effect of a dramatic slowdown in foreign currency inflows.

Worse, the move sends the wrong signal to the markets.

For one, it is probably the first time that India has regressed on its measures for external sector reforms. After effecting a shift in the mindset by allowing Indian companies to borrow in dollars to spend in rupees domestically, it is now forcing a reversal. Second, North Block has conveyed a sense of panic. The fact that foreign currency inflows are posing a macro-economic problem has never been in doubt. By undertaking a measure, which on the face of it will achieve little, the authorities have conveyed to the market that RBI is short on options.

Market players now realize that there is not much that the government can do at this stage. Any further measures to sterilize inflows are not possible, unless the Union government is willing to absorb the fiscal costs. Unless something dramatic occurs, the pressure on the rupee to appreciate will resume. In other words, the authorities would have failed to restore a two-way movement of the rupee. This could be disastrous for the shortterm, as foreign currency speculators will be emboldened to take riskier bets—making it even tougher for RBI to manage inflows.

If there is any lesson here, it is that there is no simple solution. The way forward is for the government to allow greater flexibility to the market, calibrated to account for real-world situations. The market estimates that if RBI stopped all interventions, then the rupee would settle to Rs37 to a dollar, with undoubtedly catastrophic effects on exports. The first step is to develop a vibrant market for foreign currency derivatives that can provide a foreign currency hedge. The Percy Mistry report, submitted earlier this year, has set out the blueprint. But due to internal resistance, matters have begun to drag. It is for the leadership to manage the conflicts among policy wonks within government.

The editorial in Financial Express says:

There are no two ways about this. The Indian government’s clampdown on external commercial borrowings (ECBs) for domestic use, to prevent rupee appreciation, is simply bad economic policy. Even if, for the moment, we do not question the policy of tying the rupee down to boost exports, the question to ask is whether these new impositions can be effective. Maybe they will work for a few days. But the size of ECB inflows, both as a proportion of gross dollar inflows (4.5%) and incremental gross dollar inflows last year (5%), is so small, and the size of the currency market so big, that this measure cannot really work. The new restrictions could make a marginal difference to net inflows, but on the whole, they will do little to ease the pressure on the rupee. In any case, it isn’t the ECB surge that has pressured the currency up. Rather, it is India’s irresistibility as an investment destination. Therefore, the argument that net ECB flows doubled last year and so this is what needs to be brought under control is flawed. Take a closer look. BoP data shows that gross ECB inflows went up from $14.5 billion in 2005-06 to $21.9 billion in 2006-07, nearly touching the raised annual cap. But net flows, first-year repayments being negligible, rocketed from $2.7 billion to $16 billion. This may have alarmed policymakers, but it was not a runaway figure. Assuming gross flows of the maximum permissible $22 billion next year, net flows would be lower on account of larger repayments.

Meanwhile, most foreign capital flowing into India is via other channels. By an AV Rajwade estimate, nearly $70 billion may be flowing in as trade credit for imports, and this does not even show up in the BoP data. Similarly, there are instruments by which debt flows in through equity markets. A foreign investor could buy shares of a company and have a fixed-price buyback on a future date—thus making it as good as debt. So, instead of resorting to clumsy controls that cramp the operational freedom of enterprises and send out all the wrong signals, it would be better if the government let market processes play themselves out in the external sector. The more we muddle things up, the worse will be the turbulence when market forces eventually start disentangling them, as they will.

Update: Jamal Mecklai has written an article about the restrictions on ECB.