Explanation about forex curbs and reigning in inflation

I was asked the following on 21 May 07, 16:44:

Sridhar: Sir, Could you plz explain this 'More curbs on forex inflows to reign in inflation" elaborately.

My Answer:

One of the methods by which a Government can tackle inflation is by controlling the foreign exchange inflows into the country. Before we see an example of such a control measure, let us understand that increasing inflows of foreign currency into the country leads to an increase in the circulation of the domestic currency. If not all the inflows, at least some of it will be converted into local currency for domestic use. This leads to increase in money circulation. When more money is there in the system, it leads to an increase in prices. More money chases the same quantity of goods available. Hence there will be an increase in prices i.e., inflation.

Now let us see how the Government can control the inflows of foreign currency into the country. One of the routes through which foreign currency flows into the country is raising of loans overseas by corporates in India. As interest rates in international markets are invariably lower than the interest rates prevailing in India, corporates tend to borrow in the international markets. The government prescribes the rate at which the corporates can borrow money from abroad. The government has now ordained that the corporates cannot borrow from overseas at an interest rate which is more than 1.5% over the LIBOR (London Inter Bank Offer Rate, the rate against which international financial deals are referenced). Earlier this ceiling used to be 2% over LIBOR. What impact will this have on foreign exchange inflows? Because the corporates can only raise foreign money at a more competitive rate, it becomes difficult for them to raise money abroad. So this will have a negative impact on the foreign exchange inflows into the country. This leads to lower amount of domestic currency finding its way into our system. Hence it will have a negative impact on inflation.

I hope now you will understand the full import of what I noted on 20.05.2007 about this subject.