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Note on Portfolio Flows into India

This note discusses the issues raised by the expert group on encouraging foreign institutional investor inflows released in November 2005. The spiral nature of the co-movement of inflows and stock prices warrants testing of the hypothesis that the surge in flows is based only on economic fundamentals or the strength of traded companies. The expert group did not make such an analysis and instead discusses the beneficial aspects of speculation. It quietly ignores the perception that sub-accounts and participatory notes provide the avenues through which some speculative flows could have occurred.

FII flows and capital markets

A Note on Portfolio Flows into India

This note discusses the issues raised by the expert group on encouraging foreign institutional investor inflows released in November 2005. The spiral nature of the co-movement of inflows and stock prices warrants testing of the hypothesis that the surge in flows is based only on economic fundamentals or the strength of traded companies. The expert group did not make such an analysis and instead discusses the beneficial aspects of speculation. It quietly ignores the perception that sub-accounts and participatory notes provide the avenues through which some speculative flows

could have occurred.

A VASUDEVAN

T
he recent surge in portfolio flows into India has, while adding to the country’s foreign exchange reserves, generated concerns about the stability of the financial sector. An expert group was formed under the chairmanship of Ashok Lahiri, chief economic adviser in the ministry of finance, government of India to examine this development. ‘The Report of the Expert Group on Encouraging FII Inflows and Checking the Vulnerability of Capital Markets to Speculative Flows’, released in November 2005, and placed on the website of the ministry of finance was not a unanimous one. The representative of the Reserve Bank of India (RBI) who was a member of the expert group gave a minute of dissent. It is the dissenting note that gave an aura of respectability to the report and is perceived as the government’s way of articulating its general agreement with the notion of autonomy of the central bank of the country.

We shall in this brief note discuss the issues raised by the expert group report. In doing so, we shall touch upon some of the critical aspects that need to be kept in view, in terms of the choice of policies to promote the ultimate objectives of economic growth along with financial stability. It is in the working out of the ways of achieving the ultimate objectives that there could be differences in perceptions. How one would view the processes that secure what is considered as sound financial stability and how the notions of soundness and financial stability are specified are at the heart of these differences.

Literature on Portfolio Flows

There is no standard theoretical construct relating to portfolio flows. In the early literature, foreign investment was viewed essentially in terms of foreign direct investment (FDI), a view that was given, as economic historians would recall, policy relevance in the Leninist New Economic Policy for the erstwhile Soviet Union in 1924. The rationale of FDI flows, it is well known, is that foreign savings supplementing domestic savings would help augment investment that in turn would push up growth, given the productivity of investment. However, productivity of investment would get a boost either simultaneously or with a short lag, when FDI provides technological improvements along with financial flows.

Portfolio flows by definition are not the same as FDI. Portfolio flows that began to make a mark first among the industrialised economies in the 1980s and subsequently in the emerging market economies among the category of developing countries could also raise the saving rate in case the additional expenditures incurred in the stock markets by foreign investors translate, in the next round of societal expenditures, into a marginal propensity to consume (MPC) that is less than unity. It is however not easy to quantify the savings that may be generated from the increase in gross national expenditures triggered by portfolio flows.

More importantly portfolio flows provide liquidity to capital markets and raise expectations of growth in trading volumes. The flows create additional financial resources. There is a presumption that in the case of flows in the primary issues market, the recipient corporations would be enabled to use the additional resources efficiently. This presumption is based on the argument that the flows reduce the cost of capital. Where the flows are in the secondary market, the additional resources tend to increase the stock prices.

It is here the monetary policy-makers’ concerns are relevant. The liquidity impact of portfolio flows could reduce the computational costs for monetary policy authorities who are required to often determine the optimal liquidity requirements of the economy. On the other hand, huge surges in portfolio flows could lead to inflation expectations particularly when downward risks to output growth are severe. The inflation expectations could arise either because of the monetary impact of the rise in foreign exchange reserves or due to sharp rise in consumption of goods and services generated by the wealth effect left behind by stock price boom. Besides, sharp changes in net inflows would lead to changes in the exchange rate of the rupee that would have implications for trade and investment policies. Monetary authorities would also be required to examine whether a stock price collapse is probable and whether that would have an impact on the financial system. Even where the collateral of stocks and shares is not much in vogue due either to law or to tradition, the financial system could still face credit and market risks in case other assets that are pledged or used as collateral are created on account of the wealth effect of the initial stock price boom.

Monetary authorities in emerging market economies would normally ensure that banks and other financial intermediaries adopt risk management strategies and undertake measures such as fixing of lending margins and quantitative ceilings on certain types of lending. But where there is information asymmetry, there would be

Economic and Political Weekly January 14, 2006

the “lemons” problem. This could also explain why at times the surges in flows exhibit tendencies of “herd behaviour” on the part of the foreign investors.

The expert group report has examined the analytical arguments relating to foreign investment flows along with a good many references to the theoretical and empirical literature. It also provides details about the determinants of foreign investment flows. It is not surprising that irrespective of whether the flows are of the FDI kind or of portfolio investment in primary or secondary markets, investors are said to be led by perceptions about the earning prospects of corporations. In other words, the rates of return on portfolio/ direct investment, net of taxes, would be one of the critical factors in the decisions to invest. For this purpose, good data based on sound methodologies on a frequent basis are necessary. Besides, transparency practices and communications are required to eliminate any possible lemon problem.

One could add other major determinants of foreign investment flows, including the creditworthiness of recipient countries, economic situation in the source countries, regulatory framework in both the source and recipient countries and perceptions of investors about the need for diversification of their investments, based on calculations of the probability of the associated risks. However, only empirical work would establish as to whether the determinants of foreign investment flows are relevant for particular countries and if so, to what extent.

Report of Expert Group

The evolution of policies on foreign direct investment and portfolio flows since 1992-93 provided in the expert group report is exhaustive and fascinating. There has been, as the report shows, a conscious attempt to encourage inflows with limits being set by a sufficient amount of qualifications. Foreign institutional investors (FIIs) manage both equity-related and debtrelated funds. Funds in the sub-accounts comprising foreign firms and individuals with high net worth are managed by domestic portfolio managers registered as FIIs. In addition, there are participatory notes (PNs). PN is a derivative that operates as an alternative to sub-accounts.

The sharp surge in portfolio investment since 2003-04 coincides with the general upturn along with low interest rates in most industrialised economies. Flows from FIIs have averaged almost $ 10 billion a year since 2003-04. This is also the period when stock market performance as reflected in the movements of the Sensex of the Bombay Stock Exchange and S & P CNX Nifty of the National Stock Exchange has been very buoyant, especially in the last four months. Going by the data released by the RBI in its Bulletin of December 2005, the average BSE sensitive index (base: 1978-79=100) rose from 4,492.19 to 8,220.45 in October 2005. At present it is hovering around 9,400. The National Stock Exchange’s S & P CNX Nifty averaged 1,427.50 in 2003-04. It stood at 2,486.78 in October 2005. At present it is around 2,800. The new issues market has also been active. Equity shares issued by non-government public limited companies amounted to Rs 2,323 crore in 2003-04; they stood at Rs 6,621.7 crore in the first six months of 2005-06.

The expert group report indicates that the inflows have led to an increase in stock prices, reflecting thereby the large earning prospects of Indian companies. It must however be recognised that stock prices have been on the upward incline since 2003-04, and the Indian rupee has appreciated vis-à-vis the US dollar with inflows. This enabled FIIs to reap high returns. After the positive effects of inflows on stock prices in the initial rounds, the upward movement of stock prices in the subsequent rounds too seems to have influenced FII flows. This suggests that there is a spiral at work, making it difficult to determine as to which – the FII flows or the stock prices – is the cause and the effect.

The spiral nature of the co-movement of inflows and stock prices would warrant testing of the hypothesis that the surge in flows is based only on economic fundamentals or the strength, both contemporary and potential, of the companies traded in the market. Such an empirical exercise would have given some idea as to whether there is any speculative element in the inflows. The expert group did not come out with any empirical analysis of the nature of flows, even though it is supposed at least, as the title of the report suggests, to “check” the vulnerability of capital markets to “speculative flows”. The report, on the other hand, discusses the beneficial aspects of speculation. It quietly ignores the perception that sub-accounts and PNs provide the avenues through which some speculative flows could have occurred.

Detailed data dissemination about the amounts that keep flowing into subaccounts would give some idea of the nature of flows. But such data are not readily made available. It is also not clear from the expert group report how much of the investment in sub-accounts of registered FIIs is attributable to hedge funds. While the sources of flows into sub-accounts are known to the official agencies, it is not clear whether the authenticity of the sources were checked with any official/credible agency of the source countries. The expert group, however, gave information about the PNs which shows that they, as a proportion of net FII investment (equity and debt) during the period September 2003 and March 2004, averaged 26.35 per cent. This percentage increased to 32.69 in 2004

05. Between April 2005 and August 2005, this proportion was still higher, with the average at 40.31 per cent. As the ultimate investor of a PN is not identified, the large surge in the amounts held in the form of PNs and the misgivings about the subaccounts should be viewed with concern. It is against this factual position that the minute of dissent by the representative of RBI needs to be understood. The dissent is obviously guided by a complex combination of considerations of financial stability and monetary and fiscal management.

The spirit underlying the international standards and codes relating to anti-money laundering would also suggest that a determination has to be made as to whether the flows, in entirety or in parts, in the subaccounts and in the form of PNs are speculative and whether the flows are guided entirely by considerations of the country’s fundamentals. The expert group skirts the issue by suggesting that any move to abolish PNs or to place restrictions on such flows could be seen as “rollback” of reforms. The arguments that a number of countries attract significant amounts through the medium of offshore derivative products and that flows would be “clean” since they are effected through banking channels are hardly relevant.

In the light of the above arguments, it would be in the interests of growth along with stability to wind up these two channels of inflows within a given time frame. Such a policy measure would establish India’s determination to ensure that the policy towards foreign investment flows is credible and would not give rise to any needle of suspicion that the policy leaves open the door of money laundering ajar.

If sub-accounts and PNs are wound up, a question would arise as to whether there would be a decline in FII flows into the country. The answer lies mainly in

Economic and Political Weekly January 14, 2006 administering the limits on FII investments in a flexible manner, together with initiatives to encourage the growth of new issues by both government and non-government public limited companies. In addition, commitment to improve the transparency of policies and procedures and detailed data dissemination about the economy’s working would help to ensure that foreign investment flows, both of direct and portfolio varieties, would grow and be durable. It is also necessary to intensify research on the economy’s prospects and financial stability so as to provide substance to evaluations of the strength of economic fundamentals.

EPW

Email: asurivasudevan@hotmail.com

Economic and Political Weekly January 14, 2006

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