Greasing our shock absorbers

Indian Express, 3 February 2011

Capital flows have fluctuated quite a bit in recent months. We have swung from fears of too much money coming in, to fears of too little money in. The change in inflows depends on factors ranging from conditions in global financial markets, to domestic land policies. India's approach to capital flows lies in policy changes to encourage diversified flows, and in financial development. More diversifed flows will reduce the volatility of capital flows, more liquid financial markets will make the economy resilient to fluctuations in capital inflows.

In July 2010 we saw that $11 billion came into India as foreign investment. This dropped to zero in the following month. In September and October, $13 billion and $30 billion came in. Then in November, $18 billion left the country. This sudden rise and then reversal was related to the IPO of Coal India.

In recent weeks, there is considerable gloom about the outlook for capital flows, especially FDI inflows. On one hand, when there is global geopolitical risk, global capital tends to retreat into safe havens with political stability, i.e. the OECD countries. In addition, the outlook in India has become considerably darker, with government grappling with corruption and inflation; it is an environment when little effort is taking place on long term policy change or reform. These two factors have come together to exert a certain negative spell upon capital flows into India.

There are two areas where there is a clear situation where foreigners are keen to invest in India and that investment would be beneficial for India. The first is FDI in sectors such as retail. The second is foreign portfolio investment into rupee denominated debt. In both these areas, effort on removing restrictions will debottleneck these areas, and produce a flow of capital coming into the country.

At the same time, considerable uncertainty about the outlook for the world economy remains. In coming months, political risk in the Middle East, and a potential second round of the crisis of the European periphery, could play out. These could easily involve fairly dramatic events. Capital flow fluctuations of one to two percent of GDP cannot be ruled out.

How best can India deal with this? We are now in a phase of ever deepening integration in the world economy. Particularly with the large-scale operation of MNCs operating in India -- both domestic and foreign -- the effectiveness of capital account restrictions has greatly diminished. The top 500 companies of India are turning themselves into MNCs with global treasuries. Their financial activities overseas are immune to India's capital controls.

Having signed up into the globalisation project, our focus should now be upon better absorbing shocks. What are the key shock absorbers? The three critical shock absorbers are: a flexible exchange rate, the liquidity of the currency market and the liquidity of the equity market.

What happens if $10 billion flows into the country within a week by way of FII flows on the equity market? The first source of damage can be currency policy. If RBI tries to buy dollars so as to prevent a rupee appreciation, this would lead to a distortion of monetary policy. With an inflation crisis on its hands, RBI needs to raise rates. But if RBI buys $10 billion on the currency market, it has to pay for this by creating Rs.45,000 crore of rupees within a week, which adds to reserve money. This would yield a monetary policy distortion, and help fuel inflation. In order to avoid this problem, RBI needs to stay on course with the strategy of not trading on the currency market.

Assuming RBI does not interfere in the market process, $10 billion would hit the foreign exchange market. Here, what India needs is a deep and liquid currency market so that when a large order comes along, the price does not move. BIS data shows that the rupee has a roughly $20 billion/day market in India and $20 billion/day market abroad, adding up to $40 billion/day. Today $ 2 bllion a day for a week may affect the price, but as this market grows bigger, the impact of large dollar inflows or outflows on the exchange rate will be smaller.

From a policy perspective, it is important to move forward with financial development so as to achieve a more liquid market. The Percy Mistry and Raghuram Rajan reports have written extensively about how to achieve a Bond-Currency-Derivatives Nexus. This would give us a greater ability to absorb shocks on both the currency market and the bond market.

The third leg of the story lies in the equity market. Here, overall trading in Indian equities globally works out to roughly $45 billion per day. Of this, roughly $35 billion a day happens at NSE, $1 billion a day happens at BSE and (a rough estimate of) $10 billion a day happens abroad. The offshore venues include Singapore, NewYork and London. Here also, orders of $2 billion a day for a week would affect the price.

Today India is open to portfolio investment by foreign institutional investors. Individuals are not allowed to invest easily. Yet, from the point of view incentives, decision making, knowledge about Indian markets and hence behaviour in the equity (and hence foreign exchange) markets, this reduces diversity. Allowing retail investors, some of whom may be pensioners while others may be speculating on the rupee will give us less herding behaviour that sometimes characterises institutional investors, who could tend to move in and out together. Greater diversity of opinion and behaviour would reduce flucutuations and more trading increase liqudity in these markets.

In summary, nervousness about capital inflows requires a multi-pronged response: reduction of capital controls that interfere with FDI and rupee-denominated debt, continuation of RBI's approach of not interfering with the market exchange rate, financial reforms that will yield more liquid currency and equity markets. With these, India will achieve bigger capital inflows in a difficult time. In addition, the financial markets will become better able to buffer the inevitable fluctuations of capital flows.

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