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Tuesday, February 07, 2006

RBI's yearning for more capital controls

The National Common Minimum Program (NCMP) of the UPA government had promised to encourage foreign equity flows into India, while "checking speculation". In order to translate this wish into policies, the Ashok Lahiri committee was setup in the Department of Economic Affairs [link to pdf]. The most fascinating thing about the report is actually a dissent note by RBI (page 59), which spells out the capital controls that RBI wants. In summary:

  1. They think the "origin and source" of investment funds matters greatly.
  2. They want a committee to study measures to curb volatility of portfolio flows.
  3. They want to continue to have restrictions through the separate enforcement of FDI and FII limits.
  4. They want to ban participatory notes.
  5. They want to remove any hedge funds which are FIIs today, and block future registration of hedge funds.
  6. If entity X is eligible to come into India as a subaccount, but not as an FII, and is not presently in India, they want to block it.
  7. They want to continue with the existing ceiling on the stock of FII ownership of debt securities, rather than shifting to a ceiling on the flow of debt investments per year.

Today's Business Standard has an excellent edit which disagrees with RBI's position on the direction of the evolution of India's capital controls. The edit says: Rather than keeping certain types of investors out, the policy objective with respect to foreign investment should be to keep most, if not all, in. That means making it easier for foreign investors to buy stocks in India, to the point where they should not have to come in through the conduit of registered FIIs.

Update: Andy Mukherjee has an excellent column titled Hedge Funds Bring Capital, Anxiety to India on Bloomberg, where he links up the issues of capital controls and the impossible trinity.


  1. SEBI came out with a report on their position on allowing hedge funds enter the Indian market and various policy options in this regard
    I think the problem with RBI's position is that they don't seem to understand the gains by having capital markets with a diversified investor base. In any case the large financial institutions in India like LIC aren't very big players in the markets (relative to their size) and it seems that it will take quite some doing on their part to change in this regard. In such a scenario, it makes perfect sense to have investore like hedge funds who can bring large amounts of risk appetite on to the table.
    The challenge for SEBI would then be to reduce transaction costs and costs of setting up shop in India. As Vijay Kelkar pointed out, right now its too much of a pain for some of the PN participants to take the trouble of registering as FIIs and meeting all compliance norms. Which means there is a neat cut for all registered FIIs to make in the process. I just wonder what their stands would be on this issue...

  2. The price of the PN is, of course, the rental value of the permit that the FII has. But I have been puzzled at the empirical observation (that I have been told) that relatively few FIIs are, as yet, in the PN game. Why would that be? Does someone have facts on this?

    This is important because, in the limit, as SEBI steadily gives out more FII permits and sub-account permits, there should normally be more competition in the PN market and the rent associated with being able to write PNs should go to zero, which is a happy outcome. But if something else holds back a large number of players from selling PNs, then this friction won't easily go away.

  3. In markets where there are significant foreign ownership restrictions, FIIs in the PN/market access business see demand for straightforward 'delta one' kind of structures. For investment banks (registered as FIIs) that are in this business, market size and liquidity are the primary constraints. Apart from this the ability (or the lack of) to borrow stocks, like in India, may also create some hurdles. I know for a fact that most banks will not offer instruments with indian underlyings with maturity/tenor of more than 3 years. Taiwan and Korea its usually 6 years and on Chinese underlyings its usually 3 years. (Note that all these markets have short selling restrictions in place).
    From the investors viewpoint, the PN replicates all the risks that holding the underlying would have. APart from this new risks like counterparty credit risk, FX exposure and tax treatment also are added on. While the FX risk can be hedged (in most cases with the same counterparty), I am not too sure whether the potential tax treatment of returns is playing a part in constraining this market.
    And if empirical data on PN issuance does show what you say, then its all the more reason to counter RBI's argument of "dirty" money flowing in.


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