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Monday, January 09, 2006

Capital controls in operation: Tales from the front

We all very well remember the 1960s and 1970s, when we had a complex system of quantity controls and price controls. Three things were in place: There were many quantity controls, there were many price controls, and it added up to a complex system with thousands of levers.

We know what happened in that period. Firms got focused on how to earn profits by beating the system, rather than being efficient. People who had a permit earned a rent on that permit. It was easy money. They got addicted to it, and then started political lobbying to ensure that nobody else got the scarce permits. The functioning of companies, and the technology of production, got enormously distorted in ways which emphasised earning profits by learning and exploiting the system of controls rather than being smart or being efficient.

But we learn from history that we learn nothing from history. Hence, this movie is now being played in finance, where we have the same three pieces: there are many quantity controls, there are many price controls, and it adds up to a complex system with thousands of levers.

Today, the Hindu Business Line has an article by Rajesh Abraham telling a story about a `banking stock price index ETF' product by Benchmark which has been phenomenonally successful. Benchmark are good guys, and they are among the better purveyors of index funds in India, and I like index funds in general, but Rs.2,668.39 crore invested in a bank index ETF??

I read the piece, and it's the old 1960s and 1970s story being played again. FIIs are prohibited from buying bank stocks directly, so they flock to the bank ETF as a way of getting that exposure.

On a related note, U. R. Bhat has an opinion piece in Economic Times talking about participatory notes. PNs are OTC derivatives written outside India by a finance company. The article is not as blunt as it ought to be, in one respect: No regulator in India can know what PNs are written by what firm outside India to whom.

PNs can be described as OTC derivatives written outside India. Most of the time, the PN seller would want to hedge himself by taking an offsetting position in India. Ah, I see! This is just the old 1960s / 1970s story of earning a rent on a permit. Some FIIs in India have the permit, and they're getting a fee by renting it out to the poor folk who don't.

In addition, PNs are an elegant and desirable mechanism for avoiding the procedural frictions and transactions costs of doing business in India. The buyer of the PN is avoiding these hassles, and the seller of the PN is getting a fee for taking the trouble. As U. R. Bhat says: Quite often investors who are eligible to get a FII or FII sub-account registration do participate in the Indian market through PNs. This is the case because of the procedural issues relating to registration, establishing broker and custodian relationships, undertaking forex transactions and more importantly, dealing with tax certifications, filing of income-tax returns and getting tax assessments completed. In addition, there is the added uncertainty about the tax status of foreign investors with the revenue authorities interpreting the provisions of tax treaties differently on different occasions with issues like permanent establishment, classifying investment income as business income etc, being subject matters of frequent disputes. For an investor, PNs offer an elegant solution to procedural hassles and tax uncertainties, by transferring these risks to the main FII, albeit at a price, to enable the investor to focus attention on scouting for good investment opportunities.

The price of the PN reflects the size of these frictions, and the scarcity of FII permits.

What would the 1960s / 1970s response to these things be? More control and more policemen! FIIs are beating limits on bank stocks by buying the Bank ETF? Let's Ban FII investment in ETFs! FIIs are coming in through PNs? Let's Ban PNs! We already have RBI pushing the latter (couched in the vocabulary of `unclean capital flows', which would make a 1970s bureaucrat proud). I haven't seen anyone proposing the former, yet. But who can tell? Those who fail to learn from history are doomed to repeat it.

To read more on these issues in the context of capital controls, see Kristin Forbes' excellent survey article which is part of this forthcoming NBER book.

1 comment:

  1. The overall holding by FIIs is capped at 74% for private banks and 24-49% for PSU banks. BankBEES is an Indian mutual fund so it does not suffer from these restrictions.


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