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Economy Sep 6, 2013

$30 bn inflows? Why Raghuram Rajan’s goals are in conflict with prudence

By R Jagannathan

It helps to have a suave and articulate Reserve Bank Governor. The markets are already rubbing their hands in glee, hoping for him to pull off a miracle.

But, it is important for all players to lower their expectations from Rajan, for the reality is that he has to manage many contradictions. For example, he has to lure more dollars to the country in the short-term, even if it distorts the market, but in the long-term he has to make more people interested in holding rupees and bring down external dollar debt.

In his first statement on Wednesday, Rajan announced two such dollar attracting schemes: first, he offered banks dollar-rupee swaps on fresh three-year (or above) non-resident dollar deposits at the concessional rate of 3.5 percent; and second, banks raising overseas loans will also gets swaps at rates that are 1 percent below the current market swap rate.

Together these two measures are expected to attract around $30 billion in inflows, according to The Economic Times.

But here's the problem: raising so much debt will worsen the country's overall external debt position in the medium term even while giving a false impression that it is swelling reserves in the short run. Is that a great idea?

As Rajeev Malik, Senior Economist at CLSA, points out: "The RBI is basically encouraging more overseas borrowing to increase US$ inflow and even offering a subsidy for selected swapping. However, the latter is also distortionary micromanagement."

The other contradiction is on rupee rates. He wants to improve business confidence, and the market expectation is that he will try and bring down interest rates. But Rajan also announced that he would work towards the gradual "internationalisation of the rupee." This, as we shall prove later, will call for a stronger rupee, and lower long-term inflation. Can this be achieved with lower rates?

Before Rajan tries to get foreigners to buy into the rupee, he needs to get Indians to love their rupee as much as they do dollars right now.

Before Rajan tries to get foreigners to buy into the rupee, he needs to get Indians to love their rupee as much as they do dollars right now. Reuters

Rajan, who could not have been unaware of the contradiction between meeting short-term expectations and long-term goals, said: "This might be a strange time to talk about rupee internationalisation, but we have to think beyond the next few months. As our trade expands, we will push for more settlement in rupees. This will also mean that we will have to open up our financial markets more for those who receive rupees to invest it back in. We intend to continue the path of steady liberalisation."

Internationalisation of the rupee means getting foreigners to accept payments in rupee for their exports to India, and/or getting them to buy/hold rupee-denominated assets, including rupee deposits, bonds, shares, etc. In a sense, this is already happening through portfolio and FDI flows. But the significance of Rajan's statement lies in the fact that right now the rupee is in the boondocks, unloved and unwanted. That's why its value has fallen below Rs 60 to the dollar. He needs to get more people to love the rupee.

Internationalisation of the rupee is, in a sense, a reverse form of capital account convertibility (CAC). Instead of allowing Indians to own dollars or euros freely, we entice non-residents (not just NRIs, but also non-Indians) to own rupees. However, the preconditions we need to put in place are almost no different from what we would need to do if we want Indians to freely buy and own dollars, or pounds or euros.

According to the second Tarapore Committee on Capital Account Convertibility, which submitted its report in 2006, "The 'internationalisation' of a currency is an expression of its external credibility as the economy integrates globally. In practical terms, it would mean the use of the currency for invoicing and settlement of cross-border transactions, freedom for non-residents to hold financial assets/liabilities in that currency and freedom for non-residents to hold tradable balances in that currency at offshore locations."

Getting non-residents and foreigners to own rupees is thus no different from allowing Indians to own dollars since it calls for "external credibility" - currently in short supply. The fact that the rupee is one of the world's most underowned assets outside India tells its own story on the distance Rajan will have to traverse to make the rupee truly international and credible.

Let's enumerate the hurdles in the path of internationalising the rupee and the preconditions that must be met before Rajan has any chance of success.

First, before you internationalise the rupee, you need to get Indians convinced about it. The Indian's preference for gold or real estate is an indication that she would rather own physical assets instead of rupees. If given the option, fewer Indian would own rupees, due to its domestically plumbing value. The real value of the rupee is now less than 1 paisa if valued in 1947 rupees. This is why the abolition of the 25 paise coin in 2011 went unsung, and the 50 paise coin may also soon disappear. That's more than a 99 percent erosion in value over 66 years of independence and fiscal debauchery.

Rajan has indicated that he wants to help Indian households believe in the rupee again by announcing the issue of consumer price index-linked savings certificates. This is a good move, but belief in the rupee will take years to build. Domestic disbelief in the rupee will not rise in the next few quarters even if the inflation-indexed certificates are a huge success.

While the humble Indian opts for gold and real estate, businesspersons are also said to hold illegal assets abroad. If Rajan can convince them to bring their hoards in, selling to rupee to foreigners would be easier.

Second, getting foreigners to accept rupees in payment for their goods and services is even tougher. Three conditions need to be satisfied before they accept rupee settlements: a) the value of the rupee must stabilise, both internally and externally, over the medium term; b) the holder of rupee must have large trade or other interests in India and Indian assets; and c) the holder must be assured that India will be an open economy and remain open.

The reason why people are willing to hold dollars is simple: the US is a quarter of the world economy, so everyone needs to trade with the US. Moreover, the US is one of the most open economies in the world. The dollar has also maintained its value for decades, but even the dollar is not going to remain the overwhelming international currency forever (currently, over 60 percent of global reserves are in dollars). If inflation surges in the US due to excess quantitative easing, its value will also drop.

Third, it would be easier to internationalise the rupee if we were doing roaring business with our neighbours. The world over, a country's biggest trade partners are its neighbours - the US with Canada and Mexico, China with Japan. In India's case, thanks to geopolitical tensions and mutual suspicion, our trade with Pakistan, Bangladesh, Sri Lanka and Nepal is very low. Trade with China is much larger, but here our trade deficit is so skewed in China's favour, that it is difficult to see China accepting too much payment in rupee. The only way that can happen is if we open up infrastructure investment avenues for the Chinese in the Indian economy, but due to our long-term suspicions about China's intentions, that is not easy to visualise right now.

Fourth, and most important, is macroeconomics. To get people to invest in the rupee, you have to run conservative fiscal and monetary policies for prolonged periods. No one will want to hold rupees if they believe that the country will run loose monetary and fiscal policies that will ultimately destroy the value of their holdings.

It is worth recalling that even the Chinese, the world's largest holders of dollar assets, are seriously concerned about holding $3.2 trillion in dollars, euro and yen - most of it in dollars - when all these countries are busy printing money to get their economies growing. Excess money printing - which is what our government has been doing for the last five years - leads to inflation and reduction in the value of the currency. China is desperately seeking to reduce its dollar reserves, but it has few alternatives.

It is worth recalling what the first Tarapore committee on capital account convertibility had to say in 1997 about the pre-conditions that must be met before abolishing capital controls: a gross fiscal deficit of 3.5 percent (by 1999-00), and an inflation rate of 3-5 percent for an average of at least three years, among other things.

These targets were never achieved, and today the fiscal deficit is close to 5 percent and consumer inflation is almost in double-digits. Average inflation of 3-5 percent has never been achieved by either UPA-1 or UPA-2.

If we don't run a tight ship, internationalisation of the rupee will be a pipedream.

Before Rajan tries to get foreigners to buy into the rupee, he needs to get Indians to love their rupee as much as they do dollars right now. This means he will have to court unpopularity with North Block the same way his predecessor did: by bringing down inflation and improving real returns on rupee savings.

by R Jagannathan

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