Capital Market Integrity and Stability

which do not have reputational risk or are unregulated”, may be prohibited from registration as sub-accounts.7

The recommendations listed above are intended to serve the dual goal of market integrity and stability. There are two other proposals which are addressed solely for lending stability to the capital market. First, participation of domestic pension funds in the equity market, it is suggested, will augment diversity of view in the market and tend to make share prices less volatile. Second, the EG recommends that FIIs be permitted to switch between equity and debt instruments. Such operational flexibility, it is claimed, “will induce more ‘balanced’ strategies” on the part of FIIs and contribute toward stabilisation of domestic capital markets. This along with the fact that FII investment in debt is denominated in domestic currency8 warrants,according to the EG, a progressive switch from the current ceiling on the aggregate stock of (FII held) debts to a cap on their annual flow.

The approach and recommendations of the EG raise several important analytical and policy issues. The most crucial of these relate to the effects of FII flows on (a) aggregate and sectoral investment; (b) behaviour of financial, including foreign currency, markets with special reference to their volatility; and (c) efficacy of fiscal and monetary instruments in attaining the objectives of macrostabilisation and growth. Our analysis of these issues and appraisal of the REG are organised as follows. Section II abstracts from volatility of FII flows, examines their macroeconomic impact in the light of the Indian experience, and draws some policy conclusions regarding the role of such flows. Section III addresses the issue of volatility in the Indian context. Drawing on the analysis in these two sections a critique of the EG recommendations follows in Section IV. The final section concludes.

*RBI hb 03-04, tab 153. *RBI hb 03-04 tab 153. *last data updated from RBI AR.

capital accumulation over saving, elementary economics tells us, exactly equals the net inflow of foreign capital. Before examining the relevance and implications of this line of reasoning for policies relating to external capital inflows in general and FII in particular, it is instructive to take a look at the temporal behaviour of investment, capital account transactions and other related variables in the Indian economy over the period 1992-2005.9

Table 1 provides a profile of some macroeconomic and external sector indicators during the reference period. The trajectory of the indicators does not support the conventional wisdom regarding the role of foreign capital summarised above. There was little relationship during the period (especially during 1992-2002) between aggregate investment and capital account balance, that reflects the net aggregate inflow of foreign capital other than the change in RBI’s external asset-liability position.

Third and perhaps the most important for policy prescription, except for 1992-93 and 1995-96, during the entire 13-year period, capital account balance exceeded, often by a substantial margin, the country’s current account deficit, with the three-year spell 2001-04 being characterised by a surplus in both current and capital account. Since the EG makes no mention of this important macroeconomic phenomenon, a few words on its significance for policy purposes appears to be in order.

An excess of capital account balance over current account deficit implies that a part of foreign capital is being used for acquiring financial assets abroad, not for bridging the investmentsaving (or the import-export) gap.10 When capital inflows are positive despite the country running a current account surplus

– as was the case in India during 2001-04 – a part of the country’s saving along with the entire amount of (net) capital inflow is lent or invested abroad. Under these conditions the short and long-run consequences of foreign capital for the macroeconomy as well as government finances are far from salubrious. In order to appreciate why, it is useful to identify the routes through which capital inflows affect investment, income and other macroeconomic variables.

Under the neoclassical economic analysis, inflow of foreign capital tends to cause exchange rate appreciation and hence an increase in net imports of goods and services. The consequent fall in domestic demand lowers interest rates, which in turn helps raising investment and reducing saving. Thus even in the orthodox model foreign capital does not cause an equivalent increase in investment: a part of the flow ends up in augmenting domestic consumption. The macroeconomic effects of capital inflows become radically different when the economy is bedevilled with demand deficiency or the price mechanism fails to ensure full employment in the short and medium run. The reason is that (in the absence of central bank intervention) the exchange rate adjusts immediately to capital inflows, but interest rates (especially the lending rates of financial institutions), wages and product prices are slow to fall in response to a decline in aggregate demand. Hence arises the danger of large-scale capital inflows causing a reduction in output and employment rather than fuelling an increase in domestic investment. In fact, the associated decline in capacity utilisation and profit is likely to reduce investment and magnify the negative impact of foreign capital on the level of domestic economic activity.

In terms of the chain of causation operating under sluggish wage-price-interest adjustment, it is not very difficult to appreciate why surges in capital inflows into the Indian economy have been accompanied with a declining trend in GDP growth and domestic capital formation. Thanks to a fall in public especially infrastructural investment from 1995-96 onward and monetary squeeze effected in that year, the period since the mid-1990s has been characterised by demand deficiency, fall in capacity utilisation and slowdown in private investment. Under these conditions external capital receipts may be expected to aggravate the problem of demand deficiency and make private producers still more chary of adding to their productive capacity [Rakshit 2004]. It is in this context that the Reserve Bank of India (RBI), faced with burgeoning capital inflows, undertook massive purchases of foreign currency since otherwise there would have been a sharp rise in the value of the rupee and a further widening of the output gap. However, the resulting accumulation of reserves was not costless to the economy. Since these costs figure nowhere in the EG’s discussion, it appears important to reiterate their nature and significance for the Indian economy.

Note first that the yield on RBI’s forex reserves, held in the form of short-term US or EU government securities, is significantly less than that on foreign capital invested in India. This implies a diminution of the country’s GNP on account of holding forex reserves in excess of what is required for management of external account. Taking the yield differential to be 6 per cent and the excess reserves to be USD 100 billion, the income loss on this account thus comes to USD 6 billion, or more than 1 per cent of the country’s net national product.11

No less important are the fiscal (or quasi-fiscal) costs of accretion to forex reserves. In order to keep money supply at the targeted level, RBI had to undertake sterilisation of reserves on a massive scale, balancing its purchase of foreign currency with sale of government securities. Indeed, the cumulative sale of government securities had been so large that by 2003-04 RBI holding of GoI securities became too small to conduct open market operation on the required scale (see the table). Hence, a new financial instrument called the market stabilisation bond (MSB) had to be introduced for sterilisation of accretions to reserves. Issue of MSBs (like that of ordinary government securities) adds to public debt, but their proceeds cannot be used by the government for financing its expenditure. These developments have produced three types of adverse effect on the budgetary balance.

The first has occurred through a sea change in the RBI’s assetliability position, with massive switch to low-yielding forex reserves from (relatively) high interest GOI bonds. This causes a fall in RBI profits and hence in government revenue, remembering that central bank profits accrue to the Treasury by way of dividends. Such fall in government revenue is due to reserves accretions in the past, not to current capital inflows leading to a cutback in net (flow) of RBI credit to the government. The cutback involves a loss of seignorage revenue for the government and constitutes the second source of quasi-fiscal cost. Since while at a conservative estimate, the safe level of seignorage lies between 1.5 and 2.0 per cent of GDP, net RBI credit to the government has been persistently negative in recent years, the cost by way of loss of seignorage revenue has by no means been negligible (see the table). The third type of cost arises from MSBs. Government expenditure financed through borrowing adds to public debt no doubt. But against that there is also benefit, present or future: while public consumption is welfare enhancing in the current period, government investment raises GDP and future revenue. For issuance of MSBs, against the increase in public debt and the consequent (future) cost of debt servicing, there is no increase in current welfare or government’s revenue potential. There is thus little economic sense in encouraging capital inflows if instead of promoting investment they find their way into RBI holding of forex reserves.

Finally, as we have argued elsewhere [Rakshit 2003], in a demand deficient economy, the cost of foreign capital is significant even when it is used for financing domestic investment: from the viewpoint of the economy as a whole the opportunity cost of domestic resources in such an economy is zero,12 but use of capital inflows involves the burden of meeting foreigners’ claims on domestic income due to these flows. Hence reliance on foreign capital may be justified when (a) the economy operates close to its full employment level; and (b) the return on investment does not exceed at the margin the cost of a cutback in private or public consumption.13

The foregoing analysis suggests some glaring deficiencies in the EG’s views on the investment enhancing role of FII. These limitations arise primarily from a lack of macroeconomic perspective and the lack of an appreciation of the linkages between capital inflows and the behaviour of the domestic economy. Particularly noteworthy in this regard is the absence of any mention of excess capacity, declining trend in investment, accumulation of forex reserves, sharp fall in RBI holding of public debt, issue of MSBs and negative net RBI credit to the government – features of the Indian economy which are closely related to capital inflows and of immediate relevance for policies related to FII and other forms of external funds. No wonder, the main issues concerning FII in India are hardly addressed in the report.

The EG does not seem to realise that measures for encouraging or controlling FIIs should form part of an integrated policy package for all major categories of capital receipts – FDI, FII, commercial borrowing, ADRs/GDRs, NRI deposits; otherwise the resulting flows are likely to be suboptimal or even counterproductive. The reason, our earlier analysis suggests, lies in the fact that the macroeconomic consequences of FII depend (among other things) on the magnitude of total capital inflows. Encouraging FIIs without any reference to other types of capital receipts may well reduce domestic investment and/or saving and produce considerable fiscal stress. Again, as we shall presently discuss in the next section, since the “country” risk perceived by international investors is positively related to scale and composition of external liabilities of the country, a partial approach to setting policies for different categories of capital flows is prone to end up making their costs larger than benefits.14

There is also little recognition in the REG that for reaping the benefit of external capital, the absence of an output gap is not enough; it is necessary to ensure that investment demand exceeds full employment saving. We have discussed how in an economy with an output gap capital inflows have negative consequences for investment, growth and fiscal viability. Now consider the case where with no demand deficiency to begin with, the country receives large foreign capital, but there is no change in investment demand. Under instantaneous adjustment in exchange rate but not in prices, wages and interest rates, the result will be a fall in output, employment, fiscal balance and investment – a process that may be fairly long drawn and generate its own momentum before being reversed. It is for this reason that foreign capital inflow is beneficial when it follows or accompanies a surge in domestic investment. This has some major policy implications which figure nowhere in the analysis or recommendations of the EG.

First, apart from macro policies for keeping the economy close to the full employment level, rapid expansion of infrastructural facilities is essential before measures for encouraging external capital inflows are put in place. In fact, the (first) two policies constitute the most effective means of boosting private investment, domestic as well as foreign, and paving the way for a productive use of external capital receipts.

III Vulnerability of Financial Market

There is a general agreement among economists that unlike FDI, which is governed by long-term fundamentals of the economy, FIIs are driven mostly by short-term expectations, characterised by “herd” behaviour and prone to be volatile. Hence these flows tend to make financial markets vulnerable and may end up landing the country in a currency/payments crisis. While considering the optimum scale and composition of capital inflows, policymakers (apart from the factors noted earlier) have thus to take into account volatility of the flows and the costs associated therewith. As the exchange rates, interest rates and share prices become volatile due to sudden surges in inflows and outflows, there is a rise in amplitude of fluctuations in output and employment; producers become wary of investing or entering into any long-term commitment; and economic activities get seriously distorted. It is for this reason that FIIs and other easily reversible capital flows pose serious obstacles to monetary and fiscal authorities in attaining the twin objectives of macrostabilisation and growth.

A country may seek to resolve the aforementioned problems by (a) controlling capital flows, especially those which are volatile; or (b) building up adequate forex reserves, as many an Asian nation (including India) has been doing since the east Asian currency crisis. However, accumulation of reserves as we have seen entails significant loss which may outweigh the benefit of foreign capital. This is especially true of FII. To see why, consider the case where not only is the output gap zero, but there is a surge in investment demand – a most favourable scenario where FII can be expected to augment domestic capital accumulation.

A basic presumption of the EG seems to be that there is a direct, if not one-to-one effect of FII inflows on domestic capital accumulation – a notion we have tried to disabuse in some detail in Section II. In the absence of an output gap FIIs, as we have emphasised, can help raise investment when preceded by a stepup in domestic private or public investment demand not directly financed through other types of capital inflows; otherwise, the economy is likely to pay a heavy price in terms of a fall in investment, GNP and government revenue including seignorage. Viewed in this context the group’s recommendations for reckoning FII ceilings over and above the prescribed FDI sectoral caps18 and for raising (as an interim arrangement) the composite caps “at a sufficiently high level” do not on their own appear justified from the viewpoint of promoting domestic capital formation. This is apart from the fact that a high composite cap widening the scope for large FII flows will tend to make the capital markets vulnerable and enhance volatility of share prices.

The economic logic adduced by the group for disinvestment of public sector undertakings (PSUs) also seems seriously flawed. There may be compelling reasons for disinvestment, but enlarging the supply of “good quality equities in adequate volume” in order to draw FII flows is certainly not one of them. Disinvestment per se does not raise investment demand. The government may use the proceeds to retire some public debt or borrow less; nor need FII inflows be the best way of financing social sector or other investments when sale of PSU shares is tied (as it is under the National Common Minimum Programme) to an increase in such expenditure by the government.

The recommendation that companies executing large investment projects “should be encouraged to access the domestic market” (so that there is a rise in supply of “good quality equity”) is also somewhat odd. It is possible that FII inflows being associated with a rise in these investments are justified. But the decision regarding whether the companies are to finance the projects through internal funds, term loans from the Life Insurance Corporation or other financial institutions, ADRs/GDRs, or issue of shares and debentures in the domestic capital market should not be guided by the “objective” of encouraging FII flows. In fact, as we have already noted, in view of their effect on volatility and country risk, the FII route is likely to be inferior to ADRs/GDRs, or even long-term commercial borrowing from abroad.19 It is also important to recognise that “encouraging” companies to follow a particular mode of raising funds makes economic sense only if there is some positive externality associated with that mode; otherwise the encouragement violates the spirit of economic reforms!

The EG’s recommendations for preventing “unclean” flows, e g, having a negative list of tax havens and prohibiting unregulated entities (including high net-worth individuals) from using the sub-account/PN route for purposes of investment are unexceptionable. However, as the RBI’s note of dissent records, since the beneficial ownership of PNs is extremely difficult to ascertain by the Indian regulatory authority and they can act as easy vehicles for illegal transactions, banning PNs altogether would address better the concern relating to market integrity.

Whatever the merits of individual measures suggested by the EG, in the absence of a sound macroeconomic perspective they do not add up to a coherent package for tapping FII flows for promotion of basic economic objectives. Given the resource endowment and economic structure of the country, the optimum amount of FII inflows depends crucially on receipts of other types of foreign capital as well as on the aggregated demand for investment. Yet the group’s recommendations are made without any reference to these two factors. Closely related to this are two fundamental omissions which cast serious doubt on the worth of the whole exercise.

First, there is no proper analysis and estimate of the impact of FIIs on major macro variables like investment, saving and GNP; nor does the group go into the monetary/fiscal problems FII flows often create. Second, the group makes no attempt at evaluating the relative merits of promoting/restricting alternative types of capital inflows under the current and expected configuration of the Indian macroeconomy – an evaluation which is essential for recommending policies for FIIs or any other major category of foreign capital.

The absence of an overall perspective and a somewhat cavalier approach to important issues also characterise the group’s stance on sectoral caps. Any economist approaching this issue would like to have answers to the following questions. What should be the criteria for fixing the cap in a particular sector? Why should or should not the FDI and FII caps be composite or separate? If the two caps are separate, how or whether the FII and the FDI caps should be related to one another? Why should the board of directors or the majority of shareholders of a joint stock company decide on the upper limit on FII or FDI shareholding, remembering that (a) there is no such provision for holding on the part of domestic institutional investors; and (b) it is not for a company to decide whether there should be discrimination between foreign and domestic investors? Why should the caps be uniform or separate for different sectors? What are the implications for aggregate capital inflows and their composition for setting (or changing) sectoral caps or caps on an individual FII in a particular firm? Precise answers to such questions are no doubt difficult to provide. But posing the right questions is an essential step towards advancement of knowledge of what are the relevant considerations and important factors to take into account in addressing a particular issue. Otherwise, policy formulation ends up in ad hocism and churning out figures from thin air.

The EG’s last recommendation is for initiating a research programme on ‘Capital flows and India’s Financial Sector: Learning from theory, International Experience and India evidence’. This is certainly a major improvement on the terms of reference of the group; but the ultimate focus of the research should be on capital flows and India’s macroeconomy of which the financial sector constitutes a but not the most important segment.

V Summary and Conclusion

mr'

Email: mihir.raksit@gmail.com.

Notes

1 The chairman of the committee also headed the expert group.

15 To the extent FDI is for takeover of some existing firm, its impact is similar to that of FII or NRI deposits, except for the fact that there is often an improvement in productivity through induction of superior technical/organisational knowhow and gradual diffusion of this knowhow in the rest of the economy.

16 The EG suggests that the rise in share prices due to FII inflows should have a favourable impact on investment. However, apart from the fact that the relation between prices of shares and (even) corporate investment is far from robust in the Indian economy, the EG, our earlier analysis implies, ignores some crucial macroeconomic linkages. In a neoclassical model (with two financial assets, money and bonds) capital inflows raise investment (though by less than the amount of the flow) as the real interest rate falls in response to an exchange rate appreciation. Even with perfectly flexible wages, prices and interest rates, the investment augmenting effect of the inflows will be less than what is suggested in the model since heightened share market activity raises the transaction demand for money balances and hence tends to harden interest rates. With sluggish adjustment of prices and interest rates, capital inflows, as we have explained in the text, can end up reducing investment. This is yet another example of the danger in macroeconomic analysis of relying on “common sense” instead of a coherent model.

17 It is interesting to note that the EG does refer to Chakrabarti (2001) and Mukherjee, Bose and Coondoo (2002) in Chapter 2 in a survey of the literature, but while considering policy options in Chapter 4, makes no mention of these studies and cites only Gordon and Gupta (2003) to buttress its position. One cannot help remembering in this connection one of the most important aspects of the theory of cognitive dissonance. According to this theory, when someone has already a predilection for some position, on hearing arguments for and against it, he remembers the weakest arguments against and the most plausible arguments in support of the position.

18 The group’s citation in support of its recommendation of the original 1992 rule, under which the FII ceiling was exclusive of the FDI limit, is somewhat odd: unlike in a court of law, analysis and empirical evidence, not precedent, should be the touchstone of a policy conclusion.

19 Provided there is no significant bunching of repayment (for the economy as a whole).