Borrowing time

Critics say the new RBI regulations on external borrowing will bring in only speculative capital which causes the boom-bust cycle.

Stung by the criticism that the United Progressive Alliance (UPA) government is beset by policy paralysis, the Finance Ministry and the Reserve Bank of India (RBI) announced a slew of measures on June 25 relating to the external sector. These focussed on policy pertaining to foreign institutional investment in government securities and on rationalising long-term infrastructure bonds with a new scheme for external commercial borrowings (ECBs).

In the run-up to the announcements made on Union Finance Minister Pranab Mukherjees last working day before he demitted office to join the presidential fray, a lot of expectations were raised in the markets that the government was all set to roll out a raft of forward measures, thereby signalling its intent to refurbish its moribund credentials as the original reformer. The build-up was prompted by the need to restore the confidence of investors, both domestic and overseas, so that the deceleration of growth could be arrested and entrepreneurial drive unleashed.

The context of the new set of measures focussed mostly on infrastructure, and the new ECB norms could not have been better timed as far as the moroseness of industry and trade and the market moods went. Indias growth story appeared to be slowing down, with the gross domestic product (GDP) rate falling to 6.5 per cent in 2011-12, the final year of the Eleventh Five-Year Plan. Industrial output has been persistently sluggish for several months, with a mere 0.1 per cent growth in the inaugural month of 2012-13 and with the growth of exports at a negative 0.69 per cent in dollar terms during April-May 2012.

Against the appalling developments in the economy, the new RBI regulations allow companies in the manufacturing and infrastructure sectors with foreign exchange earnings to borrow in dollars to cover rupee loans up to a ceiling of $10 billion, against the current limit of $5 billion. This is predicated on the proviso that the borrowing so contracted is to be spent on capital expenditure so that real asset creation redounds to the economy. The government also pruned the lock-in period for foreign investment in some long-term infrastructure bonds to one year from three years. This means companies in the infrastructure and manufacturing sectors can raise funds via ECBs to repay rupee debt within the ceiling of $10 billion.

The RBI also slightly eased the cap on foreign investment in government bonds from $15 billion to $20 billion. In this, up to $10 billion can now come into government securities with a residual maturity of three years against the earlier five years. This is no doubt a measure that seeks to relax capital inflows over the short term. It has come at a time when foreign institutional investors find Indian gilts quite lucrative as they offer yields of 8-9 per cent, particularly when there is a global paucity of investment-grade paper.

The RBI has also further expanded the set of foreign investors eligible to invest in Indian government securities (G-Sec) to cover sovereign wealth funds (SWFs) and pension funds with some fillips to qualified foreign institutional investors (QFIIs) in infrastructure mutual funds.

In sum, the RBI measures are designed to boost the short-term foreign fund flow through the debt route, besides helping to stem the slide in the external value of the rupee, which has lost over 25 per cent in the past one year. The high current account deficit, which is the difference between all foreign inflows and outflows, has made imports expensive and pushed the value of the external rupee on a downhill path.

Small wonder that C. Rangarajan, Chairman of the Prime Ministers Economic Advisory Council (PMEAC), said that the focus of the RBI message was on one aspect, which was to ensure capital flows. The same view was echoed by Montek Singh Ahluwalia, Deputy Chairman of the Planning Commission, who commented that the measures were a step in the right direction, aimed at encouraging basically the larger flow of resources. Rangarajan was balanced in his assessment of the ground realities when he pointed out that the impact these measures will have on the rupee will be seen only when these capital flows actually materialise.

Prodding from Government

It is also interesting to note that the normally cautious central bank would not have let this sort of relaxation of capital inflows through the debt route had it been exercising its own judicious judgement and had it not been acting under prodding from a government desperate to display some semblance of action on the economic front.

Critics contend that the recent relaxation of rules pertaining to ECBs and greater spurs for non-resident Indians (NRIs) and foreigners to invest in government paper might have been actuated by expediency. They say that equity investment and foreign direct investment (FDI) are preferred any day as they bring in their wake managerial best practices and technology that leave an imprint on the productivity of the extant manufacturing industry. The manufacturing sector in the country has to raise productivity if it is to be competitive and take its place in the global arena in terms of price and delivery of goods. Thus, the accent should be on reforms to enhance FDI flows rather than foreign institutional investment flows to stabilise the rupee and improve the worsening balance of payments position.

That the RBI had not fully immersed itself in the measures it unveiled on June 25 was revealed a couple of days later when it released data on the countrys external debt at the end of March 2012 covering the fiscal year 2011-12. The RBI conceded that Indias dependence on debt flows rose considerably during 2011-12. This was essentially on account of a widening current account deficit now estimated at 4.2 per cent of GDP for the last fiscal and prolonged uncertainty in the global economic scenario and prospects for equity flows, as the central bank put it in a plain-speaking vein.

RBI debt data make for depressing reading. Indias external debt as at end March 2012 was placed at $345.8 billion (20 per cent of GDP), logging an increase of $39.9 billion, or 13 per cent, over the end-March 2011 level owing to significant increase in commercial borrowings, short-term trade credits and rupee-denominated non-resident Indian deposits.

Even as the latest policy relaxation is mostly centred on these areas, the share of commercial borrowings was the highest, at 30.2 per cent, as at end March 2012, followed by short-term debt (22.6 per cent), NRI deposits (16.9 per cent) and multilateral debt (14.6 per cent).

What is more worrying is that at a time when the rupee is sliding rapidly against the U.S. dollar, the dollar-denominated debt accounts for 55 per cent of the total external debt stock as at end March 2012, rendering interest and principal payout costlier to borrowers, mostly companies that resorted to short-term borrowings.

According to Prof. Arvind Subramanian, Senior Fellow at the Peterson Institute for International Economics, Washington, D.C., one can justifiably question the central banks move to open the capital account, particularly when there are the heady and inexorable ingredients of high fiscal deficits, high inflation and decelerating growth. The resultant capital that flows because of the latest measures is going to be of the speculative kind, attracted as it is by high yields rather than long-term opportunities. This capital is also prone to sudden stops and will lead to the boom-bust cycle that has been the villain of the piece in the global economy in these last few years and to which domestic policymakers seem obviously oblivious.

The UPA government, in its obsessive goal of growth, is impervious to the implicit threat its neoliberal policies pose to the long-term stability of India and its inherent resilience in the face of the global financial tsunami. A government voted in on the promise of delivering inclusive growth is finding itself increasingly removed from reality as its every action on the external economy risks exposing the domestic financial system to grave threats.

Balance sheet problems

Explaining how this sort of liberalised foreign capital flows through the debt route would be ruinous, economists said external commercial borrowings are foreign-currency denominated debt. As such, they will result in balance sheet problems when the capital exits and the currency plunges (dollar liabilities of companies and banks swell in rupee terms). Moreover, attracting debt flows into government securities would only encourage the authorities to be indulgent in their wasteful expenditure on fancy or pet projects. Such schemes will not pass on real benefits to any targeted groups that deserve welfare measures at a time when food inflation is the single biggest and cruellest form of taxation on people without means.