Auctioning of ECBs: Tax Investors in Domestic Projects?

The unabated inflow of ‘copious capital’ that is threatening to be still more copious, is haunting the policy-makers, the politicians and the businessmen alike. The Forex reserves are at a high of $270 bn and are all set to rise further. External Commercial Borrowings (ECBs) that have indeed gone up during the current year have been identified as one of the major contributors to the problem of surging capital inflows.

That aside, it is the recent travails of the global financial markets, triggered by the US subprime crisis and the resultant speculation about the impeding recession in the US economy, that set not only the capital of the wealthy westerners, but also the sovereign funds of oil-exporting countries of all shades on a free flow across the emerging markets, which led to huge portfolio investments in the Indian stock market by FIIs.  The consistent impressive performance of the India Inc. that is driven by sound economic fundamentals, such as a huge domestic market, less dependence on exports for its growth and reined-in inflation, have all cumulatively made India a safe destination for investment.

The net result of such copious inflow of capital is: appreciation of rupee by about 12% over the last 10 months. The economic fallout of the rise in the rupee is the reluctant intervention of the Reserve Bank in the currency markets by way of buying up dollars, followed by sterilization of the resultant increase in rupees—all at a substantial cost. Aside of it, there was a hue and cry from businessmen/exporters, particularly those hailing from BPO, KPO, textile industry, etc., over the fall in their profit margins.  Mid-cap companies—exporters from both real and services sector—are said to be the worst hit, for they have the least cushion to absorb the sudden volatility in profits. Above it, it is the politicians crying hoarse from the rooftops about job losses.

Against this backdrop, the government, in its attempt to arrest further appreciation of rupee, has come out with yet another idea: it proposed auctioning of ECBs among the corporates and the imposition of sterilization tax. It is, perhaps, hoped that such measures would increase the cost of borrowing from overseas markets and thereby dissuade corporates  from accessing ECBs. Now the question is: in a paradigm of ‘impossible trinity’, will such tweaking here and there help arrest the capital inflows and the appreciation of rupee?

An honest answer to this question would be a ‘no’—it may not deliver the intended results on two counts. One, currently, ECBs are mostly raised by a few corporates, which are again owned and controlled by a still lesser number of industrial houses. That being the reality, it is less likely to result in competitive bidding. No wonder if it even leads to a kind of collusion among the corporates to bid for a nominal price, reminding us of the ‘Permit-Raj’ days. Two, corporates may not be deterred from borrowing under the ECB route by the mere imposition of sterilization tax so long as the rupee continues to appreciate, for it is more likely to offset the tax burden. 

And, there is no apparent indication of capital inflows drying up; nor does conventional wisdom say that countries attempting to arrest the nominal appreciation via sterilization have only ended up with more capital inflows for sterilization—particularly, in the face of fiscal deficit—that prevents a fall in interest rates, which, unwittingly acts as an incentive for fresh inflows. So, the real answer to the current problem lies in prudent fiscal management rather than auctioning of ECBs.

That aside, what is more disturbing under the proposal is: Are we to tax corporates for borrowing from global financial markets, that too, at cheaper price for investing in the domestic projects? Incidentally, we are all aware that it is the poor state of the physical infrastructure, both in terms of quantity and quality, that is the biggest and most critical hindrance for business expansion and, in turn, to India’s progress. For instance, no city in India has continuous water supply all through the day, week and month. One estimate of the Planning Commission reveals that to sustain our present GDP growth rate of 9%, India needs to invest an additional $500 bn during the next plan period.    

Now the fundamental question is: how to fund these infrastructure projects. It is to everybody’s knowledge that domestic savings alone cannot fund these investments. It is in this context that everybody is debating about private participation, which means, tapping global financial markets for capital. And Lo! We are back to square one. Intriguingly, in a speech delivered at the Metropolitan Chambers of Commerce and Industry, Dhaka, on May 17, 2007, YV Reddy, Governor of the RBI, said that monetary policies help the growth process in South Asia in three ways: first, by providing price stability; second, by ensuring financial stability; and third, by enabling availability of financial resources for an efficient growth process.

The overall assessment thus infers that monetary and fiscal policies must work in tandem to increase the absorption capacity of the economy for capital, so that copious inflows can be used to create additional assets that generate new wealth, offsetting the pressure on appreciation by creating additional demand. Or, looking at the current mood of the stock market, the government may impose transaction tax, as once proposed by the governor of RBI, on FIIs, rather than taxing ECBs.

(December, 2007)