Debating India

ECONOMIC PERSPECTIVES

Too much for comfort

Monday 10 January 2005, by CHANDRASEKHAR*C.P.

The Reserve Bank of India, in its Report on Currency and Finance 2003-04, cautions that if not managed appropriately the surge in capital inflows into India can trigger a financial crisis.

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Too much for comfort
The Bombay Stock Exchange Sensex display board at Churchgate railway station in Mumbai. The Reserve Bank of India has now chosen to distance itself from the view that a rising Sensex delivers.

IT is official now. The recently released Report on Currency and Finance 2003-04 of the Reserve Bank of India (RBI) recognises that, if not managed appropriately, the surge in capital inflows into India could trigger a future financial crisis. That being admitted, there remain two issues to be dealt with. The first is the package of "appropriate" policies to manage the inflow. The second is to answer the imponderable, "when is the future?" Judgments 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.

An increase 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 crores at the end of May 2001 to Rs.4,626 crores 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 FIIs in the Indian 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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