Jamal Mecklai: Fear of volatility, redux

MARKET MANIAC

The trauma (almost) created in the markets by Dr Reddy's comments on FII inflows last week reminded me of a column I had written over a year ago""December 1, 2003, to be precise""titled "Fear of volatility".

It is, perhaps, worth quoting its opening, since""clearly""the issue is still alive and well.

"Back in the 1970s, a novel called Fear of Flying written by Erica Jong exploded onto the cultural landscape (in the western world).

While I never read it (except for the prurient parts), I understand it was about a woman who had a pathologic fear of flying, which she was able to overcome by engaging in virtually anonymous sex in airplane toilets.

While the treatment was quite arcane, getting over her fear of flying was certainly very useful in terms of her being able to continue a contemporary life.

I believe that India's financial managers suffer""and have suffered for years""from an excessive fear of volatility, and, while I am not, by this reference, advocating that senior RBI officers scuttle into broom closets or anything like that, the point is that any pathological fear limits your ability to live your life.

In other words, the excessive fear India's financial stewards appear to have of volatility has, in my view, been constraining India's growth ..."

Last week's comments, which triggered an instant rebuttal by the ministry of finance, followed by a retraction by the RBI governor, confirms that India's financial managers are no closer to recognising that volatility is a fact of life, and that any attempt to control it without first conquering that fear is doomed to create a repetitive series of boom-bust episodes, each one louder than the last.

Dr Reddy's comments were no doubt triggered by the recognition that nearly half the FII inflows for the year came in the two months of November and December, which was followed by a sharp ($250 million) outflow in the first week of January.

I guess his comment was pointing out that it was difficult to forecast the rate at which international portfolio investors will invest in India.

Well, yes.

That is""and certainly should be""pretty obvious. The flows, which depend on international investors' perceptions of the likely returns from investing in India in comparison with investing elsewhere, without doubt would wobble""and perhaps even change fundamental direction""if fundamental perceptions changed.

The (still unconfirmed) change in view on US interest rates""that they would continue to rise, but at a higher rate""and the dollar""that maybe it won't continue to fall forever, particularly if China does revalue its currency""doubtless affected these perceptions and the future is difficult to forecast.

Except what is certain is that the future will doubtless be volatile. It is the nature of the beast.

But, and this is the key question, what's wrong with volatility? Life is volatile.

Talk to anybody, particularly the poor, whose life is far more volatile than any financial market anywhere. In trying to blindly control volatility rather than coming to grips with this""yes""pathological fear of it, the RBI (and other Indian financial stewards) is, in my view, doing more harm than good to the economy at large and, in turn, the poor, who are""or, certainly should be""focused beneficiaries of any economic policy.

I am not by this suggesting that the RBI""or, for that matter, regulators anywhere""should throw all caution to the wind""laissez-faire is lovely as an academic discussion point, but the real world is the real world.

Rather, I think they need to recognise that the deregulation of the Indian economy""itself begun as a response to the market's demand in 1991 that India has to change""has already proceeded to a point where it is well nigh impossible to keep the winds of global volatility out.

At some level, the policymakers know this""witness the hurried rebuttal of Dr Reddy's unfortunate comment.

Yet, they seem terrified of following this knowledge to its next logical step, which is that if we can't keep global volatility out, we must act to ensure that our markets are strong enough and deep enough and well-educated enough to manage this volatility.

The good news is that, over the past few years, the markets""in particular, the banking sector""have become much stronger.

Whether they are strong enough to withstand the full force of global flows remains to be seen. Many believe they are, a few remain nervous.

And while plunging in (to change) before being 100 per cent certain may seem foolhardy, the truth is that you can never be 100 per cent certain of anything.

And this, as I mentioned in my last article, is one of the conundrums of contemporary financial management""the nature of being a regulator is to try and cover every possible contingency; the nature of life is that you have to jump at some point.

Now, if we are going to jump, we need to have some sort of signal""we don't want to be seen as too foolhardy, do we? And, of course, it is better to heed the signal before you are driven to the wall""as we were, circa 1991.

In my view, I think it is clear""and in some ways, the comic pas-de-deaux we saw last week, between the ministry of finance and the RBI, suggests that the regulators also have a sense""that the market is loudly signaling that it's time for a significant change NOW.

I had actually run into Dr Reddy over the Christmas holidays""on Christmas Day, in fact""and I remember asking him if he was ready to dance. He smiled inscrutably and returned to his family lunch, but I thought I saw him later that afternoon getting out his dancing shoes.

I guess something big is brewing.

(The author is CEO of Mecklai Financial)