India
The 250 Billion Dollar Question
November 13, 2007

By Chetan Ahya | Singapore

Capital inflow tide
Over the seven weeks ending November 2, 2007, India’s foreign exchange reserves have increased by US$34 billion (annualized inflow of US$250 billion). Indeed, the trailing 12-month sum of FX reserves has increased to US$100 billion. This compares with the average annual increase of US$38 billion over three years prior to these seven weeks. With the current account still in deficit, the increase in reserves is being driven largely by a spike in capital inflows and to a very small extent because of conversion of non-dollar reserves into dollars. During the last seven weeks in which FX reserves have shot up, we believe that capital inflows would have been US$35 billion. Out of this, not more than 10% has been on account of FDI inflows. Non-FDI inflows including portfolio equity and external debt inflows form a major part of these inflows.

While the inflows are pouring in at the annualized run rate of US$250 billion, in our view, currently the country can absorb only about US$40-50 billion of capital inflows annually without causing any concern on attended risks of overheating. The key question policy makers are grappling with is how to manage these large capital inflows. As the strong growth in domestic demand has resulted in overheating of the economy recently, the central bank does not want to leave such large capital inflows fueling the domestic liquidity. Not surprisingly, the central bank has accelerated the pace of the sterilization by way of issuance of market stabilization scheme (MSS) bonds and an increase in the cash reserve ratio (CRR). Over the last 12 months, the RBI has sterilized about 58% of the foreign inflows. The sterilized liquidity (excess liquidity) stock including reverse repo less repo balances, MSS bonds, government balances with the RBI and the increase in the cash reserve ratio has shot up to US$77 billion as of end-October 2007 from US$19 as of end-October 2006.

Negative carry limits the ability to pursue sterilization
Unlike many other AXJ economies, India has had to keep domestic interest rates high due to relatively higher inflation levels and the central bank’s more cautious approach towards asset price inflation. Hence, interest rates on MSS bonds have tended to be higher than the return on the underlying dollar assets parked in the developed world government securities and bank deposits. With the Fed cutting interest rates, the negative carry is only rising. The central bank has been increasing the cash reserve ratio to reduce the weighted average cost of sterilization. However, there is a limitation of shifting all the burden of sterilization onto the cash reserve ratio (CRR) due to its adverse impact on the banking system.

Difficult to cut policy rates
As discussed earlier, the large component of capital inflows has been external debt inflows. A higher cost of capital in the domestic market has enticed the corporate sector to increase reliance on external debt inflows. While a cut in policy rates can help to reduce these inflows, the RBI is choosing to defer this move. First, although both core and headline inflation are within the RBI’s comfort zone of 5%, the recent rise in the oil and CRB foodstuff index has raised concerns. As per our Oil and Gas analyst Vinay Jaising, domestic oil product prices are marked to US$54/bbl (WTI equivalent) compared with current international price of US$96/bbl, implying that headline inflation is significantly understated. Indeed, food price pressure has kept the consumer price index (all three work groups) in the 5-8% range. The RBI has also highlighted its concerns on the potential risk of sharp inflation in China getting transmitted to its trading partners.

Second, while there are clear indications of a decline in property purchase transactions, prices remain at unusually high levels. A big drop in lending rates could quickly revive euphoria in the property market. Third, the RBI is also concerned about elevated levels of asset prices, driven by less stable capital inflows. The RBI has highlighted that “these pools of capital, which are private, often opaque, highly leveraged and largely unregulated, have the potential for heightening risks to the domestic financial system and posing a threat to financial stability”. The RBI remains concerned about the risk of potential reversal in these inflows.

Hesitation to allow appreciation in exchange rate
Theoretically, the RBI could allow appreciation of the exchange rate to avoid injecting liquidity (by way of buying dollars and selling rupees). However, the exchange rate is already over-valued. The 36-country real effective exchange rate is about 8.6% higher than the ten-year mean as of July 2007 (the last data point available). More importantly, the 12-month trailing trade deficit has shot up to 6.7% of GDP as of September 2007, resulting in an adverse impact on job creation in the manufacturing sector. Total goods exports growth has decelerated to 4.3% in rupee terms as of September 2007. In our view, small and medium enterprises would have been growing at an even slower rate, as the large companies would have been able to maintain their growth better.

Even if one were to consider the services sector exports, the trailing four-quarter sum of the current account deficit (excluding remittances) is at 4.2% of GDP as of June 2007. The headline current account deficit, however, is at a manageable level of 1%, primarily on account of the rising remittances from non-residents. The four-quarter trailing sum of non-residents’ remittances has shot up to US$30 billion (3.2% of GDP) as of June 2007. For assessing the impact of the exchange rate on the domestic output balance, we believe that we should exclude remittances, which represents transfer of income generated in foreign countries. Allowing further appreciation of the exchange rate will be difficult for the policy makers considering its adverse impact on domestic growth and job creation.

Policy makers forced to target capital controls
So far, the RBI has managed large capital inflows by pursuing a multi-faceted approach. It allowed some appreciation of the rupee. The RBI has also partly been intervening in the exchange rate market to prevent appreciation. The liquidity injected (because of intervention in the FX market – buying dollars and selling rupees) is partially allowed to be absorbed in the economy and partially sterilized by issuing rupee bonds/increasing the cash reserve ratio. However, as it is becoming difficult to pursue these options, the policy makers have started restricting capital inflows. They started with softer measures to restrict capital inflows. For instance, the RBI and Ministry of Finance had announced a measure to stop Indian companies from raising external commercial borrowings (ECBs) for rupee expenditure in August 2007. However, this had no impact on the pace of capital inflows through ECBs. Hence, now they are initiating extreme measures. The recent move of restricting equity inflows through participatory notes was the first such measure to restrict capital inflows.

What’s the ideal solution?
Ideally, the government should have accelerated infrastructure sector investment either through increasing budget allocation and/or encouraging the private sector to accelerate investment in this area by improving the regulatory environment. Although, infrastructure investment is estimated to have picked up to US$38 billion (4.2% of GDP) in F2007 from US$18.8 billion (3.1% of GDP) in F2004, this is not large enough to absorb the rise in inflows. More importantly, it is not enough to sustain the 9.4% GDP growth achieved in F2007.   

We believe that infrastructure investment is the best application for this liquidity arising from capital inflows, because we believe that one of key constraints to potential growth (i.e., effective aggregate capacity) is relatively low levels of infrastructure investments.

While the ideal response should be to improve the absorption capability of the country, the key problem for policy makers has been the short timeframe in which inflows have shot up. The response tends to be slower in India compared with its other Asian neighbors due to its political environment and bureaucratic administrative framework, particularly for infrastructure.

ECBs are next?
Despite the restrictions on equity inflows through participatory notes, capital inflows have remained strong. In second week after initiating restrictions, capital inflows have remained high at US$4 billion. Indeed, during that week as per daily investment data from SEBI (Securities Exchange Board of India), there were FII equity (cash plus derivatives) inflows of US$0.5 billion. Although an official breakdown is not available, we believe that external commercial borrowings are the key source of these capital inflows. Indeed, during the quarter ended June 2007 (the last official data available), total external loans had increased to an annualized rate of US$33.4 billion. We believe that policy makers may now focus on restricting external loans raised.

Bottom line
We believe that policy makers may wait for 3-4 weeks to see the full impact of the recent measure restricting equity inflows through participatory notes. The recent round of equity market sell-offs in the global capital markets may also help to reduce the pressure of capital inflows. However, if capital inflows continue to maintain their current momentum, we believe that policy makers may initiate some more capital control measures. In this context, we believe that the next set of measures may be targeted towards external loans.

 

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