Is a reversal of reforms on external commercial borrowings (ECBs) in the offing? Bringing back capital controls on ECBs has turned fashionable in Indian policy circles as a solution to the current problem of raging capital inflows. It is hoped that by rolling back the liberalisation of ECBs of the last two years, the RBI will find it easier to prevent rupee appreciation, which observers of the external sector believe is just a matter of the central bank restraining its interference in the currency market (yesterday’s dramatic 0.44% rupee fall against the otherwise-declining US dollar is to be taken as a blip in this analysis). But try as the RBI might, data suggests that this solution cannot work.
Here is why. Gross ECB inflows rose from $9 billion in 2004-05 to $14.5 billion in 2005-06, and then to $21.3 billion in 2006-07, thanks to an increase in ECB limits by the government. Of course, net inflows are much smaller than gross inflows; focusing on gross inflows gives us a conservative calculation. But the point is that ECB flows do not loom as large on the external sector horizon as many seem to think. Incremental ECB flows have actually declined in importance when compared with incremental gross flows into the country. In 2004-05, the incremental gross ECB inflows were only 6.7% of the incremental gross flows into the country, a small fraction to begin with. In the following two years, this ratio dropped to 6.4% and then 5%. In other words, of the $134.5 billion increase in dollars coming into India in 2006-07, only 5% of the increase was caused by ECBs. Over the two-year period, the change in gross ECB inflows was $12 billion. To put that in perspective, that sum is roughly equal to the foreign currency purchases of the RBI in February 2007 alone. Such is the scale of the central bank’s intervention in the currency market. So, even if gross inflows drop to 2004-05 levels, it will fail to address the bulk of the problem. This evidence shows that even if the clock is turned back to the control regime of 2004-05, the pressure on the rupee will not ease. It is fashionable to pin the blame of the RBI’s currency management dilemma on ECB liberalisation. However, the central bank is deluding itself if it thinks that tinkering with capital controls on dollar borrowings at this stage is going to give it significant control over the rupee again.