These beliefs, which seem to be held by India's policy makers as well, have the unintended consequence of endowing the so-called foreign institutional investors (FIIs) with real power to influence policies. For, short-run movements of stock market indices, exchange rate and foreign currency reserves are essentially generated by the behaviour of the FIIs (foreign banks, insurance companies, hedge funds, pension funds, trust funds, sovereign wealth funds, etc.), who in fact are not investors but "arbitrageurs" engaged in buying and selling of financial assets globally in order to realise gains from price differences. When they pour their "hot" money into portfolio investment in India, stock markets boom and, depending on the nature of intervention by the Reserve Bank of India (RBI), either the rupee appreciates or foreign currency reserves increase or both happen. And the movements are in the opposite direction when the FIIs decide to pull their "hot" money out. The apprehensions of policy makers that the FIIs might pull out if policies are not to their liking and that this would spell disaster for the economy gives the FIIs (as also international consultancy firms and rating agencies, who have some influence on the behaviour of FIIs) an effective say in policy-making.
Behind these beliefs and apprehensions is a presumption that FII inflow augments investment in the economy and hence stimulates growth. It is this presumption that prompted the government to open up India's economy to FII flow in 1992 and to progressively liberalise such flow since then. The presumption has been held so strongly that no need to examine the basis for the presumption has ever been felt. An expert group set up by the government in 2004 was asked to suggest ways of encouraging FII inflow but not to consider the desirability or optimum level of such inflow.
Yet it is hard to find a good reason for positing a straightforward linkage between domestic investment and FII inflow. It is inflow of foreign direct investment (FDI) that augments investment in the economy as it is normally associated with setting-up or expansion of production facilities. By augmenting investment, FDI inflow generates an investment-saving gap and, correspondingly, a current account deficit, which it also finances. But even FDI inflow may not augment investment if the RBI feels compelled to resort to full sterilisation in order to pre-empt both currency appreciation and inflation; for, the consequent rise in the cost of domestic finance lowers domestic investment so that total investment may not increase. FDI inflow then ends up augmenting foreigners' share in India's domestic investment, as also India's foreign currency reserve.
FII inflow works quite differently. In the absence of intervention by the RBI, FII inflow causes currency appreciation and thus a widening of the current account deficit, which must have its counterpart in a widening of the investment-saving gap. But the widening of the investment-saving gap is most likely to result from a fall in saving, since declining exports and cheaper imports encourage consumption, not investment. So, in the absence of intervention by the RBI, FII inflow stimulates consumption thereby widening the investment-saving gap to match the widened current account deficit, which it both creates and finances. If, on the other hand, the RBI resorts to full sterilisation, the only effects of FII inflow are a stock market boom and increased foreign currency reserves.
What makes the FIIs pour money into India's stock markets? One part of the answer is: monetary policy of the United States (the dollar being the prime currency of international transactions) and, to a lesser extent, of Britain, the European Union and Japan (whose currencies are also used in international transactions), which determines the volume of global FII flows. "Quantitative easing" (printing of money when the nominal interest rate has already fallen to zero and hence cannot be reduced), first in the United States and now in the European Union and Japan, has vastly increased these flows globally and its discontinuation would reduce them. The other part of the answer is: asset prices in India relative to those in other emerging economies, which determine whether the flows are into or out of India.
All this also tells us why FII inflow tends to be volatile and brings volatility to stock markets even if the RBI fully sterilises the inflow and uses foreign currency reserve to maintain stability of the exchange rate in the face of outflow. It is clear, too, that only direct controls can be effective in regulating FII flows. Economic policies of an individual emerging economy have little effect on FII inflow into that country; it all depends on monetary policies of developed countries and economic policies of other emerging economies.
By progressively liberalising FII inflow, therefore, the government has been progressively weakening its own autonomy of policy making without bringing tangible benefits to the economy. Indeed, there are tangible risks as neither the government nor the Reserve Bank can do much to prevent boom/bust in stock markets engendered by FII flows. Meanwhile, it is far from obvious how the Reserve Bank can adopt inflation targeting as the focus of its monetary policy when it must remain busy with maintaining a stable exchange rate. And it is not clear how the government can pursue coherent growth and trade strategies if it must be concerned with pleasing the FIIs, the rating agencies and the consultancy firms.
India needs FDI inflow, not FII inflow. Accordingly, it should liberalise FDI inflow and maintain direct controls on FII inflow.
The writer is Honorary Professor at the Institute for Human Development, New Delhi