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Flawed Analytics

The report of the expert group on FII inflows seeks to go over the arguments for further liberalisation of flows while drawing attention to possible pitfalls in the absence of proper regulation. While the policy prescriptions are conservative, the analysis is full of red herrings. Empirical evidence in the report is adduced in form to quotations from some new papers, and though these may be excellent, basing policy on a tiny bit of work while ignoring a great amount of other evidence is strange, to say the least.

Flawed Analytics

The report of the expert group on FII inflows seeks to go over the arguments for further liberalisation of flows while drawing attention to possible pitfalls in the absence of proper regulation. While the policy prescriptions are conservative, the analysis is full of red herrings. Empirical evidence in the report is adduced in form to quotations from some new papers, and though these may be excellent, basing policy on a tiny bit of work while ignoring a great amount of other evidence is strange, to say the least.


y comments on the ‘Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative Flows’ will be in three sections. First, I will present a brief overview of what most, certainly not all, observers would consider the appropriate analytical apparatus. Second, I will discuss the report. Here I had a hard choice to make – between being honest and polite. Finally, given that I found the report wanting in a lot of areas, I suggest some ways on how the intellectual input in such reports could be improved.

I Nature of Financial Liberalisation

In traditional growth experience (barring the major colonial experience of Britain), financial markets and the “real” economy grew together, feeding on each other in an organic way. Since decolonisation, and the desire for the former colonies to grow faster, “opening up” has been advanced as a quick-fix way for these economies to jump-start their growth process. “Opening up” initially meant producing for the international market and thus was in contradistinction to inward-looking import-substitution. Soon FDI in manufacturing was also seen as beneficial for bringing in the most modern technology. In any case, FDI flows were very stable in nature, i e, not prone to reversals. Finally, and much more controversially, opening up has come to encompass financial flows. Some FDI (mainly in mining and extractive industries) and financial flows (mainly in the form of short-term trade credits) were part of the colonial trade apparatus also.

Financial markets are by their very nature fragile and require constant overseeing by authorities – even the most diehard free marketeer would concede this. One only needs to look at the Japanese experience in the last 15 years to see the pain that a malfunctioning financial system can inflict. In the developing countries, this fragility is compounded by the thinness (i e, underdevelopment) of the markets. Here sometimes the markets are buoyant for no apparent reason, and sometimes depressed. And when they are depressed it is a free fall.

India started opening its financial markets to foreign investors soon after the liberalisation process began in the mid1990s – primarily by allowing FIIs to invest in the stock market. The argument in favour of allowing them, loosely speaking, was that if free trade in goods was going to raise incomes then why not free trade in assets – after all if a domestic producer could get the best price for his/ her product by selling in the international market, why prevent a borrower from borrowing where the cost of doing so was the cheapest? This would provide liquidity to the system. It is by now well established that there are good macroeconomic reasons for not doing so. And this has been borne out by failed financial liberalisations in a number of developing countries.

Let us look at the basic consequences of such flows in a simplified macroeconomic framework (and then turn to why the authors’ analysis is misleading). If India were to liberalise its capital flows, then we should expect the prices of those assets in demand to rise. But these are Indian assets, so India’s exchange rate will also appreciate, squeezing the tradeables good sector – for long discriminated against by an illiberal trading regime. The stock market boom will ensure that some posh people in posh colonies will get rich.

What about the rest of the economy? Here is where the “q” theory of investment is supposed to kick in. The stock market boom will cause firms to invest more given that the market value of investment has gone up relative to cost of buying capital. Somehow, the empirical performance of “q” leaves a lot to be desired. Before turning to the report, two points need to be noted: (1) there does not seem to be any large upward movement in fixed capital formation in India since liberalisation; and (2) the rise in value will occur for firms listed in the stock market, which are less likely to be credit-constrained than smaller firms.

II Red Herrings in Analysis

In this document, the authors seek to go over the arguments for further liberalisation of FII flows, while drawing attention to possible pitfalls in doing so in a completely unregulated manner. While their policy prescriptions are sound (read conservative), the analysis is full of red herrings (read thoroughly incompetent).

Chapter 1 of the study is a brief summary of the Indian experience, so far. Chapter 2 makes the case for why FII flows are desirable, while Chapter 3 looks mainly at hedge funds and their role in making the system more vulnerable. Chapter 4 gives the recommendations

The report in making a case for the FII flows claims (Para 40), “Foreign investment – both portfolio and direct varieties

– can supplement domestic savings and augment domestic investment without increasing the foreign debt of the country”. I have also seen this in the RBI’s Report on

Economic and Political Weekly January 14, 2006

Currency and Finance, so it is part of Indian conventional wisdom. Given that the statement is completely misleading, I prefer to be unconventional and not so wise. First, if a country runs a current account deficit, it is allowing the rest of the world to run up claims against it. To pretend that equity claims are not part of “national debt” may be true if sovereign debt is only what the government owes the rest of the world. Interestingly, General Pinochet tried to reason like that in the mid-1980s. Trade credit stoppage for a few hours had forced him to “nationalise” the private debt. Also FDI, insofar as it goes into new plants, will increase the current account deficit. Later, making a case for FIIs to invest in a bigger way in government securities, it notes that while this would raise “foreign debt”, at least, it is denominated in rupees. There is full convertibility for the FIIs, so the denomination of the debt can only be of second-order interest.

I’ll let that pass. But even if it does not increase the foreign debt, is this a case for unbridled flows? This is mixing up marginal with the average (a sin for which many undergraduate students never make it to the second year of their studies). If India’s current account deficit were Rs 20, then this amount has to be the capital account surplus (say, by selling of assets of an equal amount by Indian firms). Now, a Rs 20 capital account surplus is consistent with a sale of Rs 70 to foreigners and Rs 50 purchase, as it is with a sale of Rs 1,020 to foreigners with a purchase of Rs 1,000. In the first case, a 50 per cent reversal (leaving the surplus unchanged) would be an outflow of Rs 25, whereas in the second case Rs 500. In any case, with India’s current account being more or less in balance, thanks to IT-enabled services, an argument for increased capital flows to finance current account deficits is not even empirically justified.

I draw attention to the report harping on the positive aspects of inflows – liquidity, cost of capital, etc – but on outflows they claim that it would hardly cause a ripple because these flows are very small in relation to the market. As noted above, inflows cause problems and outflows may cause different problems.

There is not the slightest attempt at trying to come to grips with the recent literature. As an example, there are long quotations from Kaldor (1939!) on arbitrage, speculation and the like. Now this was a great paper for its time but to quote from it now

  • well, words fail me. Even if my reading stopped half a century back, a more appropriate place to quote would have been Milton Friedman (1953) on flexible exchange rates. What Friedman said was that flexible exchange rates would not mean that the exchange rate would be very volatile
  • this he attributed to the stabilising role of speculation. That the empirical evidence of last 30 years flies in the face of his touching faith in the working of financial markets, has spawned a large literature. The thrust of this literature is that excess volatility can be rational. Thus, there is nothing in the literature to say that FIIs need to be irrational when pulling out funds from a developing country. They just impart a lot of volatility to the recipient country’s economy. Things can be a lot more problematic if, in addition, they are irrational, subject to fads (these are discussed in the report).
  • To counterbalance this throwback to a prehistoric time, empirical evidence is adduced in form to quotations from a few brand new papers. Again, these papers are excellent but to base policy on a tiny bit of work, ignoring oodles of other evidence is strange to say the least.

    Perhaps the biggest reason(s) why prising the capital account further may not be such a good thing is the continuing budget deficits and the consequent desire on the part of the government (as a borrower) to hang on to the public sector banks. With a (more) open capital account this could blow up in its face. It may not be inappropriate to link this up with the notion of thin markets mentioned above. When interest rates started rising recently, what should any bank holding long-dated government security have done? Unloaded them on the market, of course. Could the State Bank of India do it? Of course not, because that would have killed the nascent market in such securities. Urjit Patel and his coauthors have drawn our attention repeatedly to instances of such “regulatory forbearance”.

    The authors also use expressions which macroeconomists use without understanding them. Two examples should suffice: (a) Para 59 says (in italics!) “…there has been increasing complexity in monetary management with the triple objectives of maintaining orderly conditions in the exchange market, price stability and interest rates. This is related to the idea of the ‘impossible trinity’.” It is as related to the idea of the impossible trinity as it is to foie gras in a Thai red curry! The impossible trinity is precise and says a fixed exchange rate regime, uncovered interest parity and control over the money supply are impossible. (b) They say reversing a policy of capital flows would not be time consistent – well time consistency presumes it was optimal in the first place and no new information has accrued since then.

    III Quality of Research

    It is not necessary for good policy-makers to keep in touch with the latest in academic research, much less to produce intellectually stimulating papers. Japan, Korea China and others have grown without the policy-makers showing deep intellectual capabilities.

    It is surely the winds of change in the Indian economy in recent times that has provoked that a report of this type has been placed in the public domain. There is no denying that this report would have been better off invoking the Official Secrets Act

    – “Winds of change? All wind, no change” as Harold Wilson remarked.

    The danger of adopting policy based on inadequate knowledge and appreciation of the macroeconomic experience in the world can only be remedied (other than following sound, if conservative, policies) by a lot of empirical research by the government agencies. The finance ministry does very little – does it have a quarterly macroeconomic model? – and what the RBI does (going by its web-site) is of the variety: “This equation has been estimated with US data, let me do it with Indian data”. The last exercise is not completely without merit, but there is no substitute for a good macro model with forward-looking behaviour. So many important people have asked in seminars what the “optimal” exchange rate policy for India would be. Do we have any empirical regularities (i e, with numbers), leave aside the issues of optimality?

    Time was when India did not have a macroeconomic tradition. But today there are a large number of Indians (in the age group 30 to 40) in various foreign universities with good PhDs in that field. But to seek their opinion would involve acknowledging that they could know more than the top dogs of North Block or the RBI. And that to the Indian bureaucracy is a fate worse than death.



    Economic and Political Weekly January 14, 2006

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