In
a surprise move on New Year's day 2012, the Government
of India decided to further liberalise its capital
account. As of that date, 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.
The FATF is an inter-governmental body created at
a G 7 Summit in 1989 to study techniques of money
laundering and recommend measures to be adopted at
national levels to combat the problem. Since then
the Task Force has extended its ambit to cover terrorist
financing. It has periodically issued a set of recommendations
that are considered standard. Most countries that
are home to the relevant investors have implemented
these measures.
It is useful to clarify the element of change here.
The announcement adds a new category of foreign investors
permitted to directly invest in equity markets to
the registered foreign institutional investors that
were permitted hitherto. These would, ostensibly,
be in the nature of individual investors or groups
seeking to expand and diversify their portfolio. Besides
the international compliance requirements, SEBI norms
specify that a QFI cannot be an Indian resident or
an FII or a holder of a sub-account with an FII. 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.
It must be noted that since FIIs could mobilise resources
through special India funds and included asset management
companies, these investors had earlier been allowed
to invest in India through FIIs. The difference now
is that they are allowed to invest directly in primary
and secondary markets and establish direct relationships
with brokers.
The crucial issue here is that the new measure does
allow 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.
Besides the fact that the information costs of engaging
in such activity would be substantial, the exchange
rate and other risks would be deterrents to long-term
commitments. So if such investors do come at all,
they would come 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.
This transition had already been in the making before
the recent announcement. Despite the requirement with
regard to FIIs permitted to register to trade in Indian
markets, unregulated entities had in the past bought
into Indian equity. This they did either by investing
capital in designated sub-accounts maintained by registered
FIIs or by buying participatory notes (PNs), which
were tradable derivative instruments linked to equity
held by custodians in the country.
The PNs proved to be controversial since they not
only allowed unregulated entities to buy and hold
ownership rights over Indian stock, but being tradable
abroad came to rest with entities whose details and
characteristics were not known to the domestic regulator.
Over time PNs came to account for a very large share
of the stock of FII investments in the country and
were known to be held by unregulated entities such
as hedge funds and private equity firms. In a shadow
conflict that ensued, the Reserve Bank of India wanted
to discourage the issue of PNs, while the Finance
Ministry saw their presence as crucial to encourage
capital flows to the country. When the SEBI attempted
to tighten rules with regard to PNs there was a sudden
exit of capital. In the ''compromise'' that followed,
the SEBI began allowing entities that were not adequately
regulated in their home countries to register as FIIs
and trade in Indian markets. Since such investors
were bound to be speculative players, the government
had indeed retreated on its original regulatory principles.
Seen in that light, the recent move is merely expanding
the set of unregulated entities permitted to trade
in Indian markets.
Yet the question arises as to why the government has
chosen to opt for this policy shift at this point
in time. The government's press release seems clear
on the matter, declaring that the object of the measure
is to ''to widen the class of investors (in equity
markets), attract more foreign funds, and reduce market
volatility and to deepen the Indian capital market''.
It is indeed true that the government had been concerned
about the fall in FII investments and net FII investment
outflows on occasion and has been attributing the
weakening of the external value of the rupee to these
tendencies.
This decline in inflows leading even to net outflows
was seen as being the result of developments abroad,
which required foreign institutional investors to
book profits in India and repatriate their funds to
meet commitments or cover losses at home. Hence, underlying
the recent measure is the presumption that there are
non-institutional investors who would not be subject
to such constraints. If such investors are permitted
to access Indian markets directly, as opposed to having
to invest through FIIs it is argued, India would be
opening itself to an ''additional'' and more stable
source of capital inflow.
The first assumption here is that such investors would
flock to India despite the guidelines issued (and,
therefore, constraints imposed) by the SEBI to make
these investments safe. No QFI can hold more than
5 per cent stock in a company, would have to deliver
or take delivery of all stock they sell or purchase,
and cannot square off their positions intra-day. This
makes it difficult to indulge in short term trades.
The requirement of an individual 5 per cent ceiling
for a single QFI in the stock of a company and disclosure
requirements when aggregate QFI investments touch
8 per cent make this a poor route in a take over attempt.
All this would deter some investors.
Yet let us go with the assumption that QFIs would
flock to India. Even then it is to be expected that
this capital would not come from a large number of
small investors, since the transaction costs associated
with making such small investments would be uneconomic
to bear. What we are likely to see is a few, large,
high net worth individuals seeking out the best stocks,
so that the expectation that the measure would significantly
widen and deepen the domestic equity market is likely
to remain unrealised.
Moreover, as noted above, these investors would most
likely be those who are willing to accept the uncertainty
and risk of investing in dispersed markets in return
for quick capital gains. Since these investors are
unlikely to spend much on gathering their own information
on individual companies, on the macroeconomic situation
and on the state of equity markets, they are likely
to base their decisions on signals from large investors.
That is, they would pursue in herd-like fashion the
large institutional investors. Hence the presence
of these new investors, even if it turns out to be
large, would not reduce speculation and volatility,
but would in all probability increase them.
Thus, unless there is some urgency about seeking out
additional sources of capital inflow, it is difficult
to explain why the government must open doors to a
source that is unlikely to deliver much foreign capital
and would, if it does, increase rather than decrease
speculation and volatility. Is there any desperate
need to attract such capital? While it is true that
there has been some reduction in the quantum of FII
inflows in recent times, the volume of net capital
inflows into the country is by no means small when
all forms of capital inflow are taken account of.
At the beginning of the first decade of the 21st century,
net capital inflows amounted to around $8-10 billion.
They then rose steeply from $17.3 billion in 2003-04
to $46.2 billion in 2006-07 and an exceptionally high
peak of $108 billion in 2007-08. After the global
crisis, these flows fell to a small $7.8 billion in
2008-09, but quickly bounced back to $51.8 billion
in 2009-10 and $57.3 billion in 2010-11. Thus recent
flows have been substantial, even if much below the
exceptional peak in 2007-08, resulting in an increase
in foreign exchange reserves in most years.
In sum it is not the volume of capital flows that
is a problem, but the fact that the trade and current
account deficits on India's balance of payments have
been rising in recent times. Though capital inflows
have been more than adequate to finance the current
account deficit in most years, the presence of that
deficit rather than the outflow of FII investments
seem to be responsible for the rupee's weakness. Thus,
neither from the point of view of the rupee's relative
strength or from the point of view of the adequacy
of reserves was the recent change warranted. Hence,
the government would do better to focus on trends
on the trade and current accounts rather than on the
capital account.
However, the evidence suggests that the government
is overcome by an obsession with attracting foreign
capital flows. Prior to the recent move, 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.
One only needs to turn to India's experience during
the balance of payments difficulties of 1990-91 to
realise how fickle such investors tend to be. But
given its inexplicable thirst for foreign finance
the government seems to be ignoring the dangers associated
with excessive flows either of NRI deposits or of
foreign portfolio investment.
*This
article was originally published in the Economic and
Political Weekly, Vol. 47, No. 04, January 28 - February
03, 2012.
