Until a few days ago, it seemed that India had largely been spared the financial contagion hitting other parts of the world. But the unprecedented storm currently ravaging global markets has reached Indian shores and the fear is that our policymakers may draw the wrong lessons from it.
An immediate impact on India of these developments is the reversal of flows from foreign institutional investors, or FIIs. From an average monthly inflow in excess of $1 billion (Rs4,840 crore) in 2007, FIIs have withdrawn over $7 billion between January and August. Of all the Bric — Brazil, Russia, India, and China — economies, the Indian economy is the most sensitive to these flows.
Equity valuations, which were sustained by strong liquidity flows, have dropped sharply. The credit squeeze combined with the repricing of risk has driven up financing costs, making credit scarce and expensive. While private equity flows, which approximated $14 billion in 2007, is likely to continue, there is a slowdown in investment flows as funds increase the rigour of their due diligence, and there is an overall recalibration of value expectations.
The impact on foreign direct investment, or FDI, flows is more difficult to assess, but these, too, could moderate if the global economy experiences a prolonged slowdown. This will have an impact on the capital raising and funding plans of Indian companies. It will also impact global acquisition plans of Indian firms, as leverage required to finance such acquisitions is either unavailable or too expensive.
However, every cloud has a silver lining. The global slowdown has led to a drop in commodity prices, and this should bring down inflation to more manageable levels.
It can be noted that, unlike the US — where hedge funds are largely unregulated — every entity associated with financial services here is highly regulated. This allows swift action by the regulator when the external environment is not benign. The action by the Reserve Bank of India (RBI) in respect of Lehman’s non-banking finance company (NBFC) and primary dealership operations is a case in point.
Having said that, where global players have a significant presence in India, strains on their parent’s balance sheets could constrain further capital commitments to India and we could see a further unwinding of positions and assets.
In this context, reports say that the mandatory three-year lock-in period specified with respect to FDI in real estate may be relaxed, on request by financial institutions stressed in the unfolding aftermath of the subprime crisis.
The redrawing of the entire financial services landscape that is currently under way presents certain positive fallouts as well, the most important being a rethinking over core competencies and strategies adopted by financial houses.
For India, this could spell the entry of more serious and focused companies in financial services and a better quality of capital backed by domain expertise. Global developments could also spur the long outstanding consolidation, particularly in banking, underpinned by the need to create better capitalized, more substantial enterprises that are better able to withstand market disruptions.
RBI’s policy stance on financial market regulation has been marked by caution. This approach has its virtues, and these become evident in crises such as the present one. However, just as making automobiles is not banned because they may cause accidents, an overly cautious approach can stifle the development of deep, liquid financial markets and the associated breadth of tools that enable firms to effectively manage funding requirements and risk profiles.
The deferral in introducing credit derivatives, the constraints introduced on offshore derivative instruments and RBI’s increased vigilance over capital market activities of banks and NBFCs are indications of this policy leaning.
The irony of the situation, however, is that large Indian firms and banks could access a range of derivative products in the overseas markets (for example, the current speculation around ICICI Bank Ltd’s overseas exposures), creating an indirect exposure for the Indian economy.
More significantly, the cautious approach could delay the opening up of financial services. A road map published by RBI in 2005 suggested that foreign banks could be allowed increasing access to the Indian market in a staged manner, with the next phase of access expansion targeted for early 2009. It now appears likely that this phase may be postponed. Foreign investment in asset reconstruction and insurance firms, much needed to bring in risk capital and domain expertise to financial markets, could be equally hit.
The moot question then is whether a regulatory approach and a policy stance based on substantial regulation and limited integration with the global economy such as India’s represents the model to weather financial crises. It may be tempting to answer this in the affirmative at this stage.
However, this could have long-term implications. Deep financial markets including money, equity, public and over-the-counter markets in derivatives are preconditions for sustained economic growth. A policy stance that limits their evolution could hamper India’s economic growth.
Eschewing risk cannot be the answer. Instead, policy prescriptions must foster depth, variety and innovation while better managing risks. Staying with the automobile analogy, the solution to chaotic traffic is not to get cars off the road, but to impose better traffic discipline, and have functioning traffic signals and vigilant policemen.
Bobby Parikh is managing partner, BMR Advisors. These are his personal views.
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