Much ado about little?

After a rambunctious day on the stock market, it is not clear how much of their objective the government and the market regulator have achieved with their late evening announcement of Tuesday. A de facto limit is proposed to be placed on the issuance of derivative participatory notes, which foreign institutional investors (FIIs) have been resorting to far more than in the past. This has created and will continue to create some selling pressure because of the unwinding of positions. And to the extent that these instruments were non-transparent (the actual investor could hide behind layers of intermediaries), the government may also achieve to a limited extent its goal of trying to stop the round-tripping of domestic money (which is believed to have been going into some active stocks).

The short-term liquidity pressures will fade, however. So while the stock market has been shaken out of its bull-market euphoria (which is welcome), and forced some overseas investors to also re-assess the level of regulatory risk (not so welcome), it is far from clear that anything longer-term has been achieved. If portfolio investment wants to come into India because "" as the finance minister emphasised on Wednesday morning ""nothing about the India story has changed, then all that the proposed step will do is to re-route the money through other windows, most of which remain open. That might explain why, after the initial crash, the market recouped most of its losses fairly quickly. The net drop in the stock index at the end of the day is less than 2 per cent, which makes it little more than an ordinary day in the office.

But the stock market was only the government's subsidiary target, as became clear on Wednesday. The real objective was to slow down the inflow of money through the capital account (running at between 5 per cent and 6 per cent of GDP) and thereby to ease the upward pressure on the rupee "" which has gained more against the dollar than almost all other currencies over the past year. This in turn had begun to slow export growth, and caused job losses in vulnerable sectors like textiles and leather goods. The government has tried to neutralise the inflow by sterilising the money coming in so that it does not impact domestic money supply, but has been only partially successful. The situation is still that if India continues to offer a rapidly growing economy and an attractive market that enthuses foreign investors, the money will continue to come in, especially when world markets are still awash with liquidity. The larger macro-economic management challenge therefore remains, and has not gone away simply because there has been a mini-crackdown on P-notes.

Sebi has said that it will ease the process of getting registered as an FII and thereby getting the regulator's approval to operate in the Indian market. The question to ask is why such a licensing restriction should be there at all. Banks, which are required to follow the rules about knowing who is their customer, are perfectly capable of being the gate-keepers when it comes to funny money, and certainly no less capable than Sebi, which is manifestly unable to find out who is behind the P-notes. Once the Indian market is thrown open, the entire business of foreign portfolio investment should become more transparent, and the limits on foreign ownership in sectors and individual companies will operate as the fencing. Those who want to hide their identities may continue to operate through new tools thought up by the financial community, but that will leave the government and Sebi no worse off than today. Just as the foreign exchange crisis of 1991 was used to usher in overdue economic reforms, the P-note issue should be used to open up the capital market. The side-benefit of opening up will be that the capital market activity that now takes place offshore will mostly come onshore ""which can only be to the country's benefit and to the goal of developing Mumbai as a financial centre.

The final point which needs to be made is that the only long-term solution to the current challenges on financial flows is to improve the productivity and efficiency of the economy, so that producers and exporters neutralise through these gains the pressures that get transmitted through a more expensive rupee. This has to be accompanied by further opening up on imports, to absorb the capital flows which are coming in and which by all accounts will continue to pour in. This translates into action on a broad range of fronts, all of which are well known and have been stated often enough. The tragedy is that the government seems unable to do what is required, for a variety of political and administrative reasons, and is therefore trying to resolve systemic issues with Band-Aid kind of solutions, that most people realise, will not work.