Opinion A new opening act

Since 1991,when India witnessed a balance of payment crisis due to short-term foreign liabilities,Indian capital controls have involved restrictions on foreign debt. There are no explicit caps on the total foreign borrowing,the two main components of which are external commercial borrowings (ECBs) — that is,dollar borrowings by companies — and FII investment in rupee-denominated bonds. The policy framework attempts to control this magnitude. However,there is a ceiling on FII investment in total rupee-denominated bonds,and within that,on government bonds and corporate bonds.

By 2009,the stock of corporate borrowing under the ECB window (dollar-denominated) stood at above $62 billion,while foreign lending to firms in rupee-denominated debt was capped at one-tenth of that value,at $6 billion. The bias of controls on rupee-denominated versus dollar-denominated debt had resulted in higher dollar-denominated borrowings by firms.

The ministry of finance working group on foreign investment,headed by the present Sebi Chairman U.K. Sinha,argued that the government needs to move away from restrictions on total foreign debt,to a restriction on dollar-denominated foreign debt where movements of the rupee dollar rate can pose unforeseen liabilities on the borrower. If an Indian company has borrowed in dollars and the rupee weakens,the company has to pay more. The policy framework has been guided by the old belief that foreign debt,as such,was dangerous. The policy lesson that emerged from the Asian crisis,however,was that foreign debt denominated in foreign currency could be a much bigger potential source of risk. Local currency debt did not pose the same risks. The Sinha report recommended that restrictions on FII investment in rupee-denominated debt — that is,corporate bonds — be removed.

The primary reason for maintaining restrictions on foreign investment in rupee corporate bonds was to control dollar inflows to prevent the appreciation of the rupee. Over the last two years,RBI intervention in foreign exchange market has been largely absent,and the rupee has witnessed two-way movements with high volatility. Once the exchange rate regime changed and the rupee became flexible,there was little reason to hang on to the restriction on rupee-denominated debt.

In his budget proposals this week,the finance minister raised the ceiling on FII investment in corporate bonds in infrastructure from $5 billion to $25 billion. This doubled the cap on total FII investment in corporate bonds to $40 billion. This is a step forward in rationalising the capital controls framework.

The other important move in the budget towards greater capital account liberalisation is to allow retail foreign investors to buy Indian mutual funds. At present,if a foreign investor wishes to invest in the listed equities market,he has to be in one of the categories of institutional investors recognised under the SEBI Foreign Institutional Investor Regulations. This framework was set up in 1992-93 when India first opened up to foreign investors. The list of investors has been widened over the years but still involves a check on the structure of the investor,which allows only collective investment schemes. If the investor is an individual,he has to register as a sub-account with an existing foreign institutional investor.

The biggest weakness of the institutional investor framework is herding behaviour by institutional investors. Due to similarity of objectives,time horizons,profit-booking dates,interconnectedness amongst the big institutions,etc,institutional investors respond to various situations in a similar manner. On the other hand,retail investors do not exhibit the same behaviour. They can bring a diversity of views and actions to financial markets. Further,the present crisis showed that large investment banks with leveraged investment were prone to disruptions and shocks. Yet,as a policy,India has allowed only such investment companies to enter the markets from abroad.

Further,the Sinha report indicated that while Sebi registers foreign investors,this is not to enforce Know-Your-Client (KYC) norms that India is now required to do as a signatory to various international anti-terror treaties.

The Budget 2011 proposal should be seen in the light of the above recommendation. The finance minister proposed to allow foreign retail investors to invest in Indian mutual funds. This will mean that Indian mutual funds do not have to go register in Mauritius or Singapore to get foreign investors,and it is thus a step forward as it removes the protection the FII framework was implicitly giving to foreigners. However,the proposal does not yet address the objective of bringing greater diversity of behaviour into the market. Since mutual funds are institutional investors,though domestic,their behaviour is,to some extent,still similar to that of foreign institutional investors. Still,it is a step in the right direction towards rationalising capital controls and moving ahead on capital account liberalisation.

India has an elaborate system of capital controls. When juxtaposed with the fact that the Indian economy recovered quickly after witnessing a setback to GDP growth after the global financial crisis,many people are tempted to draw the conclusion that it was the capital controls that made India resilient,and thus capital controls are good and should be retained. The importance of the Indian experience in the capital controls debate is,thus,huge. India is almost the only “evidence” of a large country whose historical experience of capital controls and high growth make the case for capital controls. The ministry of finance working group report and the budget proposals to move towards greater liberalisation of the capital account,rather than hanging on to capital controls,should have important lessons for other countries.

The writer is a professor at the National Institute of Public Finance and Policy,Delhi
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