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FII Flows and Capital Market

Letters

FII Flows and Capital Market

T
he four-article evaluation of Foreign Institutional Investors (FII) in the Indian context (January 14, 2006) seems to show that the Ashok Lahiri expert group recommendations are probably right. C P Chandrasekhar and A Vasudevan’s concern about the speculative nature of FII flows and the possibility of money laundering is another instance of speculation about the possibility of speculation in investment and its probable adverse effects – an application of the traditional art of the cautious to prolong debates as a ploy to defer social choice decisions. One should congratulate the Lahiri group that they did not fall into this well known trap.

Vasudevan and Chandrasekhar also suspect that the stock price spiral is largely because of surging FII inflows and is not based on the fundamental strength of the Indian economy or the Indian companies. Just as stock prices and FII flows may show high positive correlation, so do FII flows and the expectations about the fundamental strength and prospects of the Indian economy and companies. It is the investors, long-term or speculative, who make judgments about the prospects because they risk their monies and decide which countries and companies they consider better off investing in/disinvesting from. Economists or finance theorists have so far not claimed the right to develop universally acceptable, scientific, quantitative measures of such prospects for use by all investors. If all investors were to arrive at the same judgment at the same time, there would hardly be any stock market. That all FIIs have the same judgment (they buy/sell as a herd) all the time and therefore can be clubbed as one entity for analytical purposes is yet to be established. So, it is not clear why one cannot interpret surging FII inflows as the result of the judgment of a host of investors around the world that Indian economy/ companies have brighter prospects, even if Vasudevan and Chandrasekhar as investors or otherwise may not be so optimistic about the prospects of the Indian economy (even if their judgment turns out to be correct at a future point of time).

Vasudevan and Chandrasekhar express their worries about the difficulties that the Reserve Bank of India (RBI) may face in conducting its monetary policy if FII flows surged in the manner they have in the recent period and if, for some reason or other, FII outflows suddenly rise sharply. It would be too embarrassing for a central bank if experts think that the RBI expects to operate in an environment that would always remain congenial to monetary policy. A central bank is expected to find its own solutions to enhance the effectiveness of its policy in the face of foreigners buying and selling domestic financial assets. This is a challenge RBI may love to face. It is good that the Lahiri committee did not feel that it was obliged to argue for protection of RBI and exposed the note of dissent (as part of its report) demanding protection of a congenial environment for RBI’s conduct of monetary policy.

Partha Sen correctly emphasises the inadequacy of reference to available empirical evidence and the absence of quality macroeconomic modelling to support the policy prescriptions in the Lahiri committee report (though, like Vasudevan and Chandrasekhar, Sen has his share of speculative conjecture that a FII flow-induced boom in stock market only benefits some rich in posh colonies, while squeezing the tradable goods sector and not positively impacting fixed capital formation). Sen’s suggestions for improvement in quality analytical inputs to policy-making

(Continued on p 528)

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Economic and Political Weekly February 11, 2006

Letters

(Continued from p 450)

will hopefully be implemented in future by the policy-makers. But, if neither Sen nor the expert group have the benefit of quality empirical analysis and reliable macroeconomic models, a policy of encouraging FII flows has at least the same probability of being correct as does a policy of discouraging them.

With T T Ram Mohan arguing that the macroeconomic impact of volatility in stock prices, if any, is limited on many counts and that the perception that FIIs are hot money and inherently destabilising is not borne out by experience elsewhere or in India, the probability of the Lahiri committee’s prescriptions being correct increases to more than 50 per cent. Ram Mohan does not find any reason to dread FII flows. He seems to have answers to manage the uncertainties created by the participatory note (PN) component of FII inflows. Given that the Lahiri committee did not have such quality analytical inputs that Sen would have wished and given Ram Mohan’s analysis, Lahiri deserves compliments for the courage to prescribe policies associated with more than 50 per cent probability of being correct rather than a prescription for discouraging buying and selling of Indian securities by foreigners which has less than 50 per cent probability of being correct. Indian macroeconomic and monetary policy decision-making and management can no longer continue to be set under a forced framework of certainty and insulation from linkages with global environment and practices. We need to pull up our socks, apply our brains and take responsibility for our decisions in the face of increasing uncertainty and risks, irrespective of what quality of analytical inputs we are able to base our decisions on.

BASUDEB SEN

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