Are domestic markets finally maturing?

ISSUE

JAMAL MECKLAI
CEO, Mecklai Financial

Indian markets have always been driven by herd mentality. And while this is not unreasonable in the case of equities - globally, too, equities are largely herd driven - the domestic forex and interest rate markets have been all or nothing, one-way bets for far too long.

The main reason for this, of course, is that the domestic forex and interest rate markets are much less liquid - and, as a result, much less mature - than the underlying economy that they are required to serve.

Now, as anyone with growing up children knows, maturity comes from a combination of instruction and experience. Hold baby (or baba) too close to the apron strings or, set him (or her) loose in the world without adequate basic instruction (moral and otherwise), and you are most likely to get a rebound that is unfortunate at best and tragic at worst.

India's economic managers have, over the past decades, erred in the "tightly close to mama" direction.

And while some of the finance ministry mandarins and the Reserve Bank of India scholars proudly point to the financial crises suffered by some of our contemporaries as evidence that this approach is better, a recently published study suggests that countries that have been more aggressive - i.e., given baba the keys to the car when he was just 15, in a manner of speaking - have, over the long haul done much better, at least in gross economic terms.

The good news is that technology, the key driver of globalisation, is forcing us to force the pace. The old parable of the tortoise (that we have so effectively copied) and the hare is being replaced by kabhi tortoise, kabhi hare.

What our economic managers have to realise is that what's food for the tortoise may not be appropriate food for the hare.

For instance, with $100 billion of reserves (marginally lower than our foreign debt), it is ludicrous that our domestic forex market trades a meager $1.5 to $ 2 billion a day.

A country like South Africa, whose reserves are a minuscule $6 billion, has a domestic market that trades around $10 billion a day.

Globally, the forex market trades about $2 trillion a day, against total global reserves of around $3 to $4 trillion. Clearly, our market is highly underdeveloped for our level of reserves.

And it is this narrow-minded attitude to market development that sustains the word "cautious" in the dominant Indian business attitudes, as in "cautiously optimistic". Indian business has matured significantly. It is time for our financial managers to mature as well.

What they need to recognise is that they are way behind the curve right now and that while throwing the Lexus keys to baba when he is 15 may be a bit frightening for our classic, traditional taste, the fact is he's more than 15 now.

And, on the other hand, holding baby too close to mama's apron for too long will simply result in stunted emotional - and physical - growth.

The other good news is that the interest rate market, more closely linked as it is becoming, is also showing the beginnings of two-way movements.

Perhaps the best news this week was captured in the following headlines: Union Bank hikes home loan rates. PNB cuts PLR by 25 basis points to 10.75 per cent. A two-way market at last?

Some bold steps please

MAHESH VYAS
MD & CEO, CMIE

The surge in foreign exchange reserves reflect two consecutive years of current account surplus and a steady flow of capital into the country.

In the past, the capital flows financed the deficit on the current account. But now the current account in largely in balance. This leaves the capital flows free for investment purposes.

However, investment activity has been quite weak in the past several years. The total investments envisaged in projects under various stages of proposal and implementation has been declining steadily.

This lack of sufficient fresh investment has led to the capital flows contributing to the liquidity over hang. This in turn, has contributed to the sustained weakening of interest rates in the country.

However, the declining interest rates do not deter the flow of capital into the country. A big difference in the capital flows in 2003""04 against the previous year is the overwhelming role of the FIIs and the simultaneous decline in the flow in the form of FDI.

FIIs brought in $2.53 billion during April""August 2003 as against the outflow of $0.25 billion during the corresponding months of 2002.

FDI flow during the same period nearly halved from $1.36 billion to $0.72 billion. Further, capital flows from NRIs into deposits have more than doubled from $1.38 billion to $2.87 billion.

The NRI deposit flows reflect largely, the arbitrage opportunity that overseas investors have because of the relatively attractive interest offered to them, on deposits in India. As this advantage is removed, these deposits may be expected to flow out.

FII flows, on the other hand, reflect the confidence that the foreign investors have on Indian companies to deliver profits in the short to medium term.

However, the long-term perspective on India as an investment destination seen by the overseas investors is best reflected in the FDI. And, this does not reflect confidence - much like the Indian investor who is also hesitant yet, to invest into fresh capacities.

The confidence reflected in the large reserves need to be translated into investments to create new jobs and growth.

Inflow of foreign exchange assets has become the major source of the rise in money supply. Foreign exchange assets of the RBI grew by 33 per cent as of November 2003 compared to the year""ago level.

The RBI has tried to sterilise the capital flows through open market operations and repo sales under liquidity adjustment facility. As a result of this, the rupee securities held by the RBI halved over the past one year.

In spite of these interventions, the rupee continues to remain strong. Evidently, interventions have a limit. If the capital surplus cannot be absorbed into investments then, the distortions that cause the "excess" capital flow need to removed. This could obviate the need for interventions.

Minor tinkering such as the recent ones with the guidelines on external commercial borrowings are unlikely to make any difference. With the cushion of $100 billion of reserves we can take bolder steps.

A further and substantial liberalisation on the external front "" lower tariff and non""tariff barriers to trade, removal of tax incentives for exports and removal of distortions to encourage NRI flows "" is the way forward.