Fears are being expressed in official policy circles that
the country's dependence on foreign debt, as opposed to foreign investment, to
finance the external deficit is increasing, leading to specific policy
responses. C.P. Chandrasekhar and Jayati Ghosh examine these fears and assess
the responses.
It began with the Reserve Bank of India's third quarter
2011-12 Review of Macroeconomic and Monetary Developments released on January
23, 2012.
Its assessment of the situation in India's external sector
noted that: “Risk aversion in the global financial markets has slackened the
pace of capital flows to India… If the pace of FDI inflows does not pick up
once again and FII equity inflows revert to the decelerating trend, CAD (current
account deficit) may have to be largely financed through debt creating flows in
the coming quarters.”
It also underlined the fact that signs of a recent revival
of FII inflows were largely on account of investment in debt instruments.
A few days later, the RBI Governor, Dr D. Subbarao,
referring to the rise in debt flows, publicly emphasised that India has “a
preference for non-debt flows over debt flows”, and “within non-debt flows,
more of FDI”.
Along with the expression of such fears, the government has
been liberalising foreign investment rules to attract equity inflows in lieu of
debt. The most recent such policy allows individual investors to invest in
equity.
The justification provided for these fears and policies is
the evidence that investments in Indian equity have decelerated during the
first half of fiscal year 2011-12 when compared with the recent past.
In particular, there has been a collapse of foreign
portfolio investment flows, leading to an overall fall in external investment in
equity.
The RBI has released some preliminary figures for the third
quarter of 2011-12. These figures also point to a decline in monthly
average inflows of foreign equity investments during September-November in the
case of direct investment and September to December 2011 in the case of
portfolio investments. But the decline is by no means dramatic.
foreign debt inflows
These changes have been occurring at a time when the
external current account deficit, which had fallen in the second half of fiscal
2010-11, has risen significantly.
As a result, a rising share of a rising deficit is being
financed with non-equity flows.
The ratio of direct and equity investment flows to the
current account deficit in India appears to have shifted downwards over a
relatively short period of time.
The conclusion arrived at is that India has had to increase
its reliance on debt creating flows to finance its current account deficit.
Supporting that is the evidence that inflows in the form of
loans and banking capital have together risen quite sharply during the first
two quarters of this fiscal year.
Though fully collated figures for the period since September
2011 have yet to be released, there are reports that these tendencies have only
intensified more recently.
According to one report, during calendar year 2011 as a
whole, foreign debt inflows amounted to $8.65 billion, out of which as much as
$4.18 billion came in the month of December. On the other hand, calendar 2011
is said to have recorded a net outflow of equity investments to the tune of
$357 million.
Moreover, foreign debt inflows in January are placed at
$3.21 billion against a much smaller $1.7 billion of equity inflows.
Finally, SEBI figures on net FII investment suggest that
while FII investments in equity have been low or negative for much of the past
14 months, FII purchases of debt instruments have spiked during December 2011
and January 2012.
Nod for QFIs
What does this combination of figures say about the capital
inflows into the country and their role in financing the current account
deficit? To start with, they do point to the fact that, over the last year,
inflows of equity investment have been less buoyant than they were prior to the
financial crisis and during the post crisis recovery.
Secondly, they indicate that one consequence of this has
been an enhanced role for foreign debt in financing the current account
deficit.
However, this does not mean that India is having any
difficulty financing its current account deficit, nor that increased reliance
on debt is driven purely by the need to finance the current account deficit.
Rather, large Indian firms are choosing to borrow abroad to
benefit from the substantially lower interest rates in international markets as
compared with India.
Moreover, the government had, in December, deregulated
interest rates on Non-Resident (External) rupee (NRE) deposits and Ordinary
Non-Resident (NRO) Accounts, triggering a chase for non-resident deposits among
Indian banks.
According to reports, there has since been a surge in NRI
deposits, encouraged by the opportunity to earn profits through arbitrage. This
makes the volume of debt inflow much greater than needed to finance the current
account gap.
As a result, foreign exchange reserves have risen and
remained at relatively high levels.
Despite these factors, the government and the RBI appear to
be using the shift away from equity to debt inflows to liberalise the terms for
foreign equity investment inflows.
Flagging this tendency was the announcement on New Year's
day, 2012, that a new group of foreign investors identified as Qualified
Foreign Investors (QFIs) are to be permitted to invest directly in India's
equity markets.
The definition of who ‘qualifies' is rather broad: it covers
any individual, group or association resident in a foreign country that
complies with the Financial Action Task Force's (FATF) standards and is a
signatory to the multilateral Memorandum of Understanding of the International
Organisation of Securities Commissions (IOSCO), dealing with regulation of
securities markets.
Rationale behind move
Measures such as these are partly explained by the UPA
government's desire to establish that it has not slowed down on reform and to
counter the view that a form of “policy paralysis” afflicts it.
But they are also driven by the need to reverse the slowdown
in inflows of foreign portfolio investment.
The decline in FII inflows has been attributed to
developments abroad, which required foreign institutional investors to book
profits in India and repatriate their funds to meet commitments or cover losses
at home.
The presumption appears to be that individual investors
would not be affected by such compulsions.
The government's press release announcing the new QFI policy
declares that the object of the measure is to “to widen the class of investors,
attract more foreign funds, and reduce market volatility”.
In the last Budget, these investors had been allowed to
invest in Indian Mutual Fund Schemes. The recent announcement takes this a step
further and treats them on a par with FIIs.
The government's view that QFIs would make up for any loss
of FII inflows and that their investment would be characterised by greater
stability has to be tested. But the factors motivating its decision are clear.
Call for caution
One danger is that the new measure allows direct access to
equity markets to entities not regulated in their home country.
When India first began permitting foreign investment in the
equity market, the FII category was created to ensure that only entities that
were regulated in their home countries would be permitted to register and trade
in India. The logic was clear.
Since it is impossible for Indian regulators to fully rein
in these global players and impose conditions on their financing, trading and
accounting practices, controlling unbridled speculation required them to be
regulated at the point of origin.
But this kind of derivative regulatory control can apply, if
at all, only to institutional investors.
Individual investors cannot be subject to such rules even in
their home country and allowing them to enter amounts to giving up the
requirement that only foreign entities subject to some discipline and
prudential regulation should be allowed to trade in Indian markets.
This is of relevance because individual investors are
unlikely to enter India and invest in equity to hold it with the intention of
earning dividend incomes.
The exchange rate and other risks would be deterrents to
such long-term commitments.
If such investors do come it would be with the intent of
reaping capital gains through short-term trades.
Thus, to the extent that the measure is successful, it would
mark a transition towards allowing speculative players greater presence in
Indian markets.
Defending that on the grounds that it would help reduce
dependence on debt is indeed questionable.
Source: http://www.thehindubusinessline.com/opinion/columns/c-p-chandrasekhar/article2866260.ece?homepage=true
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