(Weekly Organ of the Communist Party of India (Marxist)
April 18, 2010
One More Surge
C P Chandrasekhar
doors to foreign financial investors have
known to generate currency instabilities and crises in most developing
OF DOLLAR-CARRY TRADE
Indian rupee stood at a robust Rs 44.4 to a
dollar at the beginning of the second week of April. At that level the
had appreciated by more than 13 per cent vis-à-vis the dollar over the
13 months. This suggests that the Reserve Bank of
surge in capital inflows is explained
largely by developments on the supply side, with
this kind of game is currently popular with
& SPECULATIVE SPIRAL
This process has since continued. According to figures from the Securities and Exchange Board of India, as of April 11, net investments by FIIs in debt and equity markets amounted to an additional 10.1 billion dollars during 2010. Seen in this light, the reluctance of the RBI to intervene adequately to absorb these inflows is understandable.
This trend, reflective of the dollar-carry trade, feeds on itself for two reasons. First, it is well known that despite post-liberalisation buoyancy the Indian stock market is still both narrow and shallow. Narrow because there are relatively few listed companies whose stocks are actively traded. And shallow because the proportion of “free-floating” shares in these companies not held by promoters and available for regular trading is limited. As a result, whenever there is even a minor surge in foreign institutional investment flowing into these markets, the demand they generate at the margin is enough to drive stock prices up quite quickly, widening the differential between the cost of borrowing and the return on investment and attracting further investments. This tends to generate a self-reinforcing and often speculative spiral of investment.
Secondly, the expected return to the investor is even higher than this differential because as and when she decides to sell financial assets to book profits and repatriate capital to clear debts incurred at home, the appreciation of the rupee yields more dollars than would have been the case at the exchange rate when the investment was first made. This provides an additional return that justifies even more the speculative spiral and leads to further appreciation of the rupee.
corollary of such rupee appreciation is of
course a weakening of
Whatever be the explanation for that reluctance, it is material only because as of now dealing with the source of the problem, which is the embarrassingly large and unneeded inflow of foreign capital for what are speculative investments, is not an option for the government and the central bank. Some other countries, like Brazil, have sought to deal with the recent surge with measures, however limited, that are directed at curbing speculative inflows. Since this would go against the grain of the ideology influencing economic reform, which includes the belief that maintaining a freer and more open capital account is the best option, the Reserve Bank of India that wants control over the monetary lever and is faced with a surge in capital inflows would have to tolerate rupee appreciation.
THE NEED IS TO CURB
But it is clear that the central bank cannot continue with this stance for long. India’s balance of payments statistics point to high and persisting trade and current account deficits in recent quarters, and those deficits would only widen if international oil prices continue to rise. In these circumstances, even if the protests of exporters are dismissed, a process that renders exports more expensive in dollar terms and imports cheaper in rupee terms cannot be ignored. That is “success” on the capital account of the balance of payments cannot, beyond a point, be at the expense of a weakening of the current account and the domestic economy.
Further, rising inflation is forcing the Reserve Bank of India to turn its attention to what has always been its primary brief: using the monetary level to moderate price increases. One way in which it is expected to do this is by raising interest rates and reducing the offtake of credit to cool an overheating system. But raising domestic interest rates would only encourage further those investors exploiting international interest rate differentials and engaging in the carry trade. Being relevant on the price management front may make the central bank an even greater failure with regard to exchange rate management.
The real option is, therefore, one of dealing with the source of the problem and using measures to control the inflow of financial capital, especially speculative capital. There are many policy options at hand to achieve this end. What is required is that a government that had perceived the surge in capital inflows and the accumulation of reserves as being indicators of economic success admits that even in its own framework this is proving to be too much of a good thing.