The
evidence is stark and incontrovertible. In the period
since April 2003, India has witnessed an extraordinary
surge in foreign institutional investments. Having
averaged $1776 million a year during 1993-94 to 1997-98,
net FII investment dipped to an average of $295 million
during 1997-99, influenced no doubt by the Southeast
Asian crisis. The average rose again to $1829 million
during 1999-2000 to 2001-02 only to fall $377 million
in 2002-03. The surge began immediately thereafter
and has yet to come to an end. Inflows averaged $9599
million a year during 2003-05 and are estimated at
$9429 million during the first nine months of 2005-06.
Going by data from the Securities and Exchange Board
of India (SEBI), while cumulative net FII flows into
India since the liberalisation of rules governing
such flows in the early 1990s till end-March 2003
amounted to $15,804 million, the increment in cumulative
value between that date and the end of December 2005
was $25,267 million.
It is not surprising that the period of surge in FII
investments was also one when, despite fluctuations,
the stock market has been extremely buoyant. The market
in India lacks width and depth, with few investors,
few companies whose shares are actively traded, and
a small proportion of those shares available for trading.
Hence any new capital inflow does trigger price increases.
The Bombay Sensex rose from 3727 on March 3, 2003
to 5054 on July 22, 2004, and then on to 6017 on November
17, 2004, 7077 on June 21, 2005, 8073 on November
2, 2005 and 9323 on December 30, 2005. The implied
price increases of more than 80 per cent over a 17-month
period and 50 per cent over just more than a year
are indeed remarkable. Market observers, the financial
media and a range of analysts have concurred that
FII investments have been an important force, even
if not always the only one, driving markets to their
unprecedented highs.
Underlying the current FII and stock market surge
is, of course, a continuous process of liberalisation
of the rules governing such investment: its sources,
its ambit, the caps it was subject to and the tax
laws pertaining to it. It could, however, be argued
that the liberalisation began in the early 1990s,
but this surge is a new phenomenon which must be related
to the returns now available to investors that make
it worth their while to exploit the opportunity offered
by liberalisation. The point, however, is that while
the good profit performance of domestic firms may
partly explain the high returns of recent times, there
were other factors that may have been more crucial.
To start with, current account surpluses, higher remittances
and rising inflows on account of exports of software
services had ensured a strengthening of the Indian
rupee, despite the RBI's effort to manage the exchange
rate with large purchases of foreign currency. A stronger
rupee implies better returns in dollar terms, encouraging
foreign investors looking for capital gains. This
possibly even triggered a speculative surge in inflows
because of expectations that the rupee would rise
even further. Given the role of FII investments in
increasing the supply of foreign exchange, such expectations
tend to be self-fulfilling at least for a period of
time.
Returns on stockmarket investment were also hiked
through state policy. Just before the FII surge began,
and influenced perhaps by the sharp fall in net FII
investments in 2002-03, the then Finance Minister
declared in the Budget for 2003-04: ''In order to give
a further fillip to the capital markets, it is now
proposed to exempt all listed equities that are acquired
on or after March 1, 2003, and sold after the lapse
of a year, or more, from the incidence of capital
gains tax. Long term capital gains tax will, therefore,
not hereafter apply to such transactions. This proposal
should facilitate investment in equities.'' Long term
capital gains tax was being levied at the rate of
10 per cent up to that point of time. The surge was
no doubt facilitated by this significant concession.
Once the FII increase resulting from these factors
triggered a boom in stock prices, expectations of
further price increases took over, and the incentive
to benefit from untaxed capital gains was only strengthened.
In the circumstances, there is reason to believe that
the herd instinct so typical of financial investors
played a role in sustaining the boom, with a rush
of investors into the country. The number of FIIs
registered in India stood at 502 at the end of March
2003, many of whom had registered immediately after
the rules were liberalised to permit their entry.
As many as 353 FIIs had registered by the end of March
1996. The second spike in FII registration is more
recent. Thus, the number of FIIs registered in the
country rose by 321 between end 2002-03 and end of
December 2005, when the figure touched 823.
Even a cursory assessment of recent developments would,
therefore, lead to three tentative conclusions. First,
that FII investment does seem volatile even when annual
average figures are considered. Second, while an initial
promise of high returns triggered FII interest, speculative
objectives and the herd instinct have played a role
in keeping investment high and the markets buoyant.
And, third, given the massive and concentrated inflows
in recent times there are reasons to be concerned
with their macroeconomic implications and the danger
of an equally sudden reversal.
There have been too many instances in East Asia, Latin
America, Turkey and elsewhere where a financial crisis
was preceded by a surge in capital flows other than
foreign direct investment and a simultaneous boom
in stock and/or real estate markets. Independent of
their inclinations, the exact causal mechanisms they
identify and where they place the burden of blame,
analysts of those periodic crises have accepted the
reality that liberalised financial markets are prone
to boom-bust cycles. Hence, even if the ongoing India-boom
is seen by some as being ''different'' and ''warranted
by fundamentals'', there remains ample room for caution.
Most booms were seen as signs of strength rather than
vulnerability, till they went bust.
The case for vulnerability to speculative attacks
is strengthened because of the growing presence in
India of institutions like Hedge Funds, which are
not regulated in their home countries and resort to
speculation in search of quick and large returns.
These hedge funds, among other investors, exploit
the route offered by sub-accounts and opaque instruments
like participatory notes to invest in the Indian market.
Since FIIs permitted to register in India include
asset management companies and incorporated/institutional
portfolio managers, the 1992 guidelines allowed them
to invest on behalf of clients who themselves are
not registered in the country. These clients are the
‘sub-accounts' of registered FIIs. Participatory notes
are instruments sold by FIIs registered in the country
to clients abroad that are derivatives linked to an
underlying security traded in the domestic market.
These derivatives not only allow the foreign clients
of the FIIs to earn incomes from trading in the domestic
market, but to trade these notes themselves in international
markets. By the end of August 1995, the value of equity
and debt instruments underlying participatory notes
that had been issued by FIIs amounted to Rs. 78,390
crore or 47 per cent of cumulative net FII investment.
Through these routes, entities not expected to play
a role in the Indian market can have a significant
influence on market movements. In October 2003, The
Economist reported that: ''Although a few hedge funds
had invested in India soon after the country began
liberalising its financial markets in the early 1990s,
their interest has surged recently. Industry sources
estimate that perhaps 25-30 per cent of all foreign
equity investments are now held by hedge funds.''
The problem does not end here. For some time now,
the capital surge has been eroding the ability of
the central bank to pursue its monetary policy objectives.
The foreign exchange assets of the central bank rose
sharply, from $42.3 billion at the end of March 2001
to 54.1 billion at the end of March 2002, $76.1 billion
at the end of March 2003, $113 billion at the end
of March 2004 and $142 billion at the end of March
2005. The process of reserve accumulation is the result
of the pressure on the central bank to purchase foreign
currency in order to shore up demand and dampen the
effects on the rupee of excess supplies of foreign
currency. In India's liberalized foreign exchange
markets, excess supply leads to an appreciation of
the rupee, which in turn undermines the competitiveness
of India's exports. Since improved export competitiveness
and an increase in exports is a leading objective
of economic liberalisation, the persistence of a tendency
towards rupee appreciation would imply that the reform
process is internally contradictory. Not surprisingly
the RBI and the government have been keen to dampen,
if not stall, appreciation.
Unfortunately, the RBI's ability to persist with this
policy without eroding its ability to control domestic
money supply is increasingly under threat. Increases
in the foreign exchange assets of the central bank
amount to an increase in reserve money and therefore
in money supply, unless the RBI manages to neutralise
increased reserve holding by retrenching other assets.
If that does not happen the overhang of liquidity
in the system increases substantially, affecting the
RBI's ability to pursue its monetary policy objectives.
Till recently the RBI has been avoiding this problem
through its sterilisation policy, which involves the
sale of its holdings of central government securities
to match increases in its foreign exchange assets.
But even this option has now more or less run out.
Net Reserve Bank Credit to the government, reflecting
the RBI's holding of government securities, had fallen
from Rs. 1,67,308 crore at the end of May 2001 to
Rs. 4,626 crore by December 10, 2004. There was little
by way of sterilisation instruments available with
the RBI.
There are two consequences of these developments.
First, the monetary policy of the central bank that
had been delinked from the fiscal policy initiatives
of the state by foreclosing monetisation of government
debt is no more independent. More or less autonomous
capital flows influence the reserves position of the
central bank and therefore the level of money supply,
unless the central bank chooses to leave the exchange
rate unmanaged, which it cannot. This implies that
the central bank is not in a position to use monetary
levers to influence domestic economic variables. Secondly,
the country is subject to a drain of foreign exchange
inasmuch as there is substantial difference between
the repatriable returns earned by foreign investors
and the foreign exchange returns earned by the Reserve
Bank of India on the investments of its reserves in
relatively liquid assets. While partial solutions
to this problem can be sought in mechanisms like the
Market Stabilisation Scheme (which places government
securities in a market stabilisation facility that
increases the interest costs borne by the government),
it is now increasingly clear that the real option
in the current situation is to either curb inflows
of foreign capital or encourage outflows of foreign
exchange.
