Sense And Nonsense

The global total of funds managed by institutional investors is estimated at a staggering $20 trillion. If these investors were to reallocate just 1 per cent of their total assets under management towards the emerging markets, this shift would constitute a capital flow of $200 billion. If institutional investors were to optimise their overall risks, the share of portfolios allocated to emerging markets could reach a level three times as high as it is today. The portfolio investment flows into emerging markets was $59 billion in 1996 of which Asia accounted for $20 billion. These figures appear very pleasing when they relate to inflows but the moment there is the slightest sign of an outflow, countries invariably get into a paroxysm.

 

The outstanding FII investments in India reached a peak of a little over $9 billion and in recent months there was an outflow of a few hundred million dollars. This is sufficient for us to get into a panic and to conclude that FII investment is the villain of the price and the policy of opening up to FIIs was all wrong. A few days ago, I was addressing a chamber of commerce meeting when a respected member of the financial community asked me why the authorities were not taking action against the nefarious activities of FIIs of selling on highs and buying on lows. Like good samaritans, FIIs should buy scrips on highs and sell them on lows; after all, FIIs are here to help us!

We need to avoid paranoia about FII investment in India. This is not to say that the regulatory framework should not be enforced strictly for both FIIs and domestic investors. But we must disabuse ourselves of the erroneous belief that foreign direct investment (FDI) is good and an FII is bad. We need to appreciate that a country presents an overall climate of investment and an increase in FDI is also contingent on a sane policy on FIIs. We cannot invite our house guest (FDI) into our bedroom but turn hostile as our guest (FII) steps onto the verandah.

Now what is the future of FII investment in India in the next few years and what are the ingredients of a rational policy? We should not go on the assumption that there would be a reallocation and that a sizeable part of the shift would come to India. The Indian stock market and exchange rate has not taken any kind of beating that has occurred in the Southeast Asian meltdown. The Indian market appears to be more highly priced than other markets. We need to go into a period of consolidation wherein we improve our clearing, settlement and custodial systems and increase transparency of operations by better disclosure norms. We need to keep our macroeconomic policies sensible and there could be nothing better than this for attracting investment into India.

We also need to avoid the fear of flying. After great hesitation we have allowed FIIs to cover their debt exposures in the forward exchange market. For some reason we are afraid of allowing FIIs to cover their equity exposure in the forward exchange market. This is a totally misplaced fear. The argument is that FIIs may scramble for forward cover and the premia may rise to stratospheric levels. No FII would wish to cover itself at a premium of 25-30 per cent. Now, if forward premia were to fall to unreasonably low levels, some FIIs would perhaps seek forward cover and this would bring forward premia to their appropriate level. To ensure against speculative activity without the underlying exposure, it could be stipulated that FIIs cannot cover forward beyond, say, 80 per cent of their exposures in India. This would take care of the problem of fluctuations in the value of their exposures.

We need to understand that merely covering forward does not result in an expending of foreign exchange; outflows result in a loss of foreign exchange and this takes place whether or not forward cover is provided. Again, prohibitions on forward cover merely shift the market offshore.

Our reluctance to allow FIIs to invest in Treasury bills is based on erroneous fears of the Mexican experience. The Mexican Treasury bills were denominated in dollars and the fears are totally unfounded as the volume of Indian Treasury bills is small and these are denominated only in rupees. While the dated securities market has been opened up, the FIIs have not evinced interest. FIIs will not enter a market immediately on opening up. The recent momentary escalation of yields on the shorter dated securities provided FIIs an opportunity for investment but this was apparently missed. We need to allow some time before FIIs recognise trading opportunities. The main advantage of the FIIs operation in the debt market, particularly the government securities market, is that they would add to the participants in the market and their perceptions and needs for liquidity would be different from those of other participants.

While information on FII inflows on a net basis is used to arrive at outstanding figures, there is a flaw in this approach. Over time, the value of FII investment in India would rise and as such there is a need for a periodical valuation. The FIIs should be required to report the value of their investments in India as of March 31, each year. While Reserve Bank of India surveys of foreign assets and liabilities do get published, the lag is too long and there should be a special reporting limited to FIIs. My guess would be that the $8.9 billion investment would, on a valuation basis, turn out to be significantly higher and could well be of the order of $13-14 billion, if not more i.e. the exchange rate depreciation would be more than compensated by the higher rupee valuation of their investments.

Finally, what can we expect by way of future inflows. Given the developments in the international economy, it is unlikely that there would be any major upsurge in FII inflow in 1998-99. Our objective should be to set out a reasonable framework and this will result in moderate but sustained FII inflows which will be in the best interest of both the FIIs and India. There is a mutuality of optimal benefits to the investor and the host country and we should work to that optimal situation.