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K. Subramanian

THE relationship between the Reserve Bank of India (RBI) and the Government is more like that between couples. Their differences are not aired in public. Perhaps, for the first time, a major chink is on display in the Report of the Expert Group on Encouraging FII flows and checking the vulnerability of capital markets to speculative flows.

Drawing on the report, many commentators have highlighted the RBI's `No' to participatory notes (P-Notes). However, they have not referred to the more serious difference over the macroeconomic implications of portfolio flows (P-flows). On this, the RBI is not alone. Many academics, economists and political parties, especially the Left, have expressed serious concerns earlier.

The National Common Minimum Programme (NCMP) addresses these concerns and envisages policies, which would not only encourage foreign institutional investors (FIIs) but also reduce the vulnerability of the financial system to speculative flows.

The Expert Group was set up on the directive of the Prime Minister to study the issues and prepare an Action Plan for time-bound implementation. Surprisingly, the Group, as other committees, has recommended that a research programme be initiated in the Department of Economic Affairs on the subject to build a consensus on future policies on capital account.

In short, the Group has remitted the burden back to the Ministry! In part, it is a sop to the RBI, which, while dissenting with the Group, wished that all material be placed in the public domain for a wider debate.

The debate is not new. The RBI Governor voiced his misgivings and, in January had said, "The magnitudes of FDI and FII flows are tending to be large and volatility has perhaps increased. The impact of such flows on the stock markets is discernible."

He went on to add, "There is scope for enhancing the quality of flows through a review of policies relating to eligibility for registration as FIIs, and an assessment of the risks involved in flow through hedge funds, participatory notes, sub-accounts, etc."

In a later speech, he suggested imposition of a tax, on the lines of Tobin, to moderate inflows. In no time, the Finance Minister countered the suggestion and said that the government had no intention of curbing inflows through taxes. The differences seem to run deep. It is clear that the Group could not iron out the differences with the RBI and has given a "divided" report. It is unclear how such a report will help formulate policies visualised in the NCMP.

The report has other weaknesses. Dealing with P-flows and their volatility, the report repeatedly affirms that there is no "significant evidence of volatility in India". This view is based on research done by some academics. Further, reliance on academic work is selective and relates to earlier years. It quotes earlier articles by Prof Dipankar Coondoo of the Indian Statistical Institute, but not his later study on "Volatility of FII in India", published in Money and Finance (October 3-March 4). This study states, "The FII and stock market returns in India exhibit quite high volatility in terms of both extent and duration."

These views are further reinforced by the behaviour of the stock market since last year. The BSE Sensex rose from 5,000 in July 2004 to 7,000 in June and on to 8,000 in November; it crossed 9,200 in mid-December. Given the shallowness of our market, both in terms of number of quoted companies and percentage of floating shares, this rise should unnerve any economist.

The data (page 2 of the report) suggest that the P-flows began to surge after 2003-04. It would, therefore, have been necessary to evaluate the phenomenon on later data. The Group could have requested the RBI or the Securities and Exchange Board of India (SEBI) to provide their findings rather than relying on weak, secondary sources. Further, for the FIIs, stock return is not the only anchor. Work by some others suggest that there is a positive association of FII with return on the BSE, inflation in the US and negative association with inflation in India, return on S&P, ex-ante risk on the BSE, and ex-ante-risk on S&P 500. (Mr K. Rai and Mr N. R. Bhanumurthy, "Determinants of Foreign Institutional Investment in India: The role of return, risk and inflation", The Developing Economies, December 2004.) Other economists relate FII flows to the stability of exchange rate. In other words, the relationship is complex and multi-linear. It can be irrational also.

Unrestricted FII inflows without proper monetary management by the RBI will impact exchange rate and, with the necessity to sterlise inflows, on domestic inflation, prices, etc. Truly, there are costs attached to currency management to be weighed against possible gains.

It was because of the rising volumes that the RBI began voicing concerns over the magnitude and quality of FII flows. The Group could not resolve these critical issues. It decided to set aside the RBI's views through a majority opinion.

At the end, it makes out a case for larger P-flows. It takes a benign view and argues that India Inc. has learned to live with FII. Further, it builds a case for FII as a stepping-stone for FDI. It recommends that FII limits should be exclusive of current FDI limits.

Another issue on which there is serious disagreement is over the treatment to be accorded to P-notes. The RBI wants P-notes banned. Its concerns are that the nature of the beneficial ownership or the identity of the investor will not be known unlike in the case of FIIs registered with a financial regulator.

The Group recommends continuance of the current policy of allowing P-notes and sub-accounts. The basic assumption of the Group is that current regulations are adequate as, with effect from February 3, 2004, P-notes can be issued only to regulated entities and further transfers, if any, can be issued to other regulated entities only. Moreover, the FIIs issuing P-notes are bound by `know your client' (KYC) norms.

The February decision itself was taken after a long delay and debate within the government. Unfortunately, hedge funds, which are hiding behind P-notes, are not registered in any country or with any regulator. Their ownership is opaque and location shifty.

As a measure of caution, the Report excludes countries in the in the OECD's negative list. Now there are only three in the negative list! There are 33 in the `cooperative" list.' These countries are unlikely to help SEBI in any investigation. They are mostly principalities of OECD countries and have power over them.

None of those countries nor the OECD will come to our rescue, as they might not view such security dealings as violations under their laws.

Even Mauritius, a friendly country, did not permit `fishing' while grappling with the Ketan Parekh stock scandal. Thus, any due diligence suggested in the report is on paper. We have been living with this legal fiction for long.

As for KYC requirements, the problem is that reputed institutions such as Citigroup, JP Morgan, HSBC, and Goldman Sachs, operating through their subsidiaries in Mauritius, stonewalled supply of information and took cover behind confidentiality. SEBI itself has been weakened by the reversal of its order on UBS Securities Asia by the Securities Appellate Tribunal (SAT). The SAT pointed out that it is not clear whether it is obligatory for the FIIs to provide information on clients. The Group, as a think tank, could have taken note of these issues and suggested measures to tighten regulations. Sadly, it defends the status quo complacently.

The problem with hedge funds is that they operate in unregulated realms; their dealings are secret and operational methods opaque. Many of them could be overseas corporate bodies (OCBs) which have been banned after the Joint Parliamentary Committee (JPC) report on stock scam. Much of it is `round tripping." The RBI's concerns are real.

Many observations in the Report create an impression that the Group looks upon portfolio flow as the tide to lift us to higher levels of development and the stock market as the channel for funding infrastructure projects, pension funds, disinvestments of PSUs, etc. This is contrary to much of the current work on financial integration.

Two eminent IMF economists observed thus: "Only countries with good institutions and sound macroeconomic policies tend to have lower vulnerability in the risks associated with the initial phase of financial integration and are able to realise its full benefits." (Easwar Prasad and Shang-Jin Wei, "The Chinese Approach to Capital Inflows: Patterns and Possible Explanations", NBER Working Paper No.11306, April 2005.)

The report reverses the order. It does not provide a sound base for policy decisions. It creates more controversies than it seeks to solve.

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)

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