India’s new restrictions on the issuance of offshore derivatives on derivatives are a step in the right direction. The ideal, of course, is freedom for investors to invest, not only in local markets, but also in international markets out of India. That would be a big step towards realizing the goal of making Mumbai an international financial centre. Among other things, tax laws on the incomes of funds and of asset managers will have to be amended. Remember that the country currently gets nothing by keeping out foreign fund managers. But India would only move slowly on this, if at all, in the coalition era, for it is an executive decision and not that of the stock market regulator or the central bank.
Some of the criticism of the recent measures is misdirected. For example, the question of why India alone should have problems with capital inflows is easily answered. First, India doesn’t have to explain policy inertia or incompetence in other places. Second, the conclusion that others don’t have problems is not borne out by facts. The Bank of Korea has stated that it will investigate forward currency contracts. Vietnam actively toyed with capital controls until the stock market ascent came to a halt. Andy Mukherjee of Bloomberg wrote recently that Bank Indonesia feels powerless with inadequate monetary instruments to stem capital inflows. In general, problems not revealed yet, does not mean that problems do not exist. The difficulty in creating counterfactual scenarios is no excuse for the failure of the critics to place the Indian reaction in the global context.
Further, even if the Securities and Exchange Board of India’s (Sebi) measures were actually directed at reining in capital flows rather than improving transparency, they are on surer ground than many suggest. Champions of liberal economics do not readily transfer their affections from liberal trade to liberal financial flows. After the Asian crisis in 1997-98, the International Monetary Fund (IMF) came under criticism for having championed liberal capital flows when their economic utility to the recipient nation was hardly established. In recent years, IMF has begun to address pre-conditions that need to be fulfilled for financial liberalization to confer benefits. These include sound monetary and fiscal policies and quality of economic institutions and governance.
In a recent interview with the Financial Times, the finance minister conceded that much of the recent fiscal improvement was thanks to revenues, not expenditure management. More slippage is on the cards. India will likely announce a generous raise in salaries and allowances (nothing wrong with that) to government workers in the wake of the Sixth Pay Commission recommendations—with no commensurate commitment to accountability and productivity from them. The largely wasteful National Rural Employment Guarantee Programme is to be extended nationwide and, years after the official dismantling of the administered price mechanism for fuel products, the oil subsidy bill continues to mount. Even as the price of crude oil is up more than 60% from its lows of last year, India’s fuel price has remained unchanged. Scarcity of fiscal prudence sits uncomfortably with abundance of capital flows.
Admittedly, controls and restrictions are second best solutions. But the responsibility to create conditions for first-best solutions rests with the executive. Failure to do so is a failure of governance. Privatization is dead and, among other things, that would have deepened and broadened capital markets. Abnormally high wage increases are a sign of failure of higher education. Together with infrastructure deficiencies, this hurts firms’ ability to compete globally. Allowing currency strength would pile up the misery, particularly as China’s nominal effective exchange rate has barely moved in recent years. Relentless focus on these failures would be more purposeful than a shrill and plainly wrong focus on unrestricted capital flows.
Of course, there is a risk that controls and restrictions can have unintended consequences. One experienced observer told the author that the ban on offshore derivatives on derivatives would result in a short squeeze and push Indian stock prices higher swiftly and considerably along with the drying up of liquidity. Local punters and some corporations flush with cash are apparently delirious with joy at the latest gift from Sebi. If true, this would be a dangerous emulation of the game going on in China. Subsequent corrections would be rather unpleasant and tough to contain.
But the Reserve Bank of India (RBI) and the regulator are playing gamely with the cards dealt by the executive and by international developments. Their task is set to grow in complexity enormously in the next two years. For the sake of India, one hopes that they are resolute in their convictions.
(V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org)