The current macroeconomic environment and the policies that go with it are likely to entail a set of social costs that we might not wish to bear in the long term. High inflation, for one, entails such a cost since it is known to exacerbate inequalities in income.
This happens because inflation works like a regressive tax since households, irrespective of their income levels, bear the same burden. From this perspective alone, a growth strategy premised on higher inflation is perhaps not tenable.
The other significant cost could arise from the pattern of funding or financing investments that is emerging. Let me explain. Despite rising domestic interest rates, the investment plans of larger Indian companies seem somewhat unperturbed.
Going by recent surveys and anecdotal evidence that I come across, only a few are jettisoning their plans of setting up new capacity because they find the cost of borrowing unviable. The key reason is that most large companies have recourse to external capital, whose cost has hardly changed.
While the average prime lending rate for domestic loans is about 12.75 per cent, a fully hedged dollar loan for five years would work out to anywhere between 8.5 per cent and 9.5 per cent. While the domestic cost of lending has moved up by more than 3 percentage points from early 2006, international rates have moved just by a fraction of a percentage point. Local companies' appetite for external funds is reflected in the data. In the April-December 2006 period alone, Indian companies added $12.5 billion of medium and long borrowings to their balance sheets.
The question to ask here is the following: who has access to these external loans? My guess is that it would be the relatively large companies. This is not to deny the fact that over the last couple of years, the access of domestic companies to the global loan market has improved radically.
Today, even some firms that fall in the SME category have access to foreign currency loans. That said, if one considers the entire swathe of Indian industry, there is still a bias towards the bigger firms in their access to foreign currency loans. In short, the current policy regime has effectively fostered a dual interest regime in which bigger firms have access to lower rates. Smaller firms get the short shrift.
If the objective was to weed out smaller firms and initiate a process of consolidation in industry, this structure of rates would do the trick. I am not sure, however, that this is what the government wants to achieve. The SME sector is known to be more employment-intensive than larger firms. They also contribute significantly to exports.
A UNIDO study showed that in 2003, the SME sector accounted for 35 per cent of exports directly and 15 per cent indirectly. The challenge at this stage would be to help the sector ramp up operations and become more competitive. That means better access to capital.
Export-oriented SME firms have been hit by the double whammy of rising interest costs and progressive overvaluation of exchange rates. The manifestations of this are visible in the export data, which showed single-digit growth in the first quarter of 2007. If rates continue to rise and the rupee continues to stay overvalued, things are bound to get worse. Banking regulations such as raising the risk weightings for unrated companies (most SMEs would fall in this category) would compound this.
There are no easy solutions to the problem. Subsidised credit either from SIDBI or multilateral agencies is likely to help only at the margin. One way to create a level playing field in access to capital would be to allow banks to raise external borrowings specifically for lending to SMEs. Intermediation to the global markets through large Indian banks would enable them to overcome their problems of size and credit profile and yet get better rates.
Of course, stringent guidelines for eligibility and a mechanism for ring-fencing these funds are a must. However, an apparatus for monitoring the end-use of external borrowings already exists and if these funds are channelled through banks, the RBI should not have too many operational problems in making sure that this works.
I must mention here that a number of domestic and foreign banks have been finding lending to the SME segment an increasingly attractive business opportunity. A number of them have put fairly efficient systems of credit appraisal in place and the credit quality has been satisfactory.
This, however, does not address the problem of large capital inflow, which is adding to domestic monetary growth and rising exchange rates. In fact, by giving banks access to global capital markets, it would appear to add to the problem. However, I would warn against confusing the two issues.
We need to rid ourselves of the dual interest rate structure and simultaneously tackle the problem of excessive capital flows. For the latter, I have the following suggestions. Some of them might appear somewhat anti-market and regressive but I'm afraid we are running out of options.
I would stop short of recommending a blanket curb on external borrowings, but insisting on a significantly large import component in their use could help. The logic is simple: for every dollar that comes in as a loan, a significant fraction goes out as imports. The net inflow is reduced.
Second, of the large FDI inflow that has come in recently, a significant fraction seems to have come into the real estate sector. If indeed our monetary authorities are so anxious about overheating in the sector, it is perhaps necessary to review some of the investment norms there. Finally an interim cut in import duties across the board.
That would simultaneously reduce inflation and by encouraging more imports rid the system of excess liquidity built up through external inflow.
The author is chief economist, ABN Amro. The views here are personal.
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