| It
is official now. The recently released Report on Currency
and Finance 2003-04 of the Reserve Bank of India recognises
that, if not managed appropriately managed, the surge
in capital inflows into India could trigger a future
financial crisis. That being admitted, there remain
two issues to be dealt with. First is the package of
''appropriate'' policies to manage the inflow. The second
is to answer the imponderable ''when is the future?''
Judgements on these will decide the package to be put
in place to manage a capital inflow surge.
The reasons why the RBI has chosen to express caution
and distance itself from those self-styled ''market
analysts'' who are drunk with the euphoria that a rising
Sensex and rapidly accumulating paper wealth delivers
should be clear. First, unlike in the past, the recent
surge in capital flows into the stock market has been
more substantial and prolonged. By late December, net
investments in 2004 by foreign institutional investors
(FIIs) alone in Indian stock markets were valued at
$8.8 billion. We must recall that aggregate net portfolio
investment into India during financial year 2003-04
stood at $11.4 billion (as compared with a mere $944
million in 2002-03). So not only has the surge in capital
inflow been sustained, but a substantial share of these
financial flows is accounted for by FIIs.
The surge in purely financial flows has two implications.
First, it triggers a stock market boom that invites
speculative investment in the equity of companies whose
fundamentals seem to matter less than the mere fact
that they have listed shares that are available for
trading. Second, it makes it difficult for the central
bank to prevent an appreciation of the rupee, by buying
foreign exchange to maintain some balance between demand
and supply. Any appreciation of the rupee implies that
foreign investors investing, say dollars, in rupee denominated
financial assets, would when choosing to sell-out and
repatriate that investment get more dollars per rupee.
This is a potential second source of return in dollar
terms, which spurs their speculative instincts even
further.
It is the second of these that seems to bother the RBI
most, since it declares that: ''permitting unbridled
appreciation of the exchange rate during periods of
heavy capital inflows can be a harbinger of a future
financial crisis.'' In sum, the problem of managing
capital inflows involves, besides accumulating reserves
to accommodate possible future outflows, appropriate
management of the rupee to prevent ''unbridled appreciation''.
The other reason why such appreciation needs to be managed
is because of the adverse effects it has on the competitiveness
of India’s exports.
Unfortunately for the RBI, with balance of payments
surpluses remaining persistently high since 2001, as
a result of a combination of current account surpluses
and significant or substantial capital flows, managing
the exchange rate of the rupee has become an extremely
difficult task. As a result of the RBI’s purchases of
the dollar aimed at stabilising the rupee, its foreign
exchange reserve holdings have risen from $42.3 billion
at the end of March 2001, to $113 billion at the end
of March 2004, and well above $125 billion recently.
Increases in the foreign exchange assets of the central
bank amounts 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, has fallen from Rs. 1,67,308
crore at the end of May 2001 to Rs. 4,626 crore by December
10, 2004. There is little by way of sterilisation instruments
available with the RBI.
While partial solutions to this problem can be sought
in mechanisms like the Market Stabilisation Scheme (which
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. As
the RBI’s survey of monetary management techniques in
emerging market economies reported in its Survey of
Currency and Finance makes clear, countries have chosen
to use stringent capital control measures or market-based
measures such as differential reserve requirements and
Tobin-type taxes to restrict capital inflows. Others
have loosened capital outflow norms to expend the foreign
exchange ''acquired'' through large capital inflows.
The RBI’s view, which is clearly biased against regulation,
is that confronted with its growing inability to sterilise
capital inflows, but under pressure to prevent any ''unbridled''
appreciation of the rupee, what needs to be done is
to ease conditions governing capital outflows. It justifies
this on the grounds that empirical evidence on capital
controls and other prudential measures suggest that
''these are unable to reduce the volume of capital flows.
The expected effect vanishes over time as market participants
find ways to evade the controls. Alternatively, the
effectiveness would require progressive widening of
the scope of the controls with long-run costs which
may outweigh the short-run benefits.'' This view, it
must be emphasised, is valid if at all only with reference
to certain market-based measures. And even in the case
of such measures, it does not capture their short-run
efficacy. However, unwilling to experiment with these
or stronger measures, the RBI concludes that, while
‘central banks must inoculate themselves against whimsy
and keep their eyes on the fundamentals’, monetary policy
cannot alter the movement of capital flows; it can only
hope to fashion a credible response to its effects.
If sterilisation as a response is increasingly difficult
to sustain and capital controls are unacceptable, then
efforts to increase outflows of foreign exchange may
be necessary. The RBI outlines the policies adopted
in India in this area so far. They include: substantial
expansion of the automatic route of FDI abroad by Indian
residents; greater flexibility to corporates on pre-payment
of their external commercial borrowings; liberalisation
of surrender requirements for exporters enabling them
to hold up to 100 per cent of their proceeds in foreign
currency accounts; extension of foreign currency account
facilities to other residents; and allowing banks to
liberally invest abroad in high quality instruments.
Implicit in its analysis is the argument that similar
new measures need to be adopted.
Thus, the RBI’s answer to the difficulties it faces
in managing the recent surge in capital inflows, which
it believes it cannot regulate, is to move towards greater
liberalisation of the capital account. Full convertibility
of the rupee is presumably the final goal. The problem
with that judgement is that it ignores the relative
degree of reversibility of the inflows and outflows
involved. It is in the nature of purely financial inflows
of the kind that India currently receives that they
are highly reversible. Driven by the high returns to
be made in the stock market, both from stock price appreciation
and appreciation of the rupee, they would flow in and
remain till such time that they think it appropriate
to book profits and leave.
What is more, the current position of foreign institutional
investors in India market seems to be one where they
can move the market to realise their speculative goals.
As on September 30, 2004, FIIs held 38 per cent of the
free floating shares, or shares not controlled by promoters,
of companies included in the Sensex and Nifty indices.
That figure has risen sharply from 23 per cent on December
31, 2002 and 30 per cent on December 31, 2003. Thus,
it is not just that the share of the major FIIs in marginal
investment flows into markets is high, their holdings
of shares which determine market mood and market movements
is also high. Thus they can move stock prices to levels
they think the market can bear and then book profits
and move out. Put simply, they can manipulate the markets
to milk them.
The problem is that, when the major FIIs move out, everybody
else would follow suit. The behaviour of foreign financial
investors is herd-like both when they come in and when
they choose to leave. As the RBI itself declares, these
flows are much more sensitive to what everybody else
is saying or doing than is the case with foreign trade
or economic growth. Therefore, herding becomes unavoidable.
Thus reserves can diminish as rapidly as they have accumulated
in recent months. But if that is to happen in an orderly
fashion, the reserves to accommodate such outflows must
be available.
Thus far, India has accumulated such reserves, resulting
in the problem of plenty that the RBI faces. Adopting
the policies it now seems to be advocating, would expend
those reserves in ways (such as investments by residents
abroad) that are not easily reversible. It would also
provide avenues for residents to respond to any presumed
danger of rupee depreciation with capital flight. A
crisis is therefore inevitable, as the RBI recognises
in the quotation provided at the beginning of this article.
But this does not seem to influence its judgement of
the appropriate policy package to adopt. The RBI is
right when it says: ''In a scenario of uncertainty facing
the authorities in determining the temporary or permanent
nature of inflows, it is prudent to presume that such
flows are temporary till such time that they are firmly
established to be of a permanent nature.'' However,
the policy direction it is recommending does seem to
run contrary to such wisdom.
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