ECBs : What the Latest Restrictions Mean

The rupee, as a sequel to the government’s announcement of fresh restrictions on External Commercial Borrowings (ECBs), turned volatile in the intra-day trading and ultimately closed at Rs. 40.52 registering a loss of 12 paise, which amounts to around 1%—all in a day’s trading on 9^th August.

Market reactions aside, what is more important here are the restrictions per se and their impact on the macroeconomic fundamentals. As a result of the restrictions imposed, companies can now raise ECBs for rupee expenditure only up to $20 mn, that too, with the prior approval of the Reserve Bank of India. Corporates are also required to park such borrowings overseas till the rupee expenditure materializes. The current restrictions have two implications: one, the need for the nod of the RBI disables companies from timing their ECB borrowings to their advantage; and two, for anything beyond $20 mn, companies have to approach the local market. The ECBs above $20 mn can, of course, be availed of only for incurring permissible expenditure in foreign currency.

Palpably, the motive behind the current restrictions is to strengthen the hands of the Reserve Bank of India in imposing stricter discipline under its ongoing conservative monetary policy. Admittedly, ‘plenty’ of foreign capital is always a problem to manage. In the last six months alone, it is reported that Indian companies have borrowed $19.13 bn from global financial markets as against $13.58 in the whole of 2006. Similarly, inflow through FIIs has also gone up.

       

The inflow of foreign exchange in excess of a country’s absorbing capacity poses many problems. One such major problem is the appreciation of domestic currency. Such appreciation is more acute when the central bank withdraws from its market intervention, as is currently happening. Rupee has, thus, appreciated in the recent past by 9% creating ripples in the corporate corridors, for it made Indian exports less competitive in the global markets besides eroding their profit margins. An excess inflow of foreign exchange also results in the rise of reserve money, and broad money, which indeed rose by 60.7% and 64.3% respectively by March 2007. Such rise in monetary base automatically makes more bank credit available. That aside,  if much of such credit goes towards creation of assets—reports indicate that real estate loans have gone up by 155% in 2005 and 66% in 2006—it may, over a period of time, result in asset ‘price bubbles’. Cumulatively, all this creates inflationary pressure in the economy. And no political economy of a country can afford to let these developments go unchecked.

Against this backdrop, the present restrictions imposed on ECBs sound pretty laudable. There is, however, a flip side to it: the domestic interest rates are already relatively high and in such a scenario, when the blue chip companies move towards domestic banks for their financial needs, it tends to push the interest rates further northward. In the light of the recent hike in CRR, the interest rate scenario is all set to further worsen. This increased cost of capital will obviously get translated into higher sales price of the end products of industrial activities. To that extent, goods become less competitive not only in the export market, but also in the domestic market where imported goods are today posing a threat to the domestic manufacturers owing to the drastic reductions in tariff. It means fall in demand for the industrial goods and services, of course, with a time lag. That is why some economists fear that the present restrictions on ECBs may have an adverse impact on the GDP.

There could be another unintended consequence of these restrictions. Owing to the increased cost of rupee borrowings, blue chip companies may, instead of investing in their domestic expansion/diversion projects, resort to overseas acquisitions through borrowings from global financial markets so as to keep their growth prospects intact. Such overseas acquisitions may not, of course, affect the GDP per se, but is certain to impact domestic employment opportunities, which means loss of opportunity to improve the buying power of the domestic consumers.

There is yet another dimension to these restrictions: so long as the growth rate continues to remain around 9%—for which there are strong indications—the inflow of foreign exchange will continue at the current levels, if not rise. In this context, a school of economists argues that if at all the flow of foreign capital is to be contained, it should be more through restricting FII investments by way of imposing some kind of tax rather than limiting ECBs. There is a logic in this argument: availability of capital at lower interest rates, including fully hedged borrowing, vis-à-vis domestic interest rates makes Indian businesses more competent to withstand global competition. On the other hand, FII flows are always speculative in nature and are known to move around the emerging markets exclusively with a profit motive. They are known to run away from emerging markets at the slightest provocation, as is happening today.

In view of these ground realities, the restrictions presently imposed on ECBs can, at best, be of a short-term nature and what really needs to be done is increasing the absorption capacity of the foreign capital inflows by the country.

(September, 2007)