<p>There is no such thing as a free lunch in financial markets, although the Reserve Bank of India’s latest measures may appear to offer one. By providing foreign exchange swaps at highly concessional rates, the central bank is effectively absorbing a significant part of the currency risk that would otherwise have been carried by banks, overseas depositors and public sector borrowers. Together with this, the government has removed taxes on interest and capital gains for certain foreign investors in government securities. At first glance, this looks generous, perhaps excessively so, but monetary policy has to be judged against the circumstances in which it is deployed. The first point requiring clarification is that the RBI has not guaranteed the exchange rate for every foreign investor buying Indian debt. The arrangement is more specific. Banks raising fresh FCNR deposits of three to five years can obtain protection from the RBI against the cost of hedging those dollars, while public sector enterprises borrowing overseas can also access concessional currency swaps. The economic effect is nevertheless powerful. If the rupee weakens substantially during the life of these liabilities, the RBI will bear much of the cost rather than leaving banks or borrowers fully exposed. </p><p>This creates an obvious risk. The private investor enjoys an attractive return while the RBI accepts the difficult part of the bargain. Should the rupee depreciate sharply, the RBI could suffer a serious loss on its forward commitments. It also creates the possibility of moral hazard, because investors may be encouraged to bring in leveraged money precisely because the most worrying risk has been softened. Yet this criticism cannot be considered in isolation. India had entered a deeply painful cycle in which foreign capital was leaving, the rupee weakening, imported costs rising and investors were becoming reluctant to return. A falling currency acquires a momentum of its own. Investors hold back because they fear depreciation, their absence causes further depreciation and the resulting decline confirms the anxiety that kept them away in the first place. </p><p>The tax regime had made matters worse. Foreign investors faced withholding tax on interest and capital gains tax when they sold their holdings. That burden was especially awkward because their gains were calculated in rupee terms. India wants foreign participation in its bond market, but it cannot expect investors to overlook currency risk and an uncertain post tax return merely because domestic yields appear attractive. Capital is mobile and unsentimental. It moves towards markets where returns are clear. </p><p>The larger argument in favour of the RBI’s intervention is that a disorderly currency decline imposes costs across the entire economic architecture. India imports most of its crude oil and remains dependent on overseas supplies of machinery, electronics and industrial components. A weaker rupee raises the price of all these items, feeds into inflation and can eventually force the RBI to keep interest rates higher than the domestic economy requires. What appears to be a foreign exchange problem, therefore becomes a problem for households and businesses, There is also precedent for decisive action. In 2013, a similar window for FCNR deposits helped attract substantial dollar inflows at a moment of severe pressure on the rupee. The RBI paid a price for that protection, but it succeeded in restoring confidence and breaking a damaging cycle. </p><p>The scheme will still need careful limits. It should remain temporary, transparent and closely tied to genuine foreign currency inflows rather than speculative leverage. The RBI must also ensure that banks do not take excessive risks merely because the hedge is cheap. These concerns are real, but they cannot be the basis on which to annul the policy. On balance, the intervention appears justified. The RBI has taken risk onto its own books, but it has done so to prevent the currency from becoming trapped in a vicious cycle. In calmer circumstances, such generosity would be questionable. In the present conditions, it may prove to be the least expensive way of restoring confidence. </p>
<p>There is no such thing as a free lunch in financial markets, although the Reserve Bank of India’s latest measures may appear to offer one. By providing foreign exchange swaps at highly concessional rates, the central bank is effectively absorbing a significant part of the currency risk that would otherwise have been carried by banks, overseas depositors and public sector borrowers. Together with this, the government has removed taxes on interest and capital gains for certain foreign investors in government securities. At first glance, this looks generous, perhaps excessively so, but monetary policy has to be judged against the circumstances in which it is deployed. The first point requiring clarification is that the RBI has not guaranteed the exchange rate for every foreign investor buying Indian debt. The arrangement is more specific. Banks raising fresh FCNR deposits of three to five years can obtain protection from the RBI against the cost of hedging those dollars, while public sector enterprises borrowing overseas can also access concessional currency swaps. The economic effect is nevertheless powerful. If the rupee weakens substantially during the life of these liabilities, the RBI will bear much of the cost rather than leaving banks or borrowers fully exposed. </p><p>This creates an obvious risk. The private investor enjoys an attractive return while the RBI accepts the difficult part of the bargain. Should the rupee depreciate sharply, the RBI could suffer a serious loss on its forward commitments. It also creates the possibility of moral hazard, because investors may be encouraged to bring in leveraged money precisely because the most worrying risk has been softened. Yet this criticism cannot be considered in isolation. India had entered a deeply painful cycle in which foreign capital was leaving, the rupee weakening, imported costs rising and investors were becoming reluctant to return. A falling currency acquires a momentum of its own. Investors hold back because they fear depreciation, their absence causes further depreciation and the resulting decline confirms the anxiety that kept them away in the first place. </p><p>The tax regime had made matters worse. Foreign investors faced withholding tax on interest and capital gains tax when they sold their holdings. That burden was especially awkward because their gains were calculated in rupee terms. India wants foreign participation in its bond market, but it cannot expect investors to overlook currency risk and an uncertain post tax return merely because domestic yields appear attractive. Capital is mobile and unsentimental. It moves towards markets where returns are clear. </p><p>The larger argument in favour of the RBI’s intervention is that a disorderly currency decline imposes costs across the entire economic architecture. India imports most of its crude oil and remains dependent on overseas supplies of machinery, electronics and industrial components. A weaker rupee raises the price of all these items, feeds into inflation and can eventually force the RBI to keep interest rates higher than the domestic economy requires. What appears to be a foreign exchange problem, therefore becomes a problem for households and businesses, There is also precedent for decisive action. In 2013, a similar window for FCNR deposits helped attract substantial dollar inflows at a moment of severe pressure on the rupee. The RBI paid a price for that protection, but it succeeded in restoring confidence and breaking a damaging cycle. </p><p>The scheme will still need careful limits. It should remain temporary, transparent and closely tied to genuine foreign currency inflows rather than speculative leverage. The RBI must also ensure that banks do not take excessive risks merely because the hedge is cheap. These concerns are real, but they cannot be the basis on which to annul the policy. On balance, the intervention appears justified. The RBI has taken risk onto its own books, but it has done so to prevent the currency from becoming trapped in a vicious cycle. In calmer circumstances, such generosity would be questionable. In the present conditions, it may prove to be the least expensive way of restoring confidence. </p>
