The best way to deal with capital inflows is to promote additional use of FX for onshore projects |
In the last few months the pros and cons of controls on capital inflows and participatory notes (PNs) have been fiercely debated in the columns of this newspaper. This article reviews the issues involved and at the risk of gross oversimplification the core arguments are: (i) capital inflows meet domestic funding gaps and should be allowed unrestricted entry; (ii) unfettered capital inflows result in Indian rupee (INR) appreciation leading to a drop in export competitiveness and domestic industries are hit by lower cost imports; (iii) the cost of resisting INR appreciation and inflation by sterilising capital inflows is high; and (iv) Offshore Derivative Instruments (ODIs) and Access Instruments (AIs) offered through the medium of Participatory Notes (PNs), before the October 25, 2007, changes instituted by SEBI, allowed non-residents to take non-transparent, leveraged positions. At times of financial stress this could lead to unwarranted volatility in Indian capital markets. |
Indian FX reserves are mostly invested in G7 Treasury securities. The interest rates on these sovereign securities are about 3% lower than interest rates on Government of India (GoI) debt. In 2006-07, the net accretion in our FX reserves was about $36.6 billion. Assuming that the RBI may need to mop up an additional $50 billion in 2007-08 to stem rupee appreciation and inflation would be kept in check by issuing Market Stabilisation Bonds (MSBs), the incremental cost would be about $1.5 billion per annum. In contrast, the 12% rupee appreciation against the dollar since April 1, 2007, has reduced the rupee value of $250 billion of FX reserves by $30 billion (depending on the currency composition of our reserves). The outstanding stock of oil bonds as of end March, 2007, was about Rs 31,000 crore. If this number reaches Rs 50,000 crore in 2007-08, the annual interest expense (not counting principal amortisation) would be around Rs 4,000 crore ($1 billion). In comparative terms, are MSBs as expensive as these have been made out to be? |
External investors want exposure to the Indian growth story. If infrastructure and other constraints begin to bite, the growth story would lose its way "in the dreary desert sands of dead habit" (apologies to Tagore) and inflows would slow down anyway. Otherwise, capital has a habit of finding its way to a higher (risk-adjusted) return. |
India does not have a sovereign wealth management team that is empowered to invest in a range of asset categories (Temasek's rate of return on its $100 billion portfolio has been around 18% and the return on India's FX reserves in 2006-07 was 4.6%). Consequently, concerns about the costs of immunisation have led to restrictions on capital inflows. Simultaneously, in an effort to promote FX outflows, it has been made easier for Indians to make portfolio investments abroad and send out higher amounts of remittances. |
From all accounts, there is continuing uncertainty about the extent of a slowdown in the US economy. On balance, reduced global liquidity may decrease investments into India. It follows, that India should not restrict capital inflows, since these may not last, and look to generate additional economic activity that uses FX resources. |
In the recent past ECBs have been mainly contracted by established companies. This is to be expected since there are interest rate caps on ECBs, which make it difficult for smaller companies to access foreign debt capital. There is little danger of such borrowings being used to speculate on the INR exchange rate since ECBs have to be contracted for minimum maturities of 3-5 years. However, incremental project activity stemming from ECBs contracted by smaller companies may not necessarily result in enhanced use of FX capital. |
Literally, the billion-dollar question is: Is it beyond Indian ingenuity to structure fresh projects which would absorb FX and also be commercially viable? Thinking totally at random, greenfield projects could involve the import/production of sophisticated medical equipment, hydrofoils for inland water transportation and safety systems for railways. |
SEBI's restrictions on ODIs were announced through a press release on October 25, 2007. The revised guidelines include the requirement that FIIs not issue or renew ODIs with derivatives as underlying and that existing positions be unwound over the next 18 months. Given the difficulties faced by foreign hedge funds to gain access to Indian markets the PN route offered by FIIs was popular with off-shore investors. |
The new restrictions may bring some of these players on-shore thereby enhancing transparency. However, these measures cannot reduce capital inflows because derivatives are designed to allow market participants to take leveraged positions with less capital. There are residual ambiguities in SEBI's October 25 press release, e.g. PNs can be offered only to regulated entities but the difference between registered and regulated parties is not explained. The Access Instruments offered by FIIs to off-shore investors usually do not involve derivatives and hence that business should not be affected by the SEBI order. |
On the overarching issue of transparency and identity of foreign investors, the eurobond market developed in the 1960s at the expense of the US bond market thanks to identity and 30% withholding tax requirements imposed by US authorities. This is now a classic business school case study on how not to impose regulatory and tax conditions on foreign investors. In this context, the implications of some taxes on on-shore FII trading do not appear to have been fully thought through. For example, trading gains/losses in spot transactions cannot be set off against gains/losses in derivatives and this discourages FIIs from bringing the latter activity on-shore. Further, SEBI needs to re-examine restrictions on domestic fund managers dealing with international investors. |
To summarise, should the rupee exchange rate be driven solely by capital inflows when the capital account is not fully convertible? My sense is that along with other considerations the progress towards greater capital account convertibility should be in tandem with the lowering of our effective rates of protection against imports. If the Indian growth story continues to be buoyant the only sustainable way to deal with "excessive" capital inflows is to promote additional use of FX for on-shore projects through coordinated efforts across government departments, financial sector regulators and cash rich public sector firms such as LIC. We also need to set up a sovereign wealth manager. Separately, SEBI needs to openly discuss the technical and tax issues surrounding FII investments in a series of public seminars. |
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