Eco adviser wants ECB interests taxed

Chief economic advisor to the finance ministry Arvind Virmani has argued...

Chief economic advisor to the finance ministry Arvind Virmani has argued for permitting Indians to hold unlimited foreign exchange in cash within the country instead of the current limit of $2,000. He has also suggested imposing higher reserve requirements on foreign borrowings by domestic banks, bringing interest rates on NRI deposits at par with domestic savings bank rate, imposing tax on interest paid on external commercial borrowings (ECBs) and auctioning such debts.

In a working paper, titled Macro-economic Management of the Indian Economy: Capital Flows, Interest Rates and Inflation, Virmani has said Indians should be allowed to purchase hedge products without any restrictions. They should also be permitted to trade these products on recognised futures and forward markets in commodities. He says the radical relaxations in outbound capital flows and making it costlier for foreign debt into India will reduce the problems of excessive capital inflows. These would be better than physical restrictions on ECBs and bans on other inflows. “For instance, with a global rate of 6 per cent and a domestic rate of 8 per cent, a 25 per cent (additional) reserve requirement can be a more efficient substitute than a ban on foreign borrowings by domestic banks.”

The paper, put up on the finance ministry’s web-site, says capital inflows have spurted to around 4 per cent of gross domestic product, far in excess of the current account financing requirements, which is a little over 1 per cent of GDP. This abundance of capital inflows, which comes in the form of debt and equity, complicates the macro management of the economy.

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The paper suggests the Government to discourage debt inflows such as ECBs, FII investment in government securities and commercial paper while not encouraging equity inflows like FDI and FII. It says, “A change in the emphasis of capital inflow policy from a positive to a neutral stance on equity inflows and a negative stance on debt inflows” is needed. Virmani has also suggested imposing tax on interest on foreign debt. This will discourage debt inflows by reducing the real difference between domestic and international interest rates. He has further argued for removing the limits on foreign institutional investment in government securities and in private bonds, which could help eliminate the interest gap between Indian and global financial markets and establish interest parity.

The November 2007 paper suggests discouraging short-term foreign borrowings.”Short-term credit of tenure less than one year could be subject to a minimum interest tax calculated as the absolute amount that would be paid if it was borrowed for a full year.” In this manner, the tax would rise progressively with shortening of tenure of the debt. This would also help in encouraging long term debt flows.

It also recommends auctioning the right to undertake ECBs as another and more flexible way modulating debt inflows.

“This has the added advantage that the auction cost per annum declines with term of the borrowing thus giving an incentive to long-term borrowing or debt.”