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On Liberalising Foreign Institutional Investments

This paper critiques the approach and recommendations of the 2004 government of India expert group on foreign institutional investment flows. The groupâ??s approach raise several important analytical and policy issues. The most crucial of these relate to effects of FII flows on (a) aggregate and sectoral investment; (b) behaviour of financial, including foreign currency, markets with special reference to their volatility; and (c) efficacy of fiscal and monetary instruments in attaining the objectives of macrostabilisation and growth. The article examines the macroeconomic impact of FII flows in the light of the Indian experience, and draws some policy conclusions regarding the role of such flows. It also addresses the issue of volatility in the Indian context. It finds there is no coherent macroeconomic model behind the expert groupsâ??s analysis and recommendations; no appraisal either of the optimal scale of capital inflows or the relative merit of FII vis-à-vis other categories of capital receipts at the current juncture of the economy; and no examination of monetary/fiscal problems associated with FII or of the quantitative impact of such flows on investment and other macro variables.

On Liberalising Foreign Institutional Investments

This paper critiques the approach and recommendations of the 2004 government of India expert group on foreign institutional investment flows. The group’s approach raise several important analytical and policy issues. The most crucial of these relate to effects of FII flows on (a) aggregate and sectoral investment; (b) behaviour of financial, including foreign currency, markets with special reference to their volatility; and (c) efficacy of fiscal and monetary instruments in attaining the objectives of macrostabilisation and growth. The article examines the macroeconomic impact of FII flows in the light of the Indian experience, and draws some policy conclusions regarding the role of such flows. It also addresses the issue of volatility in the Indian context. It finds there is no coherent macroeconomic model behind the expert groups’s analysis and recommendations; no appraisal either of the optimal scale of capital inflows or the relative merit of FII vis-à-vis other categories of capital receipts at the current juncture of the economy; and no examination of monetary/fiscal problems associated with FII or of the quantitative impact of such flows on investment and other macro variables.


There is nothing people can’t contrive to praise or condemn and find justification for doing it –Moliere, The Misanthrope.

I Introduction

major feature of economic reforms in India since 1991 has been a progressive liberalisation of external capital flows, especially non-debt creating ones like foreign direct investment (FDI) and foreign institutional investment (FII). This has led to a surge of capital inflows and has strengthened the country’s balance of payments position. While except for a few strategic sectors (e g, defence production and public sector banking) most entry barriers to FDI have been dismantled or lowered considerably, FIIs are still subject to a number of regulations and controls. The reason is that such flows can be volatile and make the financial system vulnerable. However, since FIIs, it is strongly believed in official circles, have a major role to play in providing a boost to the country’s growth rate, the government appointed a committee in 2002 and an expert group (EG) in 2004 in order to suggest measures for liberalising FII without making the capital markets vulnerable. The terms of reference of the expert group are wider in scope and its proposals include those already suggested by the committee1 [GoI 2004, 2005]. Hence, our focus will be on the report of the expert group (REG), its recommendations and their economic rationale.

It is interesting to note that the EG is called upon to suggest ways of “Encouraging FII Flows” along with adequate safeguards against speculative investments engendering volatility in the capital market. Thus the group is not required to examine either the desirability or the optimum level of FIIs so long as their volatility (if any) can be contained. For its part the EG regards the investment (and growth) enhancing effect of FIIs as unquestionable, and is of the view that volatility of FII flows has not been of much significance for the Indian economy. No wonder, the EG does not pay sufficient attention to factors which govern the salubrious or deleterious impact of these flows on the health of the macroeconomy and the nature of monetary/fiscal policy problems they often create;2 nor does the REG contain well thought out suggestions for checking speculative capital flows. The main problem with FII, according to the expert group, arises from the possible use of the route for money laundering or tainted transactions.

Given the above perception of the EG, its recommendations are intended primarily to (a) encourage foreign institutional investment and (b) preserve market integrity through prevention of contaminated flows, and only secondarily for (c) making FII relatively stable.3 The recommended measures under (a) consist of the following:

  • (i) As in the original 1992 stipulation,4 ceilings on FII if any are to be set over and above the prescribed sectoral caps for FDI.
  • (ii) Where there is a composite cap for both FDI and FII, the policy may continue as a purely transitional arrangement, but this composite cap should be set “at a sufficiently high level”.
  • (iii) In order to augment the supply of good quality equities which FIIs will feel tempted to invest in, EG suggests disinvestment in public sector undertakings (PSUs) and encouraging companies executing large investment projects “to access the domestic capital market”.

    Capital Market Integrity and Stability

    The expert group is in agreement with a number of analysts who have identified FII inflows through participatory notes (PNs) and sub-accounts as major areas of concern since they can undermine market integrity and produce volatility in the system. Sub-accounts are underlying entities (e g, private firms, public companies, pension funds or individuals) on whose behalf an FII, registered with the Securities and Exchange Board of India (SEBI), invests in the Indian capital market. PNs are derivative instruments issued (against some underlying Indian securities) by FIIs to their overseas clients.5 Since sub-accounts and PNs may not be regulated anywhere, it is not very difficult to use these routes for shady transactions. This is especially so for PNs since identity of their ultimate beneficiaries is not easily known or verified.

    Large-scale use of PNs and sub-accounts is also liable to make the capital market unstable. Apart from the fact that derivative instruments like PNs when not properly regulated can engender volatility, hedge funds (outside the control of any supervisory authority) can use sub-accounts and PNs for playing in the Indian market. FIIs may also use the sub-account route to get round the ceiling (currently at 10 per cent) on holding in one firm by an FII: when an FII’s own holding and holdings of its sub-accounts are treated as separate holdings, it is possible for an FII to corner through sub-accounts the entire amount of equities permitted under the sectoral cap. This defeats the objective of diversification of equity holding and makes capital markets, driven by operations of a smaller number of investors, more volatile.

    In view of the above considerations the thrust of the REG is on prevention of the FII route, through PNs, sub-accounts or other devices, from being used for unsavoury and speculative inflows. The following constitutes the main recommendations of the group intended to serve the objective:

  • (1) The EG emphasises the need for drawing up a list of tax havens and barring entities under their jurisdiction from being registered as FIIs.
  • (2) EG suggests continuance of the January 2004 SEBI stipulation regarding PNs. Under this stipulation (a) no further PNs are to be issued to an unregulated entity; (b) FIIs are to follow strictly the “know your clients” (KYCs) principle; and (c) existing non-eligible PNs must expire or be wound down within a period of five years, whichever is earlier. FIIs should also be obliged to provide any information sought by SEBI concerning the final beneficiaries of PNs.
  • (3) In order to address the problem of concentration of shareholding through sub-accounts and the tendency for “herding” arising therefrom,6 The EG suggests that the 10 per cent ceiling should be for the sum of holdings of an FII in a firm and all the sub-accounts having a common beneficial ownership as the FII (with the onus of establishing the absence of common beneficial interest of some sub-account lying entirely with the FII). For preventing unclean flows it is also recommended that “entities
  • which do not have reputational risk or are unregulated”, may be prohibited from registration as sub-accounts.7

    The recommendations listed above are intended to serve the dual goal of market integrity and stability. There are two other proposals which are addressed solely for lending stability to the capital market. First, participation of domestic pension funds in the equity market, it is suggested, will augment diversity of view in the market and tend to make share prices less volatile. Second, the EG recommends that FIIs be permitted to switch between equity and debt instruments. Such operational flexibility, it is claimed, “will induce more ‘balanced’ strategies” on the part of FIIs and contribute toward stabilisation of domestic capital markets. This along with the fact that FII investment in debt is denominated in domestic currency8 warrants,according to the EG, a progressive switch from the current ceiling on the aggregate stock of (FII held) debts to a cap on their annual flow.

    The approach and recommendations of the EG raise several important analytical and policy issues. The most crucial of these relate to the effects of FII flows on (a) aggregate and sectoral investment; (b) behaviour of financial, including foreign currency, markets with special reference to their volatility; and (c) efficacy of fiscal and monetary instruments in attaining the objectives of macrostabilisation and growth. Our analysis of these issues and appraisal of the REG are organised as follows. Section II abstracts from volatility of FII flows, examines their macroeconomic impact in the light of the Indian experience, and draws some policy conclusions regarding the role of such flows. Section III addresses the issue of volatility in the Indian context. Drawing on the analysis in these two sections a critique of the EG recommendations follows in Section IV. The final section concludes.

    II FII Inflows, Investment and Growth

    Behind the terms of reference and the EG recommendations lie the presumption that (absent volatility) FII flows are always investment and growth promoting. The same can presumably be said of other forms of capital inflows, e g, FDI, NRI deposits and commercial borrowing or funds raised through ADRs/GDRs by domestic companies from the international market. The basic logic behind the presumption is as follows. To the extent a country can secure foreign capital, it can raise its investment rate above what would be permitted by domestic saving: excess of domestic

    Table: Some Macroeconomic Including External Sector Indicators

    (Figures unless specified otherwise, are as percentage of GDP)

    1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05
    GDP growth 5.12 5.90 7.25 7.34 7.84 4.79 6.51 6.06 4.37 5.78 3.99 8.51 6.91
    Total Investment 23.61 23.09 26.00 26.90 24.48 24.60 22.57 26.29 24.36 22.95 25.19 27.25 30.10
    Private Corporate Investment 6.46 5.61 6.91 9.58 8.05 7.97 6.39 7.23 5.74 5.59 5.75 6.84 8.25
    Current account balance -1.71 -0.42 -1.05 -1.65 -1.19 -1.37 -0.96 -1.05 -0.78 0.16 0.81 1.44 -0.95
    Capital account balance 1.59 3.54 2.84 1.31 2.96 2.47 2.01 2.48 2.11 1.80 2.13 3.43 4.62
    FDI and FPI 0.23 1.52 1.59 1.38 1.59 1.31 0.58 1.16 1.48 1.70 1.18 2.67 2.09
    of which
    FDI 0.13 0.21 0.41 0.60 0.73 0.87 0.59 0.48 0.88 1.28 0.99 0.78 0.80
    FPI 0.10 1.30 1.19 0.77 0.86 0.44 -0.01 0.68 0.60 0.42 0.19 1.89 1.29
    (increase +/decrease-) 0.33 3.18 1.44 -0.82 1.52 0.94 0.95 1.38 1.32 2.48 3.33 5.22 3.73
    Net foreign exchange
    assets of RBI 3.03 5.98 7.38 6.24 6.93 7.61 7.92 8.56 9.44 11.57 14.54 17.55 19.73
    Net RBI credit to government 0.59 0.10 0.22 1.67 0.21 0.72 1.00 -0.22 0.27 -0.07 -1.28 -2.75 -2.32

    *RBI hb 03-04, tab 153. *RBI hb 03-04 tab 153. *last data updated from RBI AR.

    Source: RBI, Handbook of Statistics on Indian Economy 2004-05 ;GoI, Economic Survey 2005-06.

    capital accumulation over saving, elementary economics tells us, exactly equals the net inflow of foreign capital. Before examining the relevance and implications of this line of reasoning for policies relating to external capital inflows in general and FII in particular, it is instructive to take a look at the temporal behaviour of investment, capital account transactions and other related variables in the Indian economy over the period 1992-2005.9

    Table 1 provides a profile of some macroeconomic and external sector indicators during the reference period. The trajectory of the indicators does not support the conventional wisdom regarding the role of foreign capital summarised above. There was little relationship during the period (especially during 1992-2002) between aggregate investment and capital account balance, that reflects the net aggregate inflow of foreign capital other than the change in RBI’s external asset-liability position.

    Third and perhaps the most important for policy prescription, except for 1992-93 and 1995-96, during the entire 13-year period, capital account balance exceeded, often by a substantial margin, the country’s current account deficit, with the three-year spell 2001-04 being characterised by a surplus in both current and capital account. Since the EG makes no mention of this important macroeconomic phenomenon, a few words on its significance for policy purposes appears to be in order.

    An excess of capital account balance over current account deficit implies that a part of foreign capital is being used for acquiring financial assets abroad, not for bridging the investmentsaving (or the import-export) gap.10 When capital inflows are positive despite the country running a current account surplus

    – as was the case in India during 2001-04 – a part of the country’s saving along with the entire amount of (net) capital inflow is lent or invested abroad. Under these conditions the short and long-run consequences of foreign capital for the macroeconomy as well as government finances are far from salubrious. In order to appreciate why, it is useful to identify the routes through which capital inflows affect investment, income and other macroeconomic variables.

    Under the neoclassical economic analysis, inflow of foreign capital tends to cause exchange rate appreciation and hence an increase in net imports of goods and services. The consequent fall in domestic demand lowers interest rates, which in turn helps raising investment and reducing saving. Thus even in the orthodox model foreign capital does not cause an equivalent increase in investment: a part of the flow ends up in augmenting domestic consumption. The macroeconomic effects of capital inflows become radically different when the economy is bedevilled with demand deficiency or the price mechanism fails to ensure full employment in the short and medium run. The reason is that (in the absence of central bank intervention) the exchange rate adjusts immediately to capital inflows, but interest rates (especially the lending rates of financial institutions), wages and product prices are slow to fall in response to a decline in aggregate demand. Hence arises the danger of large-scale capital inflows causing a reduction in output and employment rather than fuelling an increase in domestic investment. In fact, the associated decline in capacity utilisation and profit is likely to reduce investment and magnify the negative impact of foreign capital on the level of domestic economic activity.

    In terms of the chain of causation operating under sluggish wage-price-interest adjustment, it is not very difficult to appreciate why surges in capital inflows into the Indian economy have been accompanied with a declining trend in GDP growth and domestic capital formation. Thanks to a fall in public especially infrastructural investment from 1995-96 onward and monetary squeeze effected in that year, the period since the mid-1990s has been characterised by demand deficiency, fall in capacity utilisation and slowdown in private investment. Under these conditions external capital receipts may be expected to aggravate the problem of demand deficiency and make private producers still more chary of adding to their productive capacity [Rakshit 2004]. It is in this context that the Reserve Bank of India (RBI), faced with burgeoning capital inflows, undertook massive purchases of foreign currency since otherwise there would have been a sharp rise in the value of the rupee and a further widening of the output gap. However, the resulting accumulation of reserves was not costless to the economy. Since these costs figure nowhere in the EG’s discussion, it appears important to reiterate their nature and significance for the Indian economy.

    Note first that the yield on RBI’s forex reserves, held in the form of short-term US or EU government securities, is significantly less than that on foreign capital invested in India. This implies a diminution of the country’s GNP on account of holding forex reserves in excess of what is required for management of external account. Taking the yield differential to be 6 per cent and the excess reserves to be USD 100 billion, the income loss on this account thus comes to USD 6 billion, or more than 1 per cent of the country’s net national product.11

    No less important are the fiscal (or quasi-fiscal) costs of accretion to forex reserves. In order to keep money supply at the targeted level, RBI had to undertake sterilisation of reserves on a massive scale, balancing its purchase of foreign currency with sale of government securities. Indeed, the cumulative sale of government securities had been so large that by 2003-04 RBI holding of GoI securities became too small to conduct open market operation on the required scale (see the table). Hence, a new financial instrument called the market stabilisation bond (MSB) had to be introduced for sterilisation of accretions to reserves. Issue of MSBs (like that of ordinary government securities) adds to public debt, but their proceeds cannot be used by the government for financing its expenditure. These developments have produced three types of adverse effect on the budgetary balance.

    The first has occurred through a sea change in the RBI’s assetliability position, with massive switch to low-yielding forex reserves from (relatively) high interest GOI bonds. This causes a fall in RBI profits and hence in government revenue, remembering that central bank profits accrue to the Treasury by way of dividends. Such fall in government revenue is due to reserves accretions in the past, not to current capital inflows leading to a cutback in net (flow) of RBI credit to the government. The cutback involves a loss of seignorage revenue for the government and constitutes the second source of quasi-fiscal cost. Since while at a conservative estimate, the safe level of seignorage lies between 1.5 and 2.0 per cent of GDP, net RBI credit to the government has been persistently negative in recent years, the cost by way of loss of seignorage revenue has by no means been negligible (see the table). The third type of cost arises from MSBs. Government expenditure financed through borrowing adds to public debt no doubt. But against that there is also benefit, present or future: while public consumption is welfare enhancing in the current period, government investment raises GDP and future revenue. For issuance of MSBs, against the increase in public debt and the consequent (future) cost of debt servicing, there is no increase in current welfare or government’s revenue potential. There is thus little economic sense in encouraging capital inflows if instead of promoting investment they find their way into RBI holding of forex reserves.

    Finally, as we have argued elsewhere [Rakshit 2003], in a demand deficient economy, the cost of foreign capital is significant even when it is used for financing domestic investment: from the viewpoint of the economy as a whole the opportunity cost of domestic resources in such an economy is zero,12 but use of capital inflows involves the burden of meeting foreigners’ claims on domestic income due to these flows. Hence reliance on foreign capital may be justified when (a) the economy operates close to its full employment level; and (b) the return on investment does not exceed at the margin the cost of a cutback in private or public consumption.13

    FII and Domestic Capital Formation

    The foregoing analysis suggests some glaring deficiencies in the EG’s views on the investment enhancing role of FII. These limitations arise primarily from a lack of macroeconomic perspective and the lack of an appreciation of the linkages between capital inflows and the behaviour of the domestic economy. Particularly noteworthy in this regard is the absence of any mention of excess capacity, declining trend in investment, accumulation of forex reserves, sharp fall in RBI holding of public debt, issue of MSBs and negative net RBI credit to the government – features of the Indian economy which are closely related to capital inflows and of immediate relevance for policies related to FII and other forms of external funds. No wonder, the main issues concerning FII in India are hardly addressed in the report.

    The EG does not seem to realise that measures for encouraging or controlling FIIs should form part of an integrated policy package for all major categories of capital receipts – FDI, FII, commercial borrowing, ADRs/GDRs, NRI deposits; otherwise the resulting flows are likely to be suboptimal or even counterproductive. The reason, our earlier analysis suggests, lies in the fact that the macroeconomic consequences of FII depend (among other things) on the magnitude of total capital inflows. Encouraging FIIs without any reference to other types of capital receipts may well reduce domestic investment and/or saving and produce considerable fiscal stress. Again, as we shall presently discuss in the next section, since the “country” risk perceived by international investors is positively related to scale and composition of external liabilities of the country, a partial approach to setting policies for different categories of capital flows is prone to end up making their costs larger than benefits.14

    There is also little recognition in the REG that for reaping the benefit of external capital, the absence of an output gap is not enough; it is necessary to ensure that investment demand exceeds full employment saving. We have discussed how in an economy with an output gap capital inflows have negative consequences for investment, growth and fiscal viability. Now consider the case where with no demand deficiency to begin with, the country receives large foreign capital, but there is no change in investment demand. Under instantaneous adjustment in exchange rate but not in prices, wages and interest rates, the result will be a fall in output, employment, fiscal balance and investment – a process that may be fairly long drawn and generate its own momentum before being reversed. It is for this reason that foreign capital inflow is beneficial when it follows or accompanies a surge in domestic investment. This has some major policy implications which figure nowhere in the analysis or recommendations of the EG.

    First, apart from macro policies for keeping the economy close to the full employment level, rapid expansion of infrastructural facilities is essential before measures for encouraging external capital inflows are put in place. In fact, the (first) two policies constitute the most effective means of boosting private investment, domestic as well as foreign, and paving the way for a productive use of external capital receipts.

    Second, capital inflows which are directly linked to setting up or expansion of production facilities are much more investment and growth enhancing than those which are not so related: unlike the latter the former effects an immediate enlargement of the gap between investment demand and (full employment) saving, apart from providing the wherewithal to finance the import-export gap. This consideration makes FII inferior to many categories of capital inflows. FDI used for setting up production units and domestic companies accessing international financial markets for executing investment plans push up domestic demand as well as the means of meeting the additional import bill arising therefrom. Hence compared with FIIs and NRI deposits (which are not linked to an increase in investment demand) these inflows tend to have a larger impact on domestic capital formation, effect a smaller fall in domestic saving, and create less problems for monetary and fiscal authorities.15

    Third and related to the second, encouraging FIIs (and NRI deposits) may be justified when there is large demand for infrastructural and other productive investments in the economy over and above the demand coming from FDI and producers who can directly tap the international capital market. In other words, FIIs should follow an increase in investment demand rather than be augmented to kick-start domestic capital formation.16 However, even when FII inflows supplement domestic saving in financing investment, they tend to make the economy vulnerable to both internal and external shocks – something on which the EG’s analysis leaves much to be desired.

    III Vulnerability of Financial Market

    There is a general agreement among economists that unlike FDI, which is governed by long-term fundamentals of the economy, FIIs are driven mostly by short-term expectations, characterised by “herd” behaviour and prone to be volatile. Hence these flows tend to make financial markets vulnerable and may end up landing the country in a currency/payments crisis. While considering the optimum scale and composition of capital inflows, policymakers (apart from the factors noted earlier) have thus to take into account volatility of the flows and the costs associated therewith. As the exchange rates, interest rates and share prices become volatile due to sudden surges in inflows and outflows, there is a rise in amplitude of fluctuations in output and employment; producers become wary of investing or entering into any long-term commitment; and economic activities get seriously distorted. It is for this reason that FIIs and other easily reversible capital flows pose serious obstacles to monetary and fiscal authorities in attaining the twin objectives of macrostabilisation and growth.

    A country may seek to resolve the aforementioned problems by (a) controlling capital flows, especially those which are volatile; or (b) building up adequate forex reserves, as many an Asian nation (including India) has been doing since the east Asian currency crisis. However, accumulation of reserves as we have seen entails significant loss which may outweigh the benefit of foreign capital. This is especially true of FII. To see why, consider the case where not only is the output gap zero, but there is a surge in investment demand – a most favourable scenario where FII can be expected to augment domestic capital accumulation.

    Even in this case however the net contribution of FII to aggregate investment may not amount to much since (i) for preventing BoP vulnerability the central bank has to add a significant part of such flows to its reserves [Rakshit 2002]; and (ii) there is a fall in domestic saving. Add to that the additional income accruing to foreign investors and the GNP increase on account of FII may well turn out to be negative.

    What is no less important to recognise, adequate foreign exchange reserves may enable the central bank in a country like India to maintain orderly movements in the exchange rate and counter speculative attacks on the country’s currency, but not generally in preventing capital market volatility or formation of stock market bubbles. This is the trilemma policy makers face in having a relatively stable exchange rate, effective control over money and capital markets, and unrestricted cross-border capital flows. The trilemma become particularly acute when the flows are volatile.

    The EG does consider the problems of volatility of FIIs, and vulnerability of capital markets arising therefrom. However, the problems are not considered very significant for the Indian economy. This judgment is based primarily on Gordon and Gupta’s findings [Gordon and Gupta 2003] that (a) FII are negatively related to stock market returns; and (b) macroeconomic factors have a significant impact on these flows. The first implies negative rather than positive feedback trading, the second the relative insignificance of purely speculative behaviour on the part of FIIs. Under these conditions one would not expect FII flows to be volatile. This is what Gordon and Gupta find in their empirical analysis. Since the group’s recommendations have been influenced so much by these findings, it is important to examine their robustness and relevance for framing policies relating to FII.

    The Gordon and Gupta study is based on the monthly data of FII flows during the period 1993-2000. There are two major drawbacks which make the findings inappropriate for policy formulation. First, the Asian crisis marked a structural break in the nature and determination of FII [Chakrabarty 2001] – something which the study misses altogether. Second, for examining the degree of volatility and drivers of FII flows, it is necessary to use daily, not monthly data. In fact, taking cognisance of the regime change and use of daily data lead to results that are radically different from those of Gordon and Gupta.

    Chakrabarti’s empirical analysis for the period 1993-99 provides some support to the hypothesis that during the pre-Asian crisis period the causality ran from FII flows to BSE returns; but after the crisis, BSE returns became the sole driver of these flows [Chakrabarti 2001]. This return-chasing behaviour of FIIs and relative insignificance of fundamentals of the domestic economy were confirmed in a later study based on daily data for the period 1999-2002 [Mukherjee, Bose and Coondo 2002]. Other important findings of this study are (i) absence of diversification motive behind FII investments in India; and

    (ii) autocorrelation or inertia of capital flows. These findings suggest strong possibilities of volatility of FII flows and generation of stock market bubbles. In fact, using the same data set, a further study reveals that (a) FII and stock market returns in India exhibit high volatility in terms of both extent and duration; and (b) volatility of the two is inter-related [Coondoo and Mukherjee 2004]. One cannot but wonder at the EG’s making light of the danger of volatility of FII flows on the basis of an inadequate empirical exercise even though much more careful studies yield diametrically opposite results.17

    There is a much more fundamental issue that seems to have escaped the attention of the EG. Suppose there is clear empirical evidence that FIIs in India have not been volatile. Does this support the case for encouraging FIIs? Clearly not. The reason is that results under a specific regulatory regime may not hold when there are major changes in rules under which economic entities operate. This consideration makes it difficult to assess how or whether relaxation or tightening of rules relating to FIIs will affect volatility of FII investment or the underlying relation between it and other variables. A study by Bose and Coondoo (2004) is of some relevance in this connection. On the basis of a time-series intervention analysis of the impact of major policy initiatives relating to FIIs during the period January 1999 to January 2004, it is found that (a) liberalisation policies produce not only an expansionary impact on FII inflows, but also raise their inertia and sensitivity to BSE-returns; (b) restrictive measures also raise the inertia of the flows and their sensitivity to domestic equity returns, but do not show any significantly negative effect on net inflows. While these results are by no means conclusive, they strongly indicate the possibility of heightened volatility of FII flows in the wake of major liberalising measures.

    IV Policy Recommendations of the Expert Group

    In light of our analysis in the previous two sections we examine how far recommendations of the EG, summarised in Section I, are likely to promote investment and growth, and contribute toward a reduction of vulnerability of the financial market to external or internal shocks. Let us first consider the efficacy of the individual measures grouped under the two heads, ‘Encouraging FII Flows’ and ‘Vulnerability to FII Flows’.

    Encouraging FII Flows

    A basic presumption of the EG seems to be that there is a direct, if not one-to-one effect of FII inflows on domestic capital accumulation – a notion we have tried to disabuse in some detail in Section II. In the absence of an output gap FIIs, as we have emphasised, can help raise investment when preceded by a stepup in domestic private or public investment demand not directly financed through other types of capital inflows; otherwise, the economy is likely to pay a heavy price in terms of a fall in investment, GNP and government revenue including seignorage. Viewed in this context the group’s recommendations for reckoning FII ceilings over and above the prescribed FDI sectoral caps18 and for raising (as an interim arrangement) the composite caps “at a sufficiently high level” do not on their own appear justified from the viewpoint of promoting domestic capital formation. This is apart from the fact that a high composite cap widening the scope for large FII flows will tend to make the capital markets vulnerable and enhance volatility of share prices.

    The economic logic adduced by the group for disinvestment of public sector undertakings (PSUs) also seems seriously flawed. There may be compelling reasons for disinvestment, but enlarging the supply of “good quality equities in adequate volume” in order to draw FII flows is certainly not one of them. Disinvestment per se does not raise investment demand. The government may use the proceeds to retire some public debt or borrow less; nor need FII inflows be the best way of financing social sector or other investments when sale of PSU shares is tied (as it is under the National Common Minimum Programme) to an increase in such expenditure by the government.

    The recommendation that companies executing large investment projects “should be encouraged to access the domestic market” (so that there is a rise in supply of “good quality equity”) is also somewhat odd. It is possible that FII inflows being associated with a rise in these investments are justified. But the decision regarding whether the companies are to finance the projects through internal funds, term loans from the Life Insurance Corporation or other financial institutions, ADRs/GDRs, or issue of shares and debentures in the domestic capital market should not be guided by the “objective” of encouraging FII flows. In fact, as we have already noted, in view of their effect on volatility and country risk, the FII route is likely to be inferior to ADRs/GDRs, or even long-term commercial borrowing from abroad.19 It is also important to recognise that “encouraging” companies to follow a particular mode of raising funds makes economic sense only if there is some positive externality associated with that mode; otherwise the encouragement violates the spirit of economic reforms!

    Vulnerability to FII Flows

    The EG’s recommendations for preventing “unclean” flows, e g, having a negative list of tax havens and prohibiting unregulated entities (including high net-worth individuals) from using the sub-account/PN route for purposes of investment are unexceptionable. However, as the RBI’s note of dissent records, since the beneficial ownership of PNs is extremely difficult to ascertain by the Indian regulatory authority and they can act as easy vehicles for illegal transactions, banning PNs altogether would address better the concern relating to market integrity.

    So far as measures intended to curb volatility are concerned, the suggestion for operation of domestic pension funds in the equity market is well taken. The only rider is that individuals should be offered a menu of pension schemes under which the proportion of funds invested in equities may vary, but be subject to a certain ceiling: this will allow less cautious individuals to try their luck in the share market, but restrain them from becoming too improvident.

    There is also merit in the recommendation for including holdings of all sub-accounts as an FII’s own holding while applying the limit on holding by the FII in any one company. However, this may not be enough in curbing volatility in share prices. If the group’s suggestion for raising the composite limit (for FII and FDI) sufficiently or reckoning the (overall) FII limit in a sector over and above the prescribed sectoral cap is implemented, the existing 10 per cent limit for an individual FII holding will in many cases be significant compared with the quantum of floating shares. This is apart from the fact that practically all FIIs, as empirical evidence suggests, are driven by the same factors so that for volatility what matters more is the total FII holding, not simply its degree of concentration.

    Particularly inappropriate in the current context appears to be the recommendation to permit FIIs to switch between equity and debt instruments and to replace the current limit on aggregate debt holding of FIIs with a cap on annual debt flows. In view of the grossly underdeveloped private debt market, FIIs dealings in the debt market trade almost wholly in GOI securities. It is important to recognise that the extent of volatility in this market due to FII operations depends on the stock of government securities held by FIIs in relation to the volume of actively traded securities. So long as the FII holding is small, monetary authorities can exercise some control over interest rates without triggering off large capital inflows or outflows. As RBI’s note of dissent records, removal of the cap on aggregate debt holding of FIIs when there is a substantial interest differential between major world economies and India will make it extremely difficult to manage the exchange rate and interest rate and preserve stability in the financial market.

    Policy Package: Some Yawning Gaps

    Whatever the merits of individual measures suggested by the EG, in the absence of a sound macroeconomic perspective they do not add up to a coherent package for tapping FII flows for promotion of basic economic objectives. Given the resource endowment and economic structure of the country, the optimum amount of FII inflows depends crucially on receipts of other types of foreign capital as well as on the aggregated demand for investment. Yet the group’s recommendations are made without any reference to these two factors. Closely related to this are two fundamental omissions which cast serious doubt on the worth of the whole exercise.

    First, there is no proper analysis and estimate of the impact of FIIs on major macro variables like investment, saving and GNP; nor does the group go into the monetary/fiscal problems FII flows often create. Second, the group makes no attempt at evaluating the relative merits of promoting/restricting alternative types of capital inflows under the current and expected configuration of the Indian macroeconomy – an evaluation which is essential for recommending policies for FIIs or any other major category of foreign capital.

    The absence of an overall perspective and a somewhat cavalier approach to important issues also characterise the group’s stance on sectoral caps. Any economist approaching this issue would like to have answers to the following questions. What should be the criteria for fixing the cap in a particular sector? Why should or should not the FDI and FII caps be composite or separate? If the two caps are separate, how or whether the FII and the FDI caps should be related to one another? Why should the board of directors or the majority of shareholders of a joint stock company decide on the upper limit on FII or FDI shareholding, remembering that (a) there is no such provision for holding on the part of domestic institutional investors; and (b) it is not for a company to decide whether there should be discrimination between foreign and domestic investors? Why should the caps be uniform or separate for different sectors? What are the implications for aggregate capital inflows and their composition for setting (or changing) sectoral caps or caps on an individual FII in a particular firm? Precise answers to such questions are no doubt difficult to provide. But posing the right questions is an essential step towards advancement of knowledge of what are the relevant considerations and important factors to take into account in addressing a particular issue. Otherwise, policy formulation ends up in ad hocism and churning out figures from thin air.

    The EG’s last recommendation is for initiating a research programme on ‘Capital flows and India’s Financial Sector: Learning from theory, International Experience and India evidence’. This is certainly a major improvement on the terms of reference of the group; but the ultimate focus of the research should be on capital flows and India’s macroeconomy of which the financial sector constitutes a but not the most important segment.

    V Summary and Conclusion

  • (1) There is something seriously amiss in setting up a committee to suggest measures for “encouraging FII flows” on the presumption that when their volatility is contained such flows invariably boost domestic capital formation and growth. The presumption is supported by neither economic logic nor empirical evidence. When there is a demand deficiency and investment demand is positively related to capacity utilisation and profits, FII tends to have a negative impact on both output and investment. This is apart from the fact that in the presence of underutilised capacity investment through foreign capital does not make macroeconomic sense. It is only when domestic investment demand exceeds full employment saving that tapping foreign capital may become a desirable course of action for raising domestic capital formation. No wonder, the surge in foreign capital inflow when the Indian economy was suffering from excess capacity went hand in hand with declining trends in investment and GDP growth.
  • (2) Even when there is enough demand for investment, reliance on other types of foreign capital, e g, FDI, ADRs/GDRs or longterm borrowing, may be superior to FII for bridging the investment-saving gap. The reason is that when some capital inflow is linked directly to investment demand (which FII is not) a greater part of the capital inflow is translated into investment and chances of a fall in aggregate demand are less. FIIs can contribute toward capital formation and growth when direct foreign funding of some highly productive investment is difficult to secure. The implication is that policy formulation relating to FIIs requires (a) a macroeconomic perspective; (b) a careful analysis of the current and prospective economic scenario; and (c) an assessment of pros and cons of alternative types of foreign capital inflows. These considerations are totally missing in the terms of reference set for the EG.
  • (3) The EG for its part also seems to subscribe completely to the presumption(s) underlying its terms of reference. There is no coherent macroeconomic model behind its analysis and recommendations; no appraisal either of the optimal scale of capital inflows or the relative merit of FII vis-à-vis other categories of capital receipts at the current juncture of the economy; and no examination of monetary/fiscal problems associated with FII or of the quantitative impact of such flows on investment and other macro variables. Indeed, the group seems to have been so swayed by its terms of reference that it advocates measures, e g, disinvestment of PSUs and encouraging companies implementing large investment projects, solely on grounds of attracting FIIs, without any reference to any other consideration.
  • (4) Recommendations of the group for checking vulnerability of domestic capital market are sensible as far as they go; but the package as a whole appears inadequate to meet the objective. The problem in this case arises from three sources. First, there is little appreciation of the fact that vulnerability depends on the stock of the country’s external liability, its composition and flows of different types of foreign capital, not on FII flows alone. Second, the group ignores substantial empirical evidence on volatility of FII flows in India and shows little awareness of the fact that liberalisation measures are generally followed by an increase in volatility of these flows. Third, despite the series of stock market scams and large number of companies vanishing
  • with impunity after raising funds, the EG reposes strong faith in the ability of the market watchdog to prevent unclean transactions through PNs or other devices in a liberalised FII regime.

    (5) In the context of the recent surge in investment and GDP growth, a rise in capacity utilisation and current account deficit and the projected increase in infrastructural investment demand, issues relating to use of different types of foreign capital for supporting domestic investment have assumed much greater importance now than in 1996-2003. It is also noteworthy that for the first time since 1995-96 capital inflows during the current year have been fully used for financing the investment-saving gap, not augmenting RBI’s holding of forex reserves. While these developments have raised the possibilities of productive use of foreign funds, for addressing issues arising in this context it is necessary (a) to go deeply into the interlinkages between capital inflows and domestic economic activity; and (b) to consider measures relating to FII as an integral part of policy package encompassing all types of external capital.


    Email: mihir.raksit@gmail.com.


    1 The chairman of the committee also headed the expert group.

    2 RBI’s Note of Dissent on recommendations of the expert group refers to the need for addressing “the macroeconomic implications of volatility of capital flows” [GoI 2005]. No less important however, as we shall see, are the implications of the flows (even when not volatile) for countercyclical policies and optimal use of foreign resources for domestic investment from a long-term perspective.

    3 Though in line with its terms of reference the group brackets measures under (b) and (c) as those intended to prevent vulnerability of capital market to FII flows.

    4 Which allowed FIIs into the Indian capital market for the first time. 5 So that they enjoy income or capital gains from these securities. 6 Herding refers to similarity of behaviour of a large group investors. 7 Such entities will be given sufficient time to wind up their account. 8 So that the potential balance of payments problem due to such debts

    is less than in the case of external borrowings denominated in foreign currency. 9 Only from 1992 were FIIs permitted to invest in the Indian capital market. 10 Ex post investment-saving gap (as per national income accounting) is the mirror image of the export-import gap.

    11 Estimated at USD579.5 billion for 2004-05. While estimating the cost of foreign exchange reserves held by developing countries Rodrik (2006) uses the spread between “the private sector’s cost of short-term borrowing abroad and the yield that the central bank earns on its liquid foreign asset” as the measure of per unit cost of reserves holding. Our measure of the cost is based on the consideration that though the capital inflows augmenting the reserves have not contributed to domestic capital formation, foreign investors’ return on them approximates marginal productivity of investment (it can be more or less depending on whether there are capital gains or losses in a given period). This consideration makes the spread between the return on capital in the domestic economy and the yield on central bank’s foreign assets the more appropriate measure of NNP loss.

    12 Since it is possible to raise both consumption and investment without any use of foreign resources.

    13 Otherwise before accessing external funds it would be better to raise domestic saving. Note that included in the cost of reducing domestic consumption are resources-cum-distortionary costs of government policies intended to promote saving.

    14 The perceptive reader must have realised that the basic reason lies in negative externalities. There are two sources of such externalities. First, when capital inflows into a country are large in relation to aggregate global flow, the average cost schedule tends to be upward rising so that the marginal cost to the economy is larger than the cost to the domestic recipient of foreign funds. Second, though capital receipts in countries like India are relatively small, country risk makes the average cost schedule positively sloped and the marginal cost exceed the average [Rakshit, 2001].

    15 To the extent FDI is for takeover of some existing firm, its impact is similar to that of FII or NRI deposits, except for the fact that there is often an improvement in productivity through induction of superior technical/organisational knowhow and gradual diffusion of this knowhow in the rest of the economy.

    16 The EG suggests that the rise in share prices due to FII inflows should have a favourable impact on investment. However, apart from the fact that the relation between prices of shares and (even) corporate investment is far from robust in the Indian economy, the EG, our earlier analysis implies, ignores some crucial macroeconomic linkages. In a neoclassical model (with two financial assets, money and bonds) capital inflows raise investment (though by less than the amount of the flow) as the real interest rate falls in response to an exchange rate appreciation. Even with perfectly flexible wages, prices and interest rates, the investment augmenting effect of the inflows will be less than what is suggested in the model since heightened share market activity raises the transaction demand for money balances and hence tends to harden interest rates. With sluggish adjustment of prices and interest rates, capital inflows, as we have explained in the text, can end up reducing investment. This is yet another example of the danger in macroeconomic analysis of relying on “common sense” instead of a coherent model.

    17 It is interesting to note that the EG does refer to Chakrabarti (2001) and Mukherjee, Bose and Coondoo (2002) in Chapter 2 in a survey of the literature, but while considering policy options in Chapter 4, makes no mention of these studies and cites only Gordon and Gupta (2003) to buttress its position. One cannot help remembering in this connection one of the most important aspects of the theory of cognitive dissonance. According to this theory, when someone has already a predilection for some position, on hearing arguments for and against it, he remembers the weakest arguments against and the most plausible arguments in support of the position.

    18 The group’s citation in support of its recommendation of the original 1992 rule, under which the FII ceiling was exclusive of the FDI limit, is somewhat odd: unlike in a court of law, analysis and empirical evidence, not precedent, should be the touchstone of a policy conclusion.

    19 Provided there is no significant bunching of repayment (for the economy as a whole).


    Bose, Suchismita and Dipankar Coondoo (2004): ‘The Impact of FII Regulations in India’, Money and Finance, July-December.

    Chakrabarti, Rajesh (2001): ‘FII Flows to India: Nature and Causes’, Money and Finance, October-December.

    Coondoo, Dipankar and Paramita Mukherjee (2004): ‘Volatility of FII in India’, Money and Finance, October-March.

    Gordon, James and Poonam Gupta (2003): ‘Portfolio Flows into India: Do Domestic Fundamentals Matter?’, IMF working paper No 03/20.

    Government of India, Ministry of Finance (2004): Report of the Committee on Liberalisation of Foreign Institutional Investment, New Delhi, June.

    – (2005): Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative Flows, New Delhi, November.

    Mukherjee, Paramita, Suchismita Bose and Dipankar Coondoo (2002): ‘Foreign Institutional Investment in the Indian Equity Market’, Money and Finance, April-September.

    Rakshit, Mihir (2001): ‘Globalisation of Capital Market: Some Analytical and Policy Issues’ in S Storm and C W M Naastepad (eds), Globalisation and Economic Development, Edward Elgar, Cheltenham.

  • (2002):The East Asian Currency Crisis, Oxford University Press, New Delhi.
  • (2003): ‘External Capital Flows and Foreign Exchange Reserves: Some Macroeconomic Implications and Policy Issues’, Money and Finance, April-September.
  • (2004): ‘Some Macroeconomics of India’s Reform Experience’ in K Basu (ed), India’s Emerging Economy, MIT Press, Cambridge, Massachusetts.
  • Rodrik, Dani (2006): ‘The Social Cost of Foreign Exchange Reserves’, NBER Working Paper No 11952, January.

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