The Hindu Business Line : Right notes

IN THE EARLY 1990s India's development strategy shifted gear from self-reliance and import substitution to a more positive attitude towards foreign capital by way of foreign direct and portfolio investments. From 1992, after putting in place appropriate restrictions, foreign institutional investors (FIIs) and Overseas Corporate Bodies (OCBs) were permitted to invest in domestic financial instruments. Since then the policy-makers have had to walk the tightrope as they moved away from a regime of restrictions on the type of investors allowed in, the kind of instruments accessible to such bodies, and the limits on such investments. With some hiccups over the last 14 years, the FII policy has been one of slow but steady relaxation. The result is evident in the depth of the capital market and the absence of any sustained volatility. But in a transitional economy, concerns about financial speculation remain and it is with this in mind that the expert committee headed by Dr Ashok Lahiri submitted its report on FII inflows and the vulnerability of the capital market to speculative money.

The terms of reference are significant because they reflect a balanced view on the capital market and foreign investments. The idea is not to stop or discourage FII inflows per se, but to insulate the market from speculative shocks. This non-partisan perspective is evident in the report's views on foreign investments, both portfolio and direct, as debt-free supplements to domestic savings and investments. Flows to the equity market via the FIIs "give higher stock prices, lower cost of equity capital and encourage investment by Indian firms." Foreign investors encourage market reforms and corporate governance. On the other hand, the speculative tendencies in an open environment make the market vulnerable. The report, therefore, looks at the issue of Participatory Notes (PN) — instruments used by foreign funds not registered in the country for trading in the domestic market.

PNs help investors not keen on incurring local transaction costs or keeping accounts put their money in Indian stocks through registered FIIs. But policy-makers are not happy that the identity of such investors remains hidden; they fear these could be channels for the flow of "hot" or tainted money into the capital market, . The rules of the PN game were modified in 1999, but the worry about such derivative instruments remains.

While endorsing the current policies on PNs, the Lahiri report cautions against a over-regulation. The safer bet would be to prohibit capital flows from dubious tax havens. And, second, the report suggests empowering the Securities and Exchange Board of India to demand and receive information about sub-accounts. The Lahiri report's value lies in its balanced view of the linkages among foreign inflows, market deepening and policy reforms, divestment of blue chip PSUs, all of which impact domestic investment and savings and therefore economic growth.