Investors got a rude shock on Wednesday. It seemed like India, the second best performing equity market in the past month after Chinese stocks in Hong Kong, was spurning their love. The misunderstanding cleared up pretty quickly, though. It transpired that the Indian government really did have a headache after all, produced by an intolerable surge in capital flows.
The Securities and Exchange Board of India said, after close of trading on 16 October, that it proposes to “urgently implement” a plan that will restrict unregulated overseas investors, such as hedge funds, from accessing the equity market in Mumbai through offshore derivative instruments.
When the market opened on Wednesday, the Sensex slumped 10%, leading to trading being suspended for an hour. After an explanation from finance minister P. Chidambaram that the curbs aren’t a moral judgement on the desirability of hedge fund money in the market, the Sensex closed at about 18,716, down less than 2%.
The market has always been jittery about the future of participatory notes, or PNs—as the offshore, over-the-counter derivatives are commonly known—given that the central bank wants them banned. The Reserve Bank of India’s stance on PNs, as outlined in its dissent memo to a November 2005 report by a government-appointed panel, is that these are “suspicious flows” because it’s difficult to identify the ultimate beneficiary. Chidambaram did well on Wednesday to avoid this line of thinking. He made it clear that hedge funds continue to be welcome and the objective of the curbs is only to moderate the pace of capital flows.
PNs make India’s capital controls porous; if they bring too much money into an overheating economy, as is the case now, the central bank loses control. It has to either accept a considerable increase in the exchange rate or a big fall in local interest rates. The former can stall exports, while the latter could worsen the overheating.
Chidambaram has so far resisted the central bank’s conservatism. He has correctly reasoned that the way forward for India is more capital flow, not less. However, it was his job, and that of other ministers in Prime Minister Manmohan Singh’s government, to make the country ready for a sustained pick-up in foreign fund inflows. That never happened.
In the past three years, offshore inflows into India have soared: PNs alone have swelled to almost $89 billion (Rs 351,550 crore) from just $7 billion in March 2004. Yet, the government has done precious little to boost the economy’s absorptive ability so that the flows could be accommodated without stoking inflation. Everything from power and skilled labour to real estate and spectrum for telecom is in short supply due to muddled policies and lack of political will.
The central bank has been behind the curve in accepting that India’s growing trade and investment linkages with the world have effectively robbed the monetary authority of its ability to simultaneously pursue an independent interest rate policy and aspire to an almost fixed exchange rate system.
Conservative policymakers and apathetic politicians have collectively dug themselves into a hole. Now they want to get out of it by tinkering with capital inflows.
Direct entry into Indian markets requires a permit that isn’t given to everyone. Pension and mutual funds, insurance firms, university endowments, and investment and charitable trusts are all allowed to invest in India directly as overseas institutional investors. Foreign firms and individuals can also obtain direct access as sub-accounts of global investment banks, which are registered as institutional investors.
The latter are responsible for ensuring that their sub-accounts are not conduits for laundering drug money or terror funds or fronts for Indian politicians or businessmen to bring back into India their ill-gotten gains parked overseas.
PNs allow those who have access to the Indian market to share it with those who don’t. Though only 34 of the 1,113 registered foreign investors and their 3,445 sub-accounts write PNs—Citigroup Inc., Merrill Lynch & Co., Goldman Sachs Group Inc. and UBS AG are the prominent issuers—the arrangement is a popular one, accounting for an estimated three-fifths of the $17 billion overseas money that has flowed into Indian stocks this year. The government wants to tame the flows. Until now, sub-accounts were allowed to sell P-notes to their clients. That flexibility is now being withdrawn.
One-third of all PNs are derivatives on derivatives: Their underlying securities are futures and options traded in India. This is now proposed to be banned altogether. Investment banks can still sell PNs to their hedge fund clients as long as the underlying securities are stocks—and not derivatives—though the value of notes can no longer exceed 40% of the registered investor’s assets under custody.
Effectively, this is what the government is telling foreign investors: “We know we can no longer choose who gets to invest in India and who doesn’t without banning PNs; and we won’t do something as drastic as that because that’s going to hurt us. But allow us some control on the pace at which you are going to bring in money; without that, we’re heading for a blowup.”
It’s a message the market can understand. After all, influential voices in India have begun discussing the possibility of a Thai-style lock-up on foreign inflows.
Thankfully, the Indian regulator’s plan isn’t nearly as ugly as that.