## Tuesday, October 16, 2007

### The middle muddle

I have an article in Business Standard titled The middle muddle, about India's attempts at running an inconsistent monetary policy regime.

The backdrop to this is recent statements from RBI, SEBI's plans about restrictions on participatory notes and S. S. Tarapore.

Watch me talk about these events on CNBC on Wednesday morning.

Thursday (18th morning), and here's more of fun and games:

• I have a piece in Business Standard talking about how the overseas OTC derivatives industry on Indian equity underlyings works. There is quite a gulf between the rhythm of this business and the SEBI proposal.
• Surjit Bhalla says in Business Standard that the need of the hour is to get past the very FII' framework.
• Akash Prakash says in Business Standard that in the short-term these proposed restrictions will bind.
• Ila Patnaik, writing in Indian Express, links up these events to larger questions of India's strategy on harnessing globalisation.
• Jayanth Varma, writing in Business Standard.
• This clarification from SEBI was useful, though ideally the drafting of their document should have been clear enough that it was not required. I'm curious - what time did this come out? In this age of realtime information flows and analysis, all documents should be timestamped! :-)
• What comes next in terms of capital controls, by Anindita Dey in Business Standard.
• An editorial, and an article by Eswar Prasad, in Economic Times.
• See this article by Ila Patnaik in Indian Express which points out how small PN-based inflows are, when compared with the scale of RBI's trading on the currency market. When the drumbeat was built up about the need for restrictions on PNs, a glance at the data would have helped keep things in perspective. But this wasn't done either in the case of PNs or in the case of ECB. What is needed is a shift away from this strategy of having no strategy, of only fire-fighting using ineffectual capital controls.

After a rambunctious day on the stock market, it is not clear how much of their objective the government and the market regulator have achieved with their late evening announcement of Tuesday. A de facto limit is proposed to be placed on the issuance of derivative participatory notes, which foreign institutional investors (FIIs) have been resorting to far more than in the past. This has created and will continue to create some selling pressure because of the unwinding of positions. And to the extent that these instruments were non-transparent (the actual investor could hide behind layers of intermediaries), the government may also achieve to a limited extent its goal of trying to stop the round-tripping of domestic money (which is believed to have been going into some active stocks).

The short-term liquidity pressures will fade, however. So while the stock market has been shaken out of its bull-market euphoria (which is welcome), and forced some overseas investors to also re-assess the level of regulatory risk (not so welcome), it is far from clear that anything longer-term has been achieved. If portfolio investment wants to come into India because — as the finance minister emphasised on Wednesday morning —nothing about the India story has changed, then all that the proposed step will do is to re-route the money through other windows, most of which remain open. That might explain why, after the initial crash, the market recouped most of its losses fairly quickly. The net drop in the stock index at the end of the day is less than 2 per cent, which makes it little more than an ordinary day in the office.

But the stock market was only the government’s subsidiary target, as became clear on Wednesday. The real objective was to slow down the inflow of money through the capital account (running at between 5 per cent and 6 per cent of GDP) and thereby to ease the upward pressure on the rupee — which has gained more against the dollar than almost all other currencies over the past year. This in turn had begun to slow export growth, and caused job losses in vulnerable sectors like textiles and leather goods. The government has tried to neutralise the inflow by sterilising the money coming in so that it does not impact domestic money supply, but has been only partially successful. The situation is still that if India continues to offer a rapidly growing economy and an attractive market that enthuses foreign investors, the money will continue to come in, especially when world markets are still awash with liquidity. The larger macro-economic management challenge therefore remains, and has not gone away simply because there has been a mini-crackdown on P-notes.

Sebi has said that it will ease the process of getting registered as an FII and thereby getting the regulator’s approval to operate in the Indian market. The question to ask is why such a licensing restriction should be there at all. Banks, which are required to follow the rules about knowing who is their customer, are perfectly capable of being the gate-keepers when it comes to funny money, and certainly no less capable than Sebi, which is manifestly unable to find out who is behind the P-notes. Once the Indian market is thrown open, the entire business of foreign portfolio investment should become more transparent, and the limits on foreign ownership in sectors and individual companies will operate as the fencing. Those who want to hide their identities may continue to operate through new tools thought up by the financial community, but that will leave the government and Sebi no worse off than today. Just as the foreign exchange crisis of 1991 was used to usher in overdue economic reforms, the P-note issue should be used to open up the capital market. The side-benefit of opening up will be that the capital market activity that now takes place offshore will mostly come onshore —which can only be to the country’s benefit and to the goal of developing Mumbai as a financial centre.

The final point which needs to be made is that the only long-term solution to the current challenges on financial flows is to improve the productivity and efficiency of the economy, so that producers and exporters neutralise through these gains the pressures that get transmitted through a more expensive rupee. This has to be accompanied by further opening up on imports, to absorb the capital flows which are coming in and which by all accounts will continue to pour in. This translates into action on a broad range of fronts, all of which are well known and have been stated often enough. The tragedy is that the government seems unable to do what is required, for a variety of political and administrative reasons, and is therefore trying to resolve systemic issues with Band-Aid kind of solutions, that most people realise, will not work.

1. This seems so much like a typical Indian tamasha. While SEBI says the intention is not to restrict inflows but to regulate and know holders of PNs, several commentators are going on about how there is a bubble in the Indian stock market and it is being manipulated. This measure, they think, will cause a welcome correction. Of course, many (most?) see it for what it may really may be - attempt to restrict forex inflows.

Will it work? At the moment only PNs are restricted/withdrawn/banned. There is money coming in from registered FIIs - they are not affected. Many investors may decide to register. And the ingenious world of finance professionals may find alternatives. Since derivatives are cash settled what prevents a derivatives market to grow and thrive elsewhere (offshore) - at the moment it is largely absent and it may not have the liquidity that comes along with a cash market but things could change. It would also be interesting to see if PN holders and others rush to sell (as some are predicting) or could there be some aggressive buying (to beat the proposed rules) in the 7-10 days that it may take for the rules to be notified.

If one looks at ECB in the last year a few large borrowers accounted for the majority of the money raised (20 firms for 50 % of the borrowings). And they have capex expenditures in forex to easily comply with the new rules. It will be the smaller entities who will be shut out - so much for the stated intention of helping SMEs.

I think we are missing a trick or two as far as inflation control is concerned. Commodity prices are at all time highs, economic growth in India is high, corporates are running at capacity and making record profits, and the fiscal situation is comfortable (not ideal but neither is it dire). However, our import duties remain stubbornly high and the spread between input and output rates is unacceptably high. Certain low value added sectors - oil refining is a prime example - enjoy high effective rates of protection (ERPs). Instead of wasting time and energy on negotiating trade agreements with all and sundry and tinkering with a few rates in every budget, the government could use this fantastic opportunity to 1) lower rates and 2) decrease, no abolish the differential between input and output rates. Ideally, one single rate for all industrial products but in any case no more than 2-3 (to take care of some exceptionals). That would be inflation-busting, promote efficiency and may not seriously affect custom revenues.

Much is made of what the rising rupee may do to the margins of Indian companies. (While the reduction in prices of one's output is highlighted, that of inputs one uses is conveniently forgotten). But should we shed a tear for India Inc? They enjoy margins which are unheard of in industrialized countries. A few stray examples - IT (25-30 % vs 12-18%). autos (12-15% vs 5-7%), construction (7-9% vs 3-5 %). One can go on and on. Linked to margins, and perhaps, more important, is the return on equity for Indian corporates (as they proudly claim - it is frequently in excess of 20%). Even utilities and fertilizer companies (which are "low" risk) can earn 12 -14 % post-tax which translates into 18 -20 % pre-tax and even higher for the most efficient units. In an environment where the US 10-year bond yields less than 5 %, Indian 10-year is about 8%, add some equity premium and it is difficult to see and justify the levels what we enjoy (admittedly this is a crude calculation and the figures presented are approximate). The point is that a move towards lower margins and return ratios seems inevitable given free movement of goods and capital.

As you point out we need to come to grips with and live with the change. Either we should not have traveled on this road, but once we have, putting roadblocks, speed-breakers and leaving potholes unattended is not the way to go (though this is what we do - both literally and metaphorically).

2. very well said on cnbc ... do u think the Left has hand in this also ?

3. Hi Ajay,

What all measures should RBI adopt to start effective monetary reforms. Can you please enlighten us ?

I know you earlier mentioned this sometime back. But I am not able to capture the link.

gaurav.

4. Gaurav, click on the label monetary policy' on my blog. Right now, there are 41 posts there.

5. well written article as usual... :)

6. Your parting comment on CNBC was pretty harsh, ouch :)

It was good to focus on the big picture. Keep at it.

7. If as Ajay Prakash argues (rather persuasively) that capital flows will be severely curtailed then the authorities would have met their objective.

That is really the game in town.

That ECBs didn't work is no reason why this won't work. (Actually in a way it it not that ECBs worked or didn't work but that flows from another avenue -portfolio investments - overshadowed, or rather overwhelmed the authorities - very likely a scenario they had not envisaged). The PN dynamics are different. In any case, the authorities are unlikely to rest unless they have their way. If changes to PN issuance doesn't work they will think of something else. Mr. Tarapore has even mentioned "unremunerated reserve requirements" on all capital inflows.

In such an environment expecting to away with FII registrations and having direct investments by foreigners is hardly going to be entertained. And while SEBI is making the right noises it can easily sit on fresh FII registration and delay the process long enough to suit themselves.

It may well be that what the authorities are doing will impose costs on the economy and several agents in the country and outside and may be undesirable, but that is hardly the point.

I think we still need an answer to the question Will the measures work? Are there enough holes elsewhere to neutralize the impact of portfolio flows? Will something else - unanticipated now - perhaps emerge?

8. How does one define these Offshore Derivative Instruments ? I think it has very interesting implications. Technically, even shares / units issued by foreign mutual funds (which are registered as FIIs / Sub-accounts) can also be defined as such...and consequently would have to comply with the 40% / 0% limit respectively.

9. hi Ajay

I read yr article in the Bus Std yesterday... I wish to defer on few points mentioned (of course, I am not as well versed with economics to give an opinion on wether the article as it stands is okay)

1. About the dollar depreciation, yes, the weakening of the dollar has a big role in rupee appr'tn. But we cant ignore the fact that the rupee has actually strengthened vis a vis every currency around.. viz the yen, euro and the pound!

2. The Govt has to have the exchange rate within a recognisable range. And therefore it has to take measures. It did take the step of imposing limits on ECBs some time ago. Now, i remember reading an article the same day in the same paper which stated that India's total ECBs last year was equal to about half of the total Negative balance of payments. Dont you think then, that it is prima facie, an effective way of controlling th exchange rate?
I dont understand macroeconomics as much as id like to. stuff like how you increase th bank rate, and the WPI falls within 2 weeks (i think its just coincidences, and economists parading it), and how a change in ECB limit will have an effect in 1 month.

now back to the issue of PNs, we all know that the current rally, was caused purely by foreign inflows, and th domestic traders wer jus enjoying somebody else's party. And it was, to say the least, frightening, from the point of view of a stock broker.
Now does that matter? maybe it doesnt matter who buys, but it is neccessary t have an idea of who exactly is buying for two reasons. one, if they are hidden as a sub account, the whole purpose of trasparency will be beaten. and secondly, they could really pull the rug from under our feet anytime, and I dont think that worry is exaggerated. It has happened before, and will again!

pls dont see this as a personal criticism, because well, its an unwritten rule at blogger! :) and secondly, I still am not economically educated enough to comment on the article. but I feel the facts could materially change the strain of it.

and finally, i personally dont think it is right for people to just bullshit the people in power just like that.. i mean, PC and th RBI and SEBI are people with brains too, are they not? dont they also see the facts for themselves.. I strongly disagree with the way Udayan Mukherjee cribs on TV

And ya, not to mention, but I want a reply!

10. Anonymous,

> How does one define these Offshore > Derivative Instruments ? I think it > has very interesting implications. > Technically, even shares / units
> issued by foreign mutual funds
> (which are registered as FIIs /
> Sub-accounts) can also be defined
> as such...and consequently would
> have to comply with the 40% / 0%
> limit respectively.

As I say here: once we have the FII framework, and foreign financial firms are able to obtain exposures on NSE and BSE for the spot market and for the exchange-traded derivatives, they then use this `raw material' to construct all kinds of innovative products - ranging from emerging market funds to Nifty put options. This is feasible, desirable and inevitable.

11. Hi Ajay,

WRT monetary policy reforms, I scanned the monetary policy blog pages. Most of the pages centered out the solution towards fiscal consolidation.

Does it include reducing public spending or reducing govt expenditures? Won't it affect various development projects which in India have started at last ?

What do you say ?

Anyway Please Please recommend me some new book on open economy issues (and obviously what's the right way to tackle them) wrt developing mkts (like India).

Best Rgds,
gaurav.

12. > WRT monetary policy reforms, I
> scanned the monetary policy blog
> pages. Most of the pages
> centered out the solution
> towards fiscal consolidation.

Did you look in the right place? I just looked and on a massive web page with 41 posts, the word "fiscal" occurs all of 7 times.

13. Ajay

Refer to Ila Patnaik article .....RBI seems to be buying much more dollars than the FII flows...what are the other channels from which foreign money is coming into the country.....the local debt window is capped and ECB are restricted.

14. i agreee with ur comment that mindless people need not run india.do u think it is necessary to have rbi as an intervening hand in our market or let market decide everything.i think these babus r serving more of their interests.i m working on this concept nd would like to see ur comments.

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