Free to borrow

The government has moved forward with Indias capital account liberalisation by increasing the limit for borrowing in dollars,on the automatic route,from 0.5 billion to 0.75 billion. Opposition to foreign borrowing has long drawn from this hypothetical scenario. An Indian firm gets tempted to borrow in dollars because of low interest rates abroad and a promise by the RBI to manage the exchange rate. When a surprise materialises,in the form of large currency depreciation,the firm goes bankrupt. Internationally,there are many examples of companies and governments going bankrupt owing to this mistake. But the solution to this problem does not lie in banning borrowing from abroad. It lies in getting the RBI out of managing the exchange rate. If the exchange rate is determined on the market,the borrower always knows a big depreciation can happen,and will be suitably careful,either by not borrowing in dollars or by hedging.

The real danger lies in the political economy. When many large firms have unhedged borrowing in dollars,they would then exert political pressure to get the RBI to try to prevent depreciation. Reports suggest the RBI sold dollars in recent days to prevent rupee depreciation. This is ill-advised,for it signals an implicit guarantee to the firms that,should a need for a large rupee depreciation arise,the RBI will come to the rescue. The RBI must stop meddling in the currency market. Its real task is to put its core monetary policy functions on a platform with high accountability. Enough accountability mechanisms would insulate the central bank from pressure from government or industry.

The government has also moved to ease borrowing by firms from China. In general,liberalisation is a good thing,but there are elements of this kind of engagement with China which are worrisome. The distortions of Chinas macroeconomic policy mean its interest rates are very low but should such dumping be allowed to reduce the market share of non-Chinese suppliers of equipment and loans? A loan from a large Chinese bank is something the Chinese government inevitably signs off on. There may be conditions on such transactions which are not publicly disclosed. These concerns merit exploration to understand facts and potential policy responses.