It
began with the Reserve Bank of India's third quarter
2011-12 Review of Macroeconomic and Monetary Developments
released on January 23, 2012. Its assessment of the
situation in India's external sector noted that: ''Risk
aversion in the global financial markets has slackened
the pace of capital flows to India… If the pace of
FDI inflows does not pick up once again and FII equity
inflows revert to the decelerating trend, CAD (current
account deficit) may have to be largely financed through
debt creating flows in the coming quarters.'' It also
underlined the fact that signs of a recent revival
of FII inflows were largely on account of investment
in debt instruments. A few days later, RBI Governor
D. Subbarao, referring to the rise in debt flows,
publicly emphasised that India has ''a preference for
non-debt flows over debt flows'', and ''within non-debt
flows, more of FDI''.
Chart
1 >>
(Click to Enlarge)
Along with the expression of such fears the government
has been liberalising foreign investment rules to
attract equity inflows in lieu of debt. The most recent
such policy allows individual investors to invest
in equity. The justification provided for these fears
and policies is the evidence that investments in Indian
equity have decelerated during the first half of fiscal
year 2011-12 when compared to the recent past (Chart
1). In particular, there has been a collapse of foreign
portfolio investment flows, leading to an overall
fall in external investment in equity.
The RBI has released some preliminary figures for
the third quarter of 2011-12 (Table 1). These figures
also point to a decline in monthly average inflows
of foreign equity investments during September to
November in the case of direct investment and September
to December 2011 in the case of portfolio investments.
But the decline is by no means dramatic.
These changes have been occurring at a time when the
external current account deficit, which had fallen
in the second half of fiscal 2010-11, has risen significantly
(Chart 2). As a result, a rising share of a rising
deficit is being financed with non-equity flows. The
ratio of direct and equity investment flows to the
current account deficit in India appears to have shifted
downwards over a relatively short period of time (Chart
3). The conclusion arrived at is that India has had
to increase its reliance on debt creating flows to
finance its current account deficit. Supporting that
is the evidence that inflows in the form of loans
and banking capital have together risen quite sharply
during the first two quarters of this fiscal year
(Chart 4).
Table
1: Capital Flows during 2011-12 ($ bn) |
|
2011-12 |
2011-12
|
|
(Apr.-Aug.) |
(Sep.-Dec.)
|
|
(Monthly
Average)
|
FDI
to India* |
4.9 |
3.2 |
FDI
by India |
1 |
0.8 |
FIIs
(net) |
0.4 |
0.1 |
ADRs/GDRs
|
0.1 |
0.1
|
ECB
Inflows (net) |
1.3 |
0.6 |
NRI
Deposits (net) |
0.5 |
1.2
|
* : April-November.
|
Table 1 >>
(Click to Enlarge)
Though fully collated figures for the period since
September 2011 are yet to be released, there are reports
that these tendencies have only intensified more recently.
According to one report (Indian Express, January 30,
2012), during calendar year 2011 as a whole, foreign
debt inflows amounted to $8.65 billion, out of which
as much as $4.18 billion came in the month of December.
On the other hand, calendar 2011 is said to have recorded
a net outflow of equity investments to the tune of
$357 million. Moreover, foreign debt inflows in January
are placed at $3.21 billion against a much smaller
$1.7 billion of equity inflows.
Finally, SEBI figures on net FII investment suggest
that while FII investments in equity have been low
or negative for much of the past 14 months, FII purchases
of debt instruments have spiked during December 2011
and January 2012.
Chart
2 >>
(Click to Enlarge)
What does this combination of figures say about the
capita inflows into the country and their role in
financing the current account deficit? To start with,
they do point to the fact that, over the last year,
inflows of equity investment have been less buoyant
than they were prior to the financial crisis and during
the post crisis recovery. Secondly, they indicate
that one consequence of this has been an enhanced
role for foreign debt in financing the current account
deficit.
Chart
3 >>
(Click to Enlarge)
However, this does not mean that India is having any
difficulty financing its current account deficit,
nor that increased reliance on debt is driven purely
by the need to finance the current account deficit.
Rather large Indian firms are choosing to borrow abroad
to benefit from the substantially lower interest rates
in international markets as compared with India. Moreover,
the government had in December deregulated interest
rates on Non-Resident (External) rupee (NRE) deposits
and Ordinary Non-Resident (NRO) Accounts, triggering
a chase for non-resident deposits among Indian banks.
According to reports, there has since been a surge
in NRI deposits, encouraged by the opportunity to
earn profits through arbitrage. This makes the volume
of debt inflow much greater than needed to finance
the current account gap. As a result, foreign exchange
reserves have risen and remained at relatively high
levels.
Chart
4 >>
(Click to Enlarge)
Despite these factors the government and the RBI appear
to be using the shift away from equity to debt inflows
to liberalise the terms for foreign equity investment
inflows. Flagging this tendency was the announcement
on New Year's day 2012 that a new group of foreign
investors identified as Qualified Foreign Investors
(QFIs) are to be permitted to invest directly in India's
equity markets. The definition of who ‘qualifies'
is rather broad: it covers any individual, group or
association resident in a foreign country that complies
with the Financial Action Task Force's (FATF) standards
and is a signatory to the multilateral Memorandum
of Understanding of the International Organisation
of Securities Commissions (IOSCO), dealing with regulation
of securities markets.
Measures such as these are partly explained by the
UPA government's desire to establish that it has not
slowed down on reform and to counter the view that
a form of ''policy paralysis'' afflicts it. But they
are also driven by the need to reverse the slow down
in inflows of foreign portfolio investment. The decline
in FII inflows has been attributed to developments
abroad, which required foreign institutional investors
to book profits in India and repatriate their funds
to meet commitments or cover losses at home. The presumption
appears to be that individual investors would not
be affected by such compulsions. The government's
press release announcing the new QFI policy declares
that the object of the measure is to ''to widen the
class of investors, attract more foreign funds, and
reduce market volatility''. In the last Budget these
investors had been allowed to invest in Indian Mutual
Fund Schemes. The recent announcement takes this a
step further and treats them on par with FIIs. The
government's view that QFIs would make up for any
loss of FII inflows and that their investment would
be characterised by greater stability has to be tested.
But the factors motivating its decision are clear.
Chart
5 >>
(Click to Enlarge)
One danger is that the new measure allows direct access
to equity markets to entities not regulated in their
home country. When India first began permitting foreign
investment in the equity market, the FII category
was created to ensure that only entities that were
regulated in their home countries would be permitted
to register and trade in India. The logic was clear.
Since it is impossible for Indian regulators to fully
rein in these global players and impose conditions
on their financing, trading and accounting practices,
controlling unbridled speculation required them to
be regulated at the point of origin.
But this kind of derivative regulatory control can
apply, if at all, only to institutional investors.
Individual investors cannot be subject to such rules
even in their home country and allowing them to enter
amounts to giving up the requirement that only foreign
entities subject to some discipline and prudential
regulation should be allowed to trade in Indian markets.
This is of relevance because individual investors
are unlikely to enter India and invest in equity to
hold it with the intention of earning dividend incomes.
The exchange rate and other risks would be deterrents
to such long-term commitments. If such investors do
come it would be with the intent of reaping capital
gains through short-term trades. Thus, to the extent
that the measure is successful it would mark a transition
towards allowing speculative players greater presence
in Indian markets. Defending that on the grounds that
it would help reduce dependence on debt is indeed
questionable.
*This
article was published in the Business Line on January
9, 2012.
