Restrictions on Capital Inflows

Indian Express, 17 August 2005

There are concerns in official circles that too much short-term foreign capital is flowing into India and pushing up the Indian stock market. The traditional recipe that is proposed to be applied once again is to make the Indian stock market less accessible to foreigners. To better understand the situation, we need to ask: why is foreign capital rushing into India?

We must place the recent equity inflows in the context of the yuan revaluation. The 12 days prior to the Chinese announcement had average net daily equity flows into India of Rs.330 crore. The 12 days after the Chinese announcement have averaged Rs.536 crore.

India is not the only country that has witnessed bigger inflows of foreign capital. It is reported that in the past one month foreign investors have put in $6 billion in Asian's stock markets. $1.2 billion came in last week. Taiwan, South Korea, Thailand, Indonesia and the Phillipines, which report data on foreign trading witnessed a sharp increase in the inflow of foreign capital. Markets such as Hong Kong, Singapore and Malaysia, which do not report foreign trading data, are also said to be seeing big inflows.

The rationale of the foreign investors is as follows. Either, the domestic currency of these Asian countries, including India, will appreciate with the yuan, thus making it profitable for them to bring USD into India now and take money out with when there is a currency appreciation. Or, if the domestic currency does not appreciate, India's exports will become more competetive with respect to China, Indian companies will do well, therefore, stock prices will rise giving the foreign investors a profit. To the extent that this logic holds, equity purchases by foreign investors are a bit of a one-way bet.

The government may be looking for ways to make it more difficult for unregulated foreign entities to enter India in order to reduce their influence on the stock market. One of the ways this is likely to be done is to restrict Participatory Notes (PNs) in the Indian markets. PNs are derivative instruments whose underlying securities are Indian stocks. These are issued by FIIs to overseas investors who want to invest in Indian stocks but are not allowed to do so.

Earlier SEBI had warned FIIs that they must be ready to furnish information about their PN clients when the regulator requires. More of this may follow. There may be other restrictions as well. But is this kind of reversion to control raj the right answer? First, will it stop the inflows? And second, if it does not, will it lead to greater transparency in the market?

When the flow of foreign capital into India is caused by a global, rather than a local Indian phenomenon, can the solution lie in blocking a few channels? In the past in India, and in every country in the world, it has been seen that people will bring in money one way or another. India now has a gigantic current account: if all else fails, overinvoicing and underinvoicing can be used to move capital across the border on a gigantic scale. Blocking the legal and transparent route will increase evasion, illegal transactions, and reduce the capacity of the government and market regulator.

So, if it does not stop inflows, we need to ask the next question: are "increased restrictions on FIIs" the best way for better regulation and increased transparency?

If the entry conditions in Indian markets were made easier, instead of money coming through PNs, it would come through registered bodies. Every modern country in the world today has an open capital account. Vast pools of foreign money are in action in the New York Stock Exchange, or the London Stock Exchange, etc. But this foreign money does not flow through PNs in those countries, because the market is more easily accessible to foreign investors. This has neither weakened regulation nor led to market manipulation.

When we do not allow simple and clean options for those investing in India, investors find roundabout and non-transparent ways of entering the market. This poses risks for the market. The way to better regulation is to make the Indian market directly accessible. The government should make the PN route unattractive and unneccessary by removing restrictions on equity transactions in India. This will allow greater transparency.

We have learned something out of India's experience of trade account restrictions from the 1960s to the 1990s. We know that restrictions breed corruption and rents. Bureacracies like RBI and SEBI would delight in having a hundred rules that they can tinker with, just like those at the Ministry of Commerce and the Ministry of Finance used to in erstwhile years. Bureaucrats get better diwali gifts, when institutional investors have to pound their corridors requesting for permissions. We should learn from our mistakes in trade policy, and avoid trying to setup a complex system of controls.

The PN route has another fallout in terms of high rents earned by FIIs registered in Indian markets. SEBI and RBI rules have made entry for foreign entities, including NRIs, cumbersome and expensive. When investors come through those already registered in the markets they pay them. This means that those in the markets get extra business and earn rents. The fact that administrative controls create rents is not new. We have seen this in the licensing regime in India in industry and trade.

Licensing puts power in the few hands that have licenses. It gives them rents. It increases their market power. It is only when India abolished licensing and opened up entry in the market for that these rents came down. The situation in the market for investment of foreign capital is no different. When we allow entry only to a few, by making it difficult for other to invest, we make the incumbents more powerful. The way to increasing competition, increasing liquidity in the market and making it more difficult to manipulate markets is through making those markets accessible to all, not by restricting entry.

If the market is made more accessible, then instead of a handful of FII's making decisons to buy or sell, as appears to be the worry today, the decisions will be made by thousands of investors scattered all over the world. As the title of the book by Raghuram Rajan and Luigi Zingalis suggests, the government's job should be to "save capitalism from the capitalists", and remove the rents earned by a few privileged FIIs and bureaucrats.

The policy of making entry into Indian markets difficult favours incumbent FII. It creates new business opportunities for those already registered in the Indian market. It is in India's interest to have a level playing field between all investors in the world, and to not concentrate the financial capital of global investors into a handful of FIIs. Narrowing the ranks of FIIs strengthens them, while hurting smaller investors abroad. It reduces liquidity and makes regulation more difficult.

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