The Hindu Business Line : ‘No severe sub-prime effect thanks to regulations’

New Delhi, Sept. 28 India might preen on the fact that the recent sub-prime loan crisis that triggered financial market turbulence across the world in major markets has not had any devastating effect on domestic markets, thanks to the necessary regulations to ensure that capital flows — inward and outward — are orderly.

But the just-released Global Financial Stability Report (GFSR) in Washington by the International Monetary Fund (IMF) has sounded the cautionary bugle when it stated that emerging markets’ risks are balanced between slightly lower sovereign risks because of their generally good economic fundamentals and “rising risks in some economies experiencing rapid credit growth and increasing reliance on flows from international capital markets”.

The report highlights in this context hedge funds and other highly leveraged pools of investment capital that are becoming more active in emerging market economies.

They have moved away from their traditional fixed-income instruments there and are seeking other higher-yielding assets — both in equity markets and structured products.

Higher tolerances

While some are operating with higher tolerances for risk and might raise important regulatory issues, the Fund said the line between hedge funds and institutional investors seems to be blurring, with some investment horizons lengthening for hedge funds and narrowing for institutions.

Interestingly, the report documents how investors gain exposure to an emerging market in the presence of capital controls by highlighting the case of India.

Even as direct access to the domestic fixed-income, foreign exchange and equity markets by international investors is either restricted through the qualified foreign institutional investor (FII) programme or closed outright, many global investors are able to acquire exposure to Indian markets while obviating India’s regime of restrictions on foreign participation, the report said.

This is achieved through an increasing number of channels, particularly as derivative markets have grown.

For instance, there is a large and relatively liquid offshore market for India’s interest rates along the full yield curve—up to 10 years.

Stating that the growth of derivatives-related and other transactions opens numerous two-way channels for investors who eye India as a desired destination, the report said foreign investors, including hedge funds, could gain entry into the Indian equity market through the purchase of participatory notes (PN) offered by registered FIIs. These notes permit offshore participants to gain exposure to Indian equities without registering as an FII.

Borrowing channel

The report further states that a borrowing channel for Indian corporates via foreign currency convertible bonds (FCCBs) gets packaged into structured credit products, such as credit-linked notes and collateralised debt obligations (CDOs).

By and large, Indian subsidiaries offshore purchase the credit portion, while hedge funds, proprietary desks of investment banks, and other international investors, prefer the equity option. Indian corporates indicate that access to low-cost financing through FCCBs is worth this minor dilution in their equity stake.

It also observes that given the extant restrictions on portfolio ownership by foreign investors, private sector participation could take an increasingly more direct ownership avenue through private equity direct investments.

In this regard, private equity accounts for a growing share of inflows, much of it targeting real estate related investments.

This development, the Fund said, often makes it difficult to distinguish between foreign direct and portfolio investment.

No doubt, privately placed syndicated loans, domestic credit growth funded by foreign borrowing and carry-trade style external borrowing and growing use of complex credit markets are some of the areas warranting enhanced surveillance in some emerging markets.

New trends

Going by the new trends by investors to gain exposure in emerging markets including India, lessons need to be drawn from the recent sub-prime loan crisis where all these new financial instruments like CDOs and structured credit products have heightened uncertainty while dispersing risks and whither they are ultimately held.

As the Fund rightly says that countries would be better off if flows can both enter and exit freely without disrupting domestic financial stability and the real economy, it is the quality of its domestic financial market — besides strong macroeconomic performance —that would put an emerging market in a position to maximise to the fullest extent the benefits of capital inflows and best deal with their potential volatility.

Perhaps, the mandarins in the RBI, the monetary authority, would ensure that the quality of the country’s financial markets does not deteriorate for want of prudent and well-designed checks and balances before any of the new instruments wreak market mayhem, say analysts.

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