FII inflows into INR denominated debt

In recent days, I have written twice about debt inflows: about the RBI policy framework on debt inflows, and about SEBI's implementation of these policies. On 13 April, Andy Mukherjee has written a column on Bloomberg on these issues.

The policy alternative that is being discussed is that of removing all restrictions on FII purchases of INR denominated bonds (whether GOI or corporate), and having controls on foreign currency borrowing. The key question that Andy asks is: What's in it for India? My response would be in two pieces. First, the proposal is superior because it avoids the currency mismatch on the part of firms that's caused by the present framework. A shift to INR denominated debt is safer. Second, it will foster the development of a local bond market, which is an essential element of financial globalisation.

Great essay on globalisation

I loved the book From Beirut to Jerusalem by Thomas Friedman (1998) when I read it (at the time). After that, I enthusiastically bought and read his The lexus and the olive tree. I got something from that book but not a whole lot. When The world is flat came out, I read an extended essay which he put out in the The New York Times and chose to skip the book. Friedman engages in too much rhetoric and now I see the book as the latest `management guru' book. I never read management gurus.

Today, I read a marvellous essay on the book by Edward Leamer which is forthcoming in Journal of Economic Literature. Much unlike Thomas Friedman, it is actually insightful and (atleast for me) said new things about globalisation other than the obvious insights of gains from trade based on diminishing frictions. If you've been uptodate with the field of international trade, it might be familiar territory, but for the rest, it's a great read.

I was struck by the fact that over time, the distance coefficient in gravity models has not dropped. It is a really surprising result. I wonder why this happens. Certainly, looking from an Indian perspective, there has been a huge upsurge of trade to faraway locations, made possible by reduced transaction costs. In particular, in terms of BPO, India appears to do huge trade with faraway locations (e.g. UK and UK) and negligible trade with close-by places. This doesn't sound like a gravity model story to me. (Richard Portes & Helene Rey have this famous result from 1999 on gravity model type stories with capital flows also, and there also, I feel that India's a bit of an outlier, doing very little business with the immediate neighbourhood.)

One possibility that struck me was like this. In the last 30 years, there have been important political developments leading to lowered trade barriers for intra-regional trade in 3 regions: EU, North America and (to a lesser extent) East Asia. Each of these events - e.g. NAFTA - might give an upsurge of trade between countries at short distances to each other, thus swamping the effects of improvements in the transportation of goods. If this happened, then it's a one-off, and in the future, we may get a decline in the distance coefficient.

Quota raj for debt inflows

As is well known, this year, the quantitative limits on FII investment into rupee debt (both government and corporate) have been raised.

Unfortunately, there's a highly bureaucratic mechanism through which the limit is operationalised. First, SEBI defines two "routes" called the "100% debt FII" and the "70:30 FII". Each of these has different rules. What is worse, it looks like SEBI has taken upon itself godlike powers in determining how much of the quantitative limit will be used by one type or the other. I'm sure the lobbying will now start where the "70:30 FIIs" will request an increase in their quota.

What is worse, within these quantitative limits, SEBI seems to want to `equitably' allocate the limit amongst all firms.

This is a really crazy idea. If you look at the ownership of shares by FIIs - which, mercifully, has no such quota system - then some firms are big and some firms are small. Customers decide which firms gets to run money. If a government tries to impose an "equitable" quota system, this would hugely distort the market structure. Today, Business Standard has an excellent editorial criticising this "quota raj".

The SEBI framework is anti-competitive. Suppose there are 10 firms and an "equitable" allocation gives them $100 million each out of a total limit of $1 billion. When a smart firm fills up it's quota of $100 million, it goes to sleep. It stops fighting in this space. A customer who wants Indian debt might like to go to a smart firm, but it will have to turn away customers because there is no room left in the quota. The customer will be forced to go to a lesser firm. The rules thus nurture weak firms and penalise strong firms.

As the BS edit suggests, there is really no role for the words "100% debt FII" or "70:30 FII". This is the disease that often afflicts Indian financial regulation - slicing up a competitive industry into walled-off slices with supreme power in the hands of bureacrats to shape the profitability of each slice. Once the walls are in place, each slice lobbies with RBI / SEBI for modifications of rules to increase its own profitability. I think we should try to do financial sector policy so that the world has not been broken up into fragments / By narrow domestic walls - where lots of finance companies have bareknuckle competition with each other, without slicing up the industry into categories which imply that firm i won't be able to compete with firm j.

It is not clear why SEBI is building this quota raj, for it does nothing to achieve the mandate of building a liquid and efficient securities market. The sensible path for SEBI is that India should only have one single "FII licence". After that, the FII should be free to invest in listed or unlisted equities, government bonds or corporate bonds, based on business considerations. Limits could exist on any one piece (e.g. a 24% limit on some company) and there can be a non-intrusive mechanism to ensure that limits are not violated as has been done with listed shares. There is no reason for the government to get into quotas.

This links up to the discussion on convertibility. Once again, we see that realworld capital controls - whether manned by RBI or SEBI - are not anywhere as elegant as the capital controls of the imagination. Realworld capital controls are manned by frail institutions, and involve all manner of rigidities and distortions. Convertibility is the solution chosen by all mature market economies, not because markets are perfect, but because the blemishes of the market are smaller than the blemishes of control raj.

Downstream from 'Fab envy'

A few weeks ago, I had written about SemIndia saying that while it would be great if semiconductor vendors chose India on merits, there was no role for the State to get involved in these choices. On a related note, Shobhana Subramanian had an article in Business Standard about the land acquisitions by India, Inc. These concerns may have been on the right track. Today, one of my readers pointed me to an article in The Times of India's Hyderabad edition (4 April 2006). I normally like to link to sources but the TOI website is so bad I will spare you the pain of going there:

HYDERABAD: You can call it the politics of Fab. With eight semiconductor companies now willing to set up units in Hyderabad, it would have been fair to assume that the city has a problem of plenty. But that's not the case.

As the state government has decided to anchor the Fab City project around SemIndia promoted by Vinod Agarwal, other semiconductor units want to keep away from the project.

Moreover, SemIndia is using technology provided by AMD and therefore the Intel partnered Non Tech Silicon India (NTSI) project --- to be announced later this week --- does not want the fulcrum of the Fab park around SemIndia.

Faced with this reality, the Andhra Pradesh government is now trying to reconfigure its Fab City project and delink the SemIndia project from the Fab City proposal. This is not as easy as it seems, because the state government has already signed an MoU with SemIndia. In the meanwhile, faced with numerous complaints about SemIndia and apprehensions about the ability of its promoter Vinod Agarwal to implement the project, the government has asked the promoter to furnish a copy of the MoU he has with AMD.

"We are yet to hear from him," an official said. When asked how the state government chose to devolve such a huge project around Agarwal without checking his antecedents, the official said that the project came to the state government via the Union government and thus it was assumed that New Delhi had done all the preliminary checks.

With the entire Fab City project going into the hands of SemIndia, which has AMD as its partner, NTSI is facing problems in closing its deal with Intel which has its reservations on locating its facility on a campus controlled by its competitor AMD.

Conceding that due diligence was not given before signing an MoU with SemIndia, they claimed private investigators had been used to check the credentials of Dr June Min-led NTSI before land was given to him.

Doing everything wrong on debt inflows

In India, there is a deeply held belief that debt inflows are bad, that all policy levers should be used to block debt inflows. In my column in Business Standard titled Doing everything wrong on debt inflows on Wednesday, I argue that a more nuanced understanding of the problems of debt inflows throws up difficulties with every aspect of existing policies.

I offer a five-part design of a sensible framework on handling debt inflows within a framework of capital controls. We could be moving towards convertibility, which would put wonks like me out of job on these kinds of questions. :-) But this five-part strategy could be put into use immediately, pending full convertibility.

I asked Joydeep Mukherji about what is going on with local currency debt issuance in Latin America. He said: Latin governments are trying seriously to get foreigners to invest in their long-term local currency debt. The Mexican government issued 20 year bonds 2 years ago and is thinking of issuing 30 year bonds now in Pesos, with fixed nominal interest rates. Most of these bonds are bought by foreigners, who have the choice of hedging currency risk if they so desire. Colombia is doing the same, but issuing in Pesos but in the foreign market (due to imperfections in its own markets). Brazil, as you cite, is trying to get FII money into its own debt market to lengthen the yield curve. These sovereigns have been trying to take advantage of the currently liquid state of global capital markets by rapidly reducing their dollar exposure, reducing a major source of vulnerability to their finances.

Update (17/6/2006): in a speech two days ago, Randall Kroszner said:

Since 2000, ten-year nominal fixed-coupon bonds in local currency have been introduced in Brazil, Colombia, Indonesia, Mexico, and Russia, while Korea issued a ten-year fixed coupon bond in 1995. To illustrate in more detail, the governments of Mexico and Korea have been able extend the average maturity of their local-currency debt significantly in just the past few years. The Mexican government issued ten-year maturities in 2001 and then 20-year maturities in 2003. The proportion of local-currency debt in Mexico maturing within one year was nearly 90 percent in 2002 and is now below 75 percent. (I have included floating rate debt in the one-year maturity category.) The Korean government continues to increase the proportion of its domestic currency debt in longer maturities, with the one-year-and-under segment falling from roughly one-half in 1999 to one-quarter by the end of last year.

Two, bond yields in local currencies of emerging-market countries have also declined. It is perhaps not surprising that, given their high rates of saving and generally high level of economic development, the governments of Hong Kong and Korea can borrow at close to industrial-country levels. More notable, however, is that the Mexican government can borrow in pesos at a ten-year maturity at rates that have averaged roughly 9 percent. And Mexico is not unique in this regard. Other middle-income emerging markets with ten-year local-currency fixed rate bond yields in the single digits include Chile, Malaysia, Russia, and Thailand, to name but a few. For countries with longer maturities, implied short-term interest rates five years ahead also have been declining and have reached very low levels, although there have been some increases in the past few months.

I got lots of comments on these issues. Here are some comments, and my responses:

Comment: But the FII limit is not binding and hence it's not really a limit. My response would be in two parts. First, my article was about the structure of capital controls, pointing out that it's just wrong to limit FII investments into INR debt (both GOI and firms) while supporting liability dollarisation by both the State and by firms. So whether the limit binds or not, the policies are wrong. The policies claim to keep India safe but are actually in the opposite direction. Second, I think that when India advertises tiny limits to the world, the biggest institutional investors get turned off. If India said that our FII framework for debt is the same as our FII framework for equity, then the big institutional investors would get going setting up offices in India to learn and trade Indian bonds.

Comment: Do foreign investors really want to buy INR denominated GOI bonds? My personal experience is: Yes. By world standards, India's GDP (~ $800 billion) is a big number and by world standards, we issue a lot of debt. Global investors would generally not ignore a country of this size. A lot of people feel that the 25-year perspective on the INR is quite positive. The USD, the Euro and the JPY have problems. I think it's not hard to make a case to global fixed income portfolios that they should be putting 2% into India for the purpose of diversification and for the purpose of riding the optimistic future of the INR.

Comment from Jayanth Varma: I agree with Ajay Shah that this is truly absurd but it is fully explained by the political economy of the situation. The corporate sector usually gets what it wants through intensive lobbying. This happened in East Asia before the crisis and it is happening in India now. I think a good businessman understands that liability dollarisation isn't pretty, so I'm not sure the corporate sector yearns for the present policy framework. I thought the political economy was about the influence that banks have with RBI. Whether it's ECB or NRI deposits, it looks like policies are being designed to feed fees to banks and shrivel securities markets.

Comment from Jayanth Varma: If foreign investors are allowed to hedge currency risk, then the true national exposure may still be that of foreign currency debt if it is an Indian entity that stands on the other side of the hedge. In fact, the effective position of the nation can be that of short term foreign currency debt. This problem is not insurmountable but some thought needs to be given to it. I think in terms of a world with covered interest parity (CIP). Fairly soon now, India will have a GDP of $1 trillion and gross flows across the border of $1 trillion per year. I think in terms of a world where infinite capital is deployed into CIP arbitrage. Then whether a few billion dollars here and there seek currency hedging doesn't change anything big. If we think that India will have a debt/GDP of roughly 60% and if 10% of the debt market is owned by foreigners, then that's (at the maximum) roughly $60 billion of outstanding hedge positions on the currency derivatives market. This is not a big number compared with flows of $1 trillion per year sloshing through the currency market.

Comment from Jayanth Varma: As Martin Wolf points out, many countries have been able to overcome original sin and borrow in their own currencies once they have persuaded their own citizens to lend to them. We need a proper government debt market instead of the captive market that we have now. I agree that the INR yield curve is distorted owing to financial repression (e.g. banks, insurance companies, pensions) and the lack of speculative price discovery. That should impede some foreign investors. But I don't think it's a show stopper. I have met many foreign fixed income investors who are keen on getting invested in INR debt at existing (distorted) interest rates.