MacroScan (Printable Version) - Thirst for Foreign Capital

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.



Themes > Features	27.01.2012


Thirst for Foreign Capital*

C.P. Chandrasekhar

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.



© MACROSCAN 2012