First steps

First steps

The stock market has been shaken and stirred by the new discussion paper on participatory notes (P-notes) put out by the Securities and Exchange Board of India (Sebi) on Tuesday evening—though share prices did recover from their day’s low.

P-notes offer international investors a back-door entry into the Indian stock market. Global brokerages and investment funds registered in India sell these offshore notes to other investors, often hedge funds. The money collected is then shovelled into the market here. Nobody knows for sure who the real investors in P-notes are, since the funds that buy them are not registered with the local regulator. That has been the big worry.

This is the right time to alter the policy on P-notes. India has emerged as one of the growth hot spots in the world and the inflow of money through foreign direct investment, private equity, venture capital, apart from the FII route, can only increase. In a sense, P-notes are, therefore, instruments that have outlived their usefulness.

And if, in the process, some of the froth is taken off the equity markets, so much thebetter. While there may be some pain in the short term, foreign investors are unlikely to stay away from participating and profiting from India’s development.

However, the issue goes beyond P-notes. As finance minister P. Chidambaram reiterated several times during his comments on the Sebi move, the intention is to curb the pace of capital inflows. It’s easy to see the reasons for his disquiet. The inflows into the country have recently become a flood and both the government and the Reserve Bank of India have been at their wits’ end. The interest that the government is forced to pay on the rising volume of market stabilization securities, for instance, is now a tidy sum, while the central bank is worried that the liquidity that results from its policy of buying dollars could lead to a resurgence in inflation.

Large capital inflows have always posed a problem for emerging markets, with their relatively illiquid markets, the lack of sophistication among many market participants, and the dearth of hedginginstruments.

To take an example, it’s a fact that the small-scale sector, which accounts for the bulk of the country’s exports, has been badly hit both by the rise of the rupee and the rise in interest rates. Many of these producers do not have the knowledge to hedge their positions. Also, the recent bout of rupee appreciation has led to several companies offshoring part of their operations. That could have adverse implications for employment.

While Sebi’s measures may work in the short term, studies have shown that their long-term efficacy is doubtful. Thailand’s recent attempt to impose capital controls has been unsuccessful. Indeed, the International Monetary Fund’s World Economic Outlook explicitly says that capital controls do not succeed in preventing currency appreciation and the favoured option is for countries to prune their fiscal deficit to prevent overheating. After all, if the rising rupee has hit exporters, it is also a fact that it has made imports cheaper. The rise in crude prices, for instance, has been blunted somewhat by the rupee’s rise.

Hasty measures to cool down the market will not work in the long run. A long-term strategy should focus on three things: deeper and more sophisticated markets; a more disciplined fiscal policy; and more independent regulators.

Unfortunately, we see few signs of that happening.

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