The Hindu Business Line : FII flows and RBI's dilemma

The real worry for the RBI vis-à-vis foreign institutional investments is that it cannot monitor capital flows, and, that it will not be able to continue with its exchange rate policy, which enables the central bank to intervene to smoothen the volatility in the currency market. There is, then, the other option of giving up capital account management and moving towards convertibility. This is the dilemma for the RBI that needs to be resolved quickly by the Government, says S. Narayan.

THE Reserve Bank of India Governor, Dr Y. V. Reddy's recent speech, from which the Finance Minister, Mr P. Chidambaram, so hurriedly distanced himself, brings to the fore a fundamental issue in capital account and currency policy that needs to be addressed.

In his speech, Dr Reddy appears to have made three important observations: First, a concern that capital flows into the country were more in the nature of FII (foreign institutional investor) investments rather than FDI (foreign direct investment); second, that the FII flows have been significantly large in 2004, amounting to over $9 billion during the year; and, third, that the "quality" of the flows needs improvement — implying that there should be greater monitoring and supervision of these flows. He went on to add that a view needs to be taken on the capping of these flows into the market, and that price-based measures such as taxes could be considered.

Dr Reddy recommended enhancing the quality of flows through a review of policies relating to the eligibility of registration as an FII, and an assessment of the risks involved in flows through hedge funds, participatory notes, etc. He appeared particularly concerned that participatory notes had contributed to 40 per cent of FII flows during the year. Sensing that these remarks might disturb the market, the Finance Minister reacted that there was no proposal either to cap the flows or to tax the FIIs.

Behind all this is the concern of the RBI over currency (exchange rate) policy and capital account policy. The RBI, quite deservedly, prides itself in steering the country through a very severe foreign exchange crisis in the last decade, through a carefully administered capital account policy and a currency policy.

Through capital account controls and a managed exchange rate, the country managed to ride through the tremors of the East Asian crisis fairly smoothly. At the core of the policy is intervention in the exchange rate, which, without any predetermination on the exchange rate as such, enables the RBI to intervene to smoothen the volatility in the currency markets.

This `moving peg policy' has served it very well in the past. Whenever the RBI has been intervening in the market to purchase dollars, the excess liquidity generated in the system has been mopped up through the sale from the stock of government bonds that it holds.

Coupled with restrictions on capital account convertibility, it has, until now, given the RBI a fairly close control over flows and rates of foreign exchange. It has, therefore, been able to guide monetary policy largely independently of external exchange considerations.

Two recent developments have rocked this boat. First, the increasing nature of capital flows, and the inherent weakening of the dollar in the last three years have necessitated repeated interventions in the market to prop up the dollar, and, the RBI does not have enough government bonds left to sterilise the market. Interventions will, therefore, lead to creation of additional liquidity in the market, which is likely to be inflationary.

In the last Budget, the RBI came up with a novel idea of Market Stabilisation Bonds, which are off-Budget documents to be used only for the purpose of mopping up the excess liquidity caused by intervention, and the interest charges for these bonds would be borne by the government.

Since the interest is a debit on the Budget, governments have, till now, provided Rs 60, 000 crore in the fund — the problem is that the RBI has to come back to the government every time it wants the fund replenished, which must be bruising for its autonomy and self-esteem. Thus, the option of market stabilisation is getting more and more complex as the flows increase.

Second, reforms in the financial and securities markets, economic growth, and a growing awareness of India have renewed investor interest in India. Relaxation of capital account controls has enabled cross-border transactions to become easier, and we are seeing significant interest in the secondary market flows. It is important to realise that there are no good funds or bad funds — all are in the market to make money, and they are mobile funds that would move to every market where there is opportunity of making money. Harvard University fund is no better or worse from an unknown offshore fund — it just wants to maximise return for its investors.

And, in a global world, it is not possible to categorise good funds and bad funds — one can only ensure that regulatory processes are in place in the country of origin (the Securities and Exchange Board of India has already stipulated this).

Thus, the real worry of the RBI is that, first, it will not be able to monitor capital flows, and second, that it will not be able to continue its exchange rate policy. There is hardly a country in the world that insists on having all three — a capital account policy, a currency policy, and a monetary policy.

China, for example, has decided that it requires external capital flows for employment and economic growth, and has consciously decided to have a fixed exchange rate, and (almost) no monetary policy, and has also decided to weather the inflationary and other problems that the lack of a monetary policy would entail. Other developed countries do not intervene in the exchange rate.

With large foreign exchange reserves, a healthy economy, and openness in the financial architecture, we can only expect the external flows to strengthen. It is time to consider what is it that we want. It is possible to argue that with a large service sector based economy, high savings rate, and low external dependency, we can go back to an era of capital controls.

In fact, the RBI is hinting at this. It would be back in the era of `P' forms and exchange permits, and a fixed exchange rate, the economy ring fenced against external shocks, and a monetary policy that is determined by governmental priorities of the day.

The other option is to give up management of the capital account, move as much as we want towards convertibility, and most important, give up the exchange rate intervention, and allow the market to determine the rate. Or, finally, to give up monetary management, and allow international availability of funds to determine the cost of funds.

There is evidence that all our major corporates are already doing this, and are confident about managing the consequent exchange rate risks. Each of these have implications in the political economy — exporters will shout if the rupee strengthens very much more, interest rate management is dear to any government, and so on. This indeed is the RBI's dilemma, which needs to be resolved quickly by the government. How serious are we about capital flows? If we are, then let us give up these controls.

Finally, there is merit in the view that FDI investment is superior to FII flows. The former is investing in India while the latter is an India investment portfolio. It must be the effort of the Government to change the nature of the flows, and take necessary measures.

Improved FDI flows will arise out of transparency, ability to start and close businesses quickly, and the sanctity and quick enforceability of contracts. The written word, in policy, finance or in contracts, must mean what it says. Once the world has this confidence, FDI flows will match and outperform FII investments.

(The author is a former Union Finance Secretary.)

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