The Hindu Business Line : Downside of foreign portfolio investment

Foreign investors have poured in over a hundred billion dollars into portfolio investments in India. It was touted as a vote of confidence in Government’s economic policies and the economy. In the stock market boom, they earned returns north of 30 per cent in short time. Some saw triple digit appreciation. In effect, we were borrowing dollars at these rates. For, the return on stocks is no different from interest on dollar debt, except that equity is risk investment and carries no assurance of capital-protection or dividends.

On the whole, the Indian experience with foreign portfolio investment has been mixed. There was a brief period in the nineties when returns were exceptional followed by a lull in the second half of the decade. It was only from 2002-3 that foreigners rode the boom for a length of time. It was also the period when the Government opened up the real estate sector — always the quickest route to profits in a property boom — to offshore investors. However, even earlier there were no restrictions on NRIs investing in property and repatriating capital and profits.

Shortage of capital has always been the stock argument in favour of foreign investment. A developing economy is then supposed to be able to achieve a higher rate of growth. In the good old days, foreign investment meant only direct ownership or investment in industry. Portfolio investment was barely known.

With financial mobility, things have radically changed. Portfolio investment dwarfs the other kind of foreign investment (called FDI). Proponents of the former underplay the distinction between the two, preferring to lump them together as if they are the same. But there is no abstracting from the fact that FDI is ‘patient money’ while the other is ‘hot’ money, ever ready to run, especially when the host economy is at its most vulnerable.

So it is no surprise that portfolio funds in the Indian market are heading for the exit in recent months. If the market could absorb the selling, there is little doubt much more money would leave.

Willy-nilly, therefore, the third world has been drawn into the vortex of currents in the rich world’s financial markets. They too face the risk of a recession or slower growth driven by the credit and bank seizures in the US, Europe and Japan.

Policies to attract foreign investment must be designed to maximise benefits and minimise risk, especially of the systemic type.

Has that lesson been learnt in the current crisis? Have the financial reformers been silenced, at least now?