A few days of moderate selling by foreign institutional investors have sufficed to worry India's financial markets. Since the new fiscal year began on April 1, FIIs have sold a net $275 million of Indian equity. This is negligible compared to the $26 billion of equity (and the $6 billion of debt) they bought in 2012-13, but the Indian investing community is alarmed at the thought that this could be the start of a trend. Unfortunately, despite much tinkering with reform measures on the part of the regulator, the Indian investor has become increasingly disenchanted with equity. Households have pared down allocations to equity and equity mutual funds in the last two years. This, in turn, has led to funds being forced to sell in the face of redemption pressure. Domestic institutions sold shares worth Rs 23,000 crore in the last fiscal. The FIIs are, thus, the only buyers of significance and if the FII selling continues for a sustained period, the stock market will drop for want of counter-parties with deep pockets. More worryingly, FII selling could have an adverse impact on the balance of payments and accentuate the existing pressure on foreign exchange reserves.
The numbers are disquieting. As of March 29, 2013, foreign exchange reserves were at about $292 billion. Discounting bullion ($26 billion), special drawing rights and International Monetary Fund (IMF) holdings ($6.6 billion), "free" reserves are at $260 billion. The latest figures assess external debt at $376 billion on December 31, 2012. About $92 billion was short-term debt, redeemable in 12 months or less. External debt, including short-term debt, has risen between January and March 2013, largely due to trade credits on a negative trade balance. Foreign direct investment (FDI) inflows between January and December 2012 amounted to $27 billion. The Securities and Exchange Board of India estimates FIIs hold a combined stock of $147 billion in Indian equity and debt ($32 billion). This flow could become volatile if the FIIs reduce India's weight in their portfolios. Even in the best scenarios, servicing short-term debt will put some pressure on reserves since exports are not expected to grow at any great pace in 2013-14. Ideally, India would hope for combined inflows of $60-70 billion through the FDI and FII routes to maintain comfortable reserves. If, instead, there are serious FII redemptions, maintaining reserves would be a tough task.
The scenario could improve somewhat, if international crude oil prices maintain their current downtrend and gold prices too remain soft, as both the developments would considerably ease the pressure on India's current account. Nevertheless, the combination of an over-reliance on portfolio money and a rising component of short-term external debt can be toxic. The Asian Flu in 1997 was triggered when precisely such situations prevailed in Thailand and Indonesia and foreigners stampeded for the exit. If such a trend develops in India and is exacerbated by a rise in prices of crude oil and gold, drastic action such as capital controls (as imposed by Malaysia in 1997), or a huge hike in rupee interest rates, may be required to contain it. Neither alternative looks palatable. Liberalising FDI regulations is desirable anyhow and it could certainly help in the long run. But FDI flows have a long gestation period. In the short run, the government needs to consider building a war chest of long-term overseas debt to pre-empt any run on reserves. The issuance of floating sovereign bonds has been mooted in this context, but there are large risks associated with those instruments. Going to the IMF for support via an early-stage arrangement has been suggested before by this newspaper. Given the overhang of a massive current account deficit, tapping the IMF for funds and moral support looks increasingly like the most pragmatic form of prophylaxis to ward off the possibility of high FII redemptions.
