A new opening act

Indian Express, 2 March 2011

Increasing corporate debt caps for foreign institutional investment and allowing retail foreign investors to invest in Indian mutual funds are two significant initiatives in Budget 2011. These steps towards greater capital account liberalisation will not only attract foreign capital for India's enormous infrastructure needs, they will also make Indian financial markets more stable and the economy more resilient.

Since 1991 when India witnessed a balance of payment crisis due to short-term foreign liabilities, Indian capital controls have involved restrictions on foreign debt. There are two main components of foreign borrowing: Indian firms borrowing abroad in dollars (termed `ECB'), as opposed to FIIs buying rupee denominated bonds issued in India by Indian firms. While there is no explicit cap on total foreign borrowing, government has tried to hinder it. There is a ceiling on FII investment in total rupee denominated bonds.

By 2009, the stock of corporate borrowing through ECB (which is dollar denominated) stood at above USD 62 billion, while foreign lending to firms in rupee denominated debt was blocked at a ceiling of USD 6 billion. The bias of controls on rupee denominated versus dollar denominated debt had resulted in higher dollar denominated borrowings by firms.

The Ministry of Finance Working Group on Foreign Investment, headed by the present SEBI Chairman UK Sinha, argued that the government needs to move away from restrictions on total foreign debt, to a restriction on dollar denominated foreign debt. It is with dollar denominated debt, and only dollar denominated debt, that movements of the rupee dollar rate can pose unforeseen liabilities to the borrower. If an Indian company has borrowed in dollars and the rupee weakens, the company has to pay more.

The existing Indian policy framework has been guided by the old belief that foreign debt, as such, is dangerous. The policy lesson that emerged from the Asian crisis, in the late 1990s, was that the essence of the problem lies in foreign currency denominated debt. Local currency debt does not pose the same risks. The Sinha report has hence recommended that restrictions on FII investment in rupee denominated debt, i.e corporate bonds issued in India, be removed.

One rationale for restrictions on foreign investment in rupee corporate bonds was to control dollar inflows, to prevent appreciation of the rupee. However, from 2009 onwards, RBI's trading in the currency market has been largely absent, and the rupee has witnessed two way movements with high volatility. Once the exchange rate regime changed and the rupee became flexible, there is little reason to hang on to the restriction on rupee denominated debt.

In the budget proposals, the Finance Minister raised the ceiling on FII investment in corporate bonds in infrastructure from USD 5 billion to USD 20 billion. This doubled the cap on total FII investment in corporate bonds to USD 40 billion. This is a step forward in rationalising the capital controls framework.

The other important move in the budget towards greater capital account liberalisation is to allow retail foreign investors to buy Indian Mutual Funds. At present, if a foreign investor wishes to invest in the listed equities market, he has to be one of the categories of institutional investors recognised under the SEBI Foreign Institutional Investor Regulations. This framework was set up in 1992-93 when India first opened up to foreign investors. The list of investors has been widened over the years but still involves a check on the structure of the investor, which allows only collective investment schemes. If the investor is an individual he has to register as a sub-account with an existing foreign institutional investor.

The biggest weakness of the institutional investor framework is herding behaviour by institutional investors. Due to similarity of objectives, time horizons, profit-booking dates, interconnectedness amongst the big institutions etc. institutional investors respond to various situations in a similar manner. On the other hand, retail investors do not have the same behaviour. They can bring a diversity of views and actions to financial markets. Further, the present crisis showed that large investment banks with leveraged investment were prone to disruptions and shocks. Yet, as a policy, India has allowed only such investment companies to enter the markets from abroad.

Further, the Sinha report indicated that while SEBI registers foreign investors, this is not to enforce Know-Your-Client (KYC) norms that India is now required to do as a signatory to various international anti-terrror treaties.

The Budget 2011 proposal should be seen in the light of the above recommendation. The Finance Minister proposed to allow foreign retail investors to invest in Indian mutual funds. Indian mutual funds can now compete for the business of foreigners investing in India; this business is now not the exclusive preserve of FIIs. However, the proposal does not yet address the objective of bringing greater diversity of behaviour into the market. Since mutual funds are also institutional investors, their behaviour suffers from the maladies seen with institutional investors. The government decision thus improves the level playing field, but it needs to be followed through by fully enabling direct participation in the Indian market by foreign individuals.

India has an elaborate system of capital controls. When juxtaposed with the fact that the Indian economy recovered quickly after witnessing a set back to GDP growth after the global financial crisis, many people are tempted to draw the conclusion that it was the capital controls that made India resilient, and thus capital controls are good and should be continued. The importance of the Indian experience in the capital controls debate is, thus, huge. India is almost the only 'evidence' of a large country whose historical experience of capital controls and high growth make the case for capital controls. The Ministry of Finance Working Group report and the Budget 2011 proposals to move towards greater liberalisation of the capital account, rather than hanging on to capital controls, should have important lessons for other countries.

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