Subir Roy: India vulnerable to financial risk

VALUE FOR MONEY

In the last two weeks the rupee and stock market indices have touched record highs. India is basking in the glory of being an investment destination of choice which has got most of its macro fundamentals right. But the world has simultaneously been remembering the Asian financial crisis on its tenth anniversary. Hence the issue that has emerged uppermost is whether in savouring the fruits of success, the country has gone low on caution.

A key lesson of the Asian crisis was that full capital account convertibility was not a magic potion and had to be handled with great circumspection. With hindsight, India is credited with having come out of the Asian crisis unscathed because it had some capital account controls in place. Today, those are fast disappearing and the country is moving towards full capital account convertibility at quite a trot. Are we playing with fire without having become an expert in handling it?

The central bank's official position remains that it does not target any specific exchange rate for the rupee and restricts itself to reducing volatility. In the last week it has been seen to be somewhat active in the foreign exchange market, unlike in the April-June period, when the rupee appreciated by around 7 per cent. That was also the period when inflation was seen to be going out of control, and adding to liquidity by buying dollars to keep the rupee down was not an option. Exporters, for their part, have lately become more active in seeking forward cover, even of the long-term kind, and the general expectation is that the rupee will remain firm over the longer term.

All this creates the feeling that the economy has achieved a new equilibrium through a combination of high growth, low inflation, a strong exchange rate and an export sector reconciled to living with a strong currency. The reality is that while longer-term economic fundamentals are indisputably positive, in the near term a lot can go wrong and policy mechanisms do not appear in place to tackle them. The most obvious downside lies embedded in the political scenario.

The current ruling coalition is not immediately threatened but could be if the leftists decide to demonstrate that their bite is as formidable as their bark. If that happens and money starts quitting the stock market and the country, what then? The indices have witnessed a meteoric rise by as much as a fifth in a mere six weeks but lost a tenth in the preceding month. This can happen again. In fact, in the first half of the year, the market ended up where it had begun, gaining not a jot. What is important is to be equipped with the necessary weapons to contain a serious market downside should that come, reduce indices volatility over time, and pursue a path of slow and steady market growth.

Importantly, the tools needed to tackle the present scenario and attendant dangers are not the same as those which stood the country in good stead in 1997. It is restrictions on speculative outflows which came to India's aid ten years ago. Since then restrictions on outflows have been relaxed further. What is critically lacking today are restrictions on speculative inflow, whereas, if inflow is not overly easy, quick outflow and attendant dangers will reduce.

The single-biggest weakness in India's external financial defence appears to be the ease with which investment can come into the secondary market via the foreign institutional investor route. Despite advice from the Reserve Bank of India to the contrary, the investment window through the participatory note route remains.

Any perceptible FII withdrawal will bring the market crashing down in such a manner that there will not be much value left thereafter to take out. This must act as a deterrent to FIIs. While this is true, FII stake in India is very small in their total portfolio but Indian stake in FII investment is enormous. FIIs hold 22 per cent of the BSE500 group of stocks. If they so feel, FIIs can make a fire sale in India, book losses and go home and keep living. If that should happen, India will be in turmoil and suffer a severe shock.

The most obvious way to restrict FII inflow is by constricting the PN route. Plus, and this is perhaps the most important, policy can be geared to raising the role of domestic investors, institutional and retail, in the Indian market. More space can be created for the Indian retail investor to do better in IPOs.

The long-term prospects for the India stock market seem absolutely marvellous and individual investors need to be sold the virtue of carefully choosing scrips and staying invested for, say, five years. They will not do that so long as inflation is high and stock markets are volatile, giving rise to an endless supply of stories of fortunes made on the stock market virtually overnight. There is also the need to develop a debt market, which will happen when the equity market offers chances of steady returns only over long periods and inflation stabilises at a low level.

Once FII inflows are partially curbed, the rupee will stop appreciating steeply. This will restore some of the health of the exporting sectors, removing the fear of job losses. Over time, as the economy continues to perform well and corporate earnings remain on a high growth path, price-earning multiples will go down, thus making the market less volatile and less overheated. There was a time when you could not look a gift FII investor in the mouth. Today, the country can be far more choosey. It needs to be so for its own good. The only thing standing in the way is the reluctance of the government to take away the punch bowl when the party is swinging.

subir.roy@bsmail.in