Opinion Greasing our shock absorbers

In recent weeks,there is considerable gloom about the outlook for capital flows,especially FDI inflows. On the one hand,when there is global geopolitical risk,global capital tends to retreat into safe havens with political stability,mainly the OECD countries. In addition,the outlook in India has become considerably darker,with the government grappling with corruption and inflation; it is an environment when little effort is spent on long-term policy change or reform. These two factors have come together to exert a certain negative effect on capital flows into India.

There are two areas where foreigners are clearly keen to invest in India and that investment would equally clearly be beneficial for India. The first is FDI in sectors such as retail. The second is foreign portfolio investment into rupee-denominated debt. In both these areas,efforts to remove restrictions will ease bottlenecks,and produce a flow of capital into the country.

At the same time,considerable uncertainty about the outlook for the world economy remains. In coming months,political risk in the Middle East,and a potential second round of crises in the European periphery,could play out. These could easily involve fairly dramatic events. Capital flow fluctuations of 1 to 2 per cent of GDP cannot be ruled out.

How best can India deal with this? We are now in a phase of ever-deepening integration into the world economy. Particularly with the large-scale operations of MNCs in India — both domestic and foreign — the effectiveness of capital account restrictions has greatly diminished. The top 500 Indian companies are turning themselves into MNCs with global treasuries. Their financial activities overseas are immune to India’s capital controls.

Having signed up for the globalisation project,our focus should now be on better absorbing shocks. What are the key shock absorbers? The three critical ones are: a flexible exchange rate,a liquid currency market and a liquid equity market.

What happens if $10 billion flows into the country within a week by way of FII flows on the equity market? The first source of damage can be currency policy. If the RBI tries to buy dollars so as to prevent a rupee appreciation,this would lead to a distortion of monetary policy. With an inflation crisis on its hands,the RBI needs to raise rates. But if the RBI buys $10 billion on the currency market,it has to pay for this by creating Rs 45,000 crore within a week,which adds to reserve money. This would yield a monetary policy distortion,and help fuel inflation. In order to avoid this problem,the RBI needs to stay on course with the strategy of not trading on the currency market.

Assuming the RBI does not interfere in the market process,$10 billion would hit the foreign exchange market. Here,what India needs is a deep and liquid currency market so that when a large order comes along,the price does not move. Data from the Bank of International Settlements shows that the rupee has a roughly $20 billion/day market in India and $20 billion/day market abroad,adding up to $40 billion/day. Today $2 billion/day for a week may affect the price,but as this market grows bigger,the impact of large dollar inflows or outflows on the exchange rate will be smaller.

From a policy perspective,it is important to move forward with financial development to achieve a more liquid market. The Percy Mistry and Raghuram Rajan reports discuss how to achieve a bond-currency-derivatives nexus. This would give us a greater ability to absorb shocks on both the currency market and the bond market.

The third leg of the story lies in the equity market. Here,globally,trading in Indian equities works out to roughly $45 billion a day. Of this,roughly $35 billion a day happens at the National Stock Exchange,$1 billion a day happens at the Bombay Stock Exchange and (a rough estimate of) $10 billion a day happens abroad. The offshore venues include Singapore,New York and London. Here also,orders of $2 billion a day for a week would affect the price.

Today India is open to portfolio investment from foreign institutional investors. Individuals are not allowed to invest easily. Yet,from the point of view of incentives,decision-making,knowledge about Indian markets and thus behaviour in the equity (and hence foreign exchange) markets,this reduces diversity. Allowing retail investors,some of whom may be pensioners while others may be speculating on the rupee,will give us less of the herding behaviour that sometimes characterises institutional investors,who could tend to move in and out together. Greater diversity of opinion and behaviour would reduce fluctuations,and more trading would increase liquidity,in these markets.

In summary,nervousness about capital inflows requires a multi-pronged response: the reduction of capital controls that interfere with FDI and rupee-denominated debt; a continuation of the RBI approach of not interfering with the market exchange rate; and financial reforms that will yield more liquid currency and equity markets. With these,India will achieve bigger capital inflows in a difficult time. In addition,the financial markets will become better able to buffer the inevitable fluctuations of capital flows.

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