Informed
by the global experience the RBI has been making a
case for caution. It has pointed to the problems created
by volatile capital inflows for exchange rate and
monetary management. It has flagged the dangers associated
with investments through the sub-account or participatory
note (PN) routes, which can be exploited by unregulated
and/or unidentified entities involved in take-over
bids, money laundering or short-term speculation.
And it called for policies that can reduce the vulnerability
associated with volatility.
It must be said to the credit of the UPA that currently
rules the country that it had sensed these tendencies
quite early, so that its National Common Minimum Programme
declared that ''FIIs will continue to be encouraged
while the vulnerability of the financial system to
the flow of speculative capital will be reduced.''
In keeping with that perception, the Prime Minister
constituted an Expert Group to provide an action plan
to meet that commitment. The committee's constitution
was officially notified on November 2, 2004 and it
was to submit its report by November 30, 2004. The
Group actually submitted its report a year later in
November 2005.
If the gravity of its content is the yardstick to
go by, there would be no reason to take note of this
report. Filled with assertions, it reads more like
a pamphlet advocating financial liberalisation than
the report of a group of experts. And where there
are indications of expertise, these amount to no more
than an excessively selective review of related literature,
which is often not even woven into the flow of the
report's argument. There have been many other reports
dealing with similar issues emanating from agencies
like the Reserve Bank of India in which policy-makers
may fruitfully invest their reading time. However,
because this report emanates from the Finance Ministry
and includes a note of dissent from the representative
of the RBI, which substantially distances the central
bank from the contents of the report, it partly reflects
both the trend of thought and the tensions which prevail
in the corridors of decision-making. It is the source
not the content that warrants giving it attention.
From the discussion of recent trends with regard to
FII movements it should be clear that by the time
the Group was constituted and definitely by the time
the Group submitted its report, the issue of encouraging
FIIs was of little significance, with the problem
being one of managing the surge in such flows. Yet
the thrust of the whole report is on encouraging FII
flows and not dealing with vulnerability. The emphasis
seems to be on ensuring that no corrective policies
are adopted and that the process of liberalisation
is continued with. To quote the report: ''While there
is indeed the issue of timing the policy of encouragement
appropriately, to avoid the pitfalls of throwing the
baby with the bath water, there can not be a turnaround
from the avowed policy of gradual liberalisation.
Any recommendation made today should be consistent
with the broad strategy of further liberalisation,
and not look like or be a rollback of reforms.''
On what grounds then does the expert group justify
its case for further encouragement rather than increased
regulation? To start with, there are arguments extolling
the virtues of foreign institutional investment, each
of which needs examination. Prime among these is the
view that FII investments help increase stock prices
and therefore reduce the cost of equity capital. It
is unclear exactly how this occurs. FII investments
in themselves do not increase earnings. So if FII
investments that raise prices are warranted by fundamentals,
earnings should be high and price-earnings ratios
should be low. If these earnings are not being paid
out as dividends then the expectation should be that
earnings would rise from their current levels, so
that capital gains can be booked. This makes the investment
inherently speculative.
In any case, the price increase occurs mainly in the
secondary market, and does not directly contribute
to additional equity for investment unless new shares
are issued at higher prices. This has indeed been
true of some large firms which have been able to mobilise
large sums through the premium at which they are able
to issue additional equity. But, unlike the case during
the scam-induced stock market boom of the early 1990s,
the recent boom or any of the mini-booms that occurred
in between did not see successful IPO issues by smaller
or new firms. In essence, therefore, the effect of
the stock price boom is to transfer surpluses from
investors to large corporates through the so called
cheap-equity route. To the extent that the investors
are small savers, this amounts to a form of forced
saving, leveraged through speculation.
The second argument advanced in favour of FII investment
is that, like FDI, it is a safe and sustainable mechanism
of funding the current account deficit. Elsewhere
the report suggests that because of ''infirmities
of Indian indirect taxes and transportation infrastructure'',
FDI flows to India have remained small relative to
China. While sweeping generalisations of this kind
need not detain us here, it must be noted that the
FII surge to India occurred precisely at a time when
India did not need these flows to finance her balance
of payments. In the event, as noted above much of
this foreign exchange was added to India's reserves.
Finally, FII investments are supported on the grounds
that FII participation in domestic capital markets
often leads to sound corporate governance practices,
improved efficiency and better shareholder value.
One only needs to refer to the innumerable instances
of fraudulent accounting practices, conflict of interest
and manipulation involving FII principals periodically
reported from their home country markets, to make
light of this claim.
While the authors of the report stretch themselves
in this fashion to advocate the cause of the FIIs,
they virtually dismiss all arguments that point to
the dangers involved in the growing presence of FIIs
in Indian markets. Herding is not a problem because,
FIIs are ostensibly observed to be involved in buying
and selling at the same time. Vulnerability is not
an issue ostensibly because there has never been an
occasion when more than a billion dollars flowed out
in one month. The fact that there has not been any
previous period except the last three years when FII
investments anywhere near an annual $9-10 billion
Indian has entered Indian markets is conveniently
ignored. Similarly, the problem of opaqueness of sub-accounts
and PNs is set aside by suggesting that FIIs should
be ''obliged'' to report on the identity of their
investment sources. And since all modern market economies
have ostensibly evolved policies to reconcile prudent
monetary management with the benefits of a liberal
capital account, there is seen to be no scope for
diffidence in India.
Having set the stage with these assertions, the report
goes on to advocate measures that would further encourage
FII investments. Thus, it recommends that FII investment
and FDI must be treated separately, and the cap on
FII investment ''if any'' reckoned over and above
prescribed FDI caps. The danger that takeover efforts
may be strengthened through opaque means such as sub-accounts
and PNs must be dealt with by requiring the reporting
of clients holding such positions. However, the current
dispensation with regard to participatory notes should
continue. Any policy with regard to the operation
of Hedge Funds should be postponed till such time
as regulatory mechanisms are introduced in the US
and elsewhere and these are studied. FIIs should be
given operational flexibility by allowing them the
freedom to switch between equity and debt investments,
so that they can pursue more ''balanced'' strategies.
Finally, since with the growing presence of FIIs in
the market there is a shortage of good quality equity,
disinvestment of profitable public sector equity,
as in the case of Gas Authority of India Ltd. (GAIL),
Oil and Natural Gas Corporation (ONGC) and National
Thermal Power Corporation (NTPC), must be resorted
to! At least to the knowledge of this author this
is the first time such a bizarre argument in favour
of disinvestment of public sector units (PSUs) has
been advanced.
All these are clearly aimed at encouraging more FII
investment flow. But what does the report say about
vulnerability? To the extent that it matters, here
too more liberalisation is the answer. In the view
of the experts: ''The participation of domestic pension
funds in the equity market would augment the diversity
of views on the market. This would also end the anomaly
of the existing situation where foreign pension funds
are extensive users of the Indian equity market but
domestic pension funds are not.'' That will socialise
the cost of dealing with unrecognised vulnerability,
by making a section of the middle class bear a part
of the burden of seeking to promote the ''irrational
exuberance'' that seems to characterise the market.
Fortunately, the RBI has not been taken in by this
euphoria. In its own sober fashion it makes the following
points: (i) that the Expert Group's report does not
address the macroeconomic implications of volatility
of capital flows and the fall-out of excessive inflows
and outflows for macroeconomic management and suggest
appropriate measures to deal with the problem; (ii)
that a special group should be constituted on a priority
basis to address these issues comprehensively; (iii)
that in view of the growing international concern
regarding the origin and source of investment funds
flowing into the country, the issue of participatory
notes should not be permitted (since trading of these
PNs will lead to multi-layering) and hedge funds,
which by their very nature cannot be subject to regulation,
registered with SEBI should be examined for deregistration;
(iv) that the government should continue with its
policy of keeping separate FII and FDI limits; (v)
that the requirement of special resolutions to be
passed by both the shareholders (in an EGM) and the
board of a company for enhancing the FII limit beyond
24 per cent, wherever applicable under the present
policy guidelines should continue, and in cases like
retail trading, where FDI is not allowed and the limit
for FII investments is 24 percent, that limit should
not be increased; and (vi) that it would not be appropriate
to permit FII to treat debt securities (both government
and corporate debt) as an investment avenue and a
ceiling on the total stock of FII investment in debt
should be retained.
In sum, the RBI, conscious of the problems created
by volatility and the surge in FII inflows, has virtually
disowned much of the report, which now reflects a
Finance Ministry view. The fact that the so-called
Expert Group was loaded with members from the Finance
Ministry seems to explain its failure to accommodate
the legitimate concerns of the central bank which
is charged with managing the balance of payments and
the exchange rate. And the desire of the Finance Ministry
to continue to impose it views is reflected in the
recommendation that the Department of Economic Affairs
should initiate a research program on ''Capital flows
and India's Financial Sector: Learning from theory,
international experience, and Indian evidence''. Given
the circumstances, this seems to be nothing more than
the launch of another effort to offer an apology for
international speculators operating in India's stock
and debt markets, ignoring the views of the central
bank.
