Foreign Investment Inflows: Controls and taxes can be harmful
Businessline. Chennai: Apr 27, 2005. pg. 1
http://proquest.umi.com/pqdweb?did=828182291&sid=5&Fmt=3&clientId=68814&RQT=
309&VName=PQD
G. Ramachandran & V. Subrahmanyeswara Sarma
(The authors are financial analysts. Feedback may be sent to indiagrow@yahoo.com
and sarma.vempati@gmail.com)
Abstract (Document Summary)
The portentous rise in the proportion of net portfolio investment is also driven by a rising
deficit in the merchandise account. The net merchandise deficit rose by about Rs 20,000
crore. The truth is the surge in FII investments has saved India the blushes. Without this
surge, the rupee would have sunk a few notches. The oil imports bill would have
depressed India's growth aspirations considerably. Do FII investments deserve to be
controlled and discouraged? No.
If the RBI Governor is yet convinced of the need to impose the controls, he is likely to
include them in the RBI's announcement of the annual policy statement on April 28. Of
course, he may retain the option to impose them at a later date. Regardless of when
they are imposed, controls on FII investments would discourage inflows from high quality
investors. The desirable influence of high quality investors on financial markets will be
whittled down. The number and the investment power of those that have the
temperament and competence, and the resources and the right appetite for risk will be
eroded by the controls. The influence of the so-called hot-money investors could actually
rise. The quality of inflows could decline. Such a measure would overlook the existence
of a well-structured, well-managed and reliable equity futures and options market in
India. The RBI Governor has, perhaps, been impressed by Mexico's exit tax.
On the flip side, high-quality foreign investors may have insufficient asset holdings to sell
stocks when their prices rise insanely. This too will be a direct result of the quantitative
restrictions. When hot money gushes in, the rupee could strengthen dramatically. Highquality investors are India's best defence against hot-money marauders. But controls on
FII inflows lock out one or more high-quality investors. Controls will have an adverse
impact on prices, trading volumes, the timing of trades and, therefore, on liquidity. India
cannot afford to weaken its best defence against hot money. This redoubtable defence
against poor- quality inflows has already been erected and fortified by India Inc.
Full Text (1886 words)
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If the RBI Governor is convinced of the need to impose controls on foreign institutional
investors, he is likely to include them in his Monetary Policy statement on April 28.
Regardless of when they are imposed, the controls would discourage inflows from
quality investors and their influence on financial markets will, thus, be whittled down.
They will have an adverse impact on prices, trading volumes, timing of trades and,
therefore, on liquidity, say G. Ramachandran and V. Subrahmanyeswara Sarma.
INDIAN companies and their equity shareholders will soon know whether equity
investments by foreign institutional investors (FIIs) will be subjected to a set of new
controls. The RBI Governor, Dr Y. Venugopal Reddy, had recently expressed the need
for controls.
They could include qualitative criteria and quantitative limits, and a tax on investments.
The RBI Governor's case for controls on FII investments is apparently strong. But from a
fundamental perspective it is not strong. Perhaps, the Governor has no case at all.
Why? Its objective is to improve the quality of inflows. The assumption is high quality
inflows will be India's all-weather allies. This is debatable.
FIIs have their own objectives and obligations to the providers of funds. They will invest
and disinvest as often as is necessary to serve them. They are not here to serve India.
Qualitative controls could lead to the exclusion of some FIIs from the list of registered
investors. Quantitative controls would impose an upper limit on the magnitude of
investments by FIIs, both individually and collectively.
The purported objective of these controls would be to limit the exposure of Indian stocks
to hot money. To be fair to the RBI Governor, he has made no reference to hot money.
His focus is on improving the quality of FII inflows. It is our reasonable assumption that
hot money is poor-quality money. The inference then is that controls on FII investments
would improve the quality of future inflows. We think they will not.
Flawed basis
The case for controls is flawed. It is driven primarily by a set of numbers in India's
current account and the capital account. Portfolio investments by FIIs and other
accredited external investors in the recent past have surged in absolute and relative
terms. FII inflows have had a significant impact on the capital account in 2003-04.
The net portfolio investment between April 2003 and March 2004 was over Rs 52,000
crore. By contrast, it was merely Rs 4,504 crore between April 2002 and March 2003.
But there is more to this significant rise. And, they may have provoked the RBI Governor
into speaking his mind. Net portfolio investment was 5.42 per cent of India's aggregate
net inflows in the current and capital account in 2002-03. It was 8.60 per cent of net
inflows in the capital account in 2002-03. By contrast, net portfolio investment rose to
36.48 per cent (from 5.42 per cent) of aggregate net inflows in the current and capital
account in 2003- 04. And, rather disconcertingly, it rose to 54.98 per cent (from 8.6 per
cent) of net inflows in the capital account in 2003-04.
The rise in the relative percentages may strike fear. But they should not. The menacing
rise in the proportion of net portfolio investment is driven by a decline in net inflows of
foreign direct investment (FDI). Net FDI fell by about Rs 6,000 crore.
The portentous rise in the proportion of net portfolio investment is also driven by a rising
deficit in the merchandise account. The net merchandise deficit rose by about Rs 20,000
crore. The truth is the surge in FII investments has saved India the blushes. Without this
surge, the rupee would have sunk a few notches. The oil imports bill would have
depressed India's growth aspirations considerably. Do FII investments deserve to be
controlled and discouraged? No.
High-quality assets
If India's corporate competence is overlooked or misunderstood, the rise in FII
investments would appear to be driven by hot money. However, these investments are
an earnest and well-judged response by the FIIs.
India Inc.'s managers have raised their performance by confronting challenges head on
and by seizing opportunities. They have smartly improved capital asset productivity,
profitability from operations and value delivered to customers, and the contribution to the
exchequer through corporate tax (see Table).
Over a 13-year period since 1990, India Inc. and its dominant shareholders and
managerial teams, have served the interests of suppliers of capital, customers and
government admirably well. They have smartly transformed themselves into a global
benchmark against which FIIs evaluate corporate equities from other emerging
economies. The rise in net portfolio investment by FIIs to Rs 52,002 crore is not an
abnormality. India Inc.'s managerial strengths deserve more FII investment, and not less.
Unintended consequences
If the RBI Governor is yet convinced of the need to impose the controls, he is likely to
include them in the RBI's announcement of the annual policy statement on April 28. Of
course, he may retain the option to impose them at a later date. Regardless of when
they are imposed, controls on FII investments would discourage inflows from high quality
investors. The desirable influence of high quality investors on financial markets will be
whittled down. The number and the investment power of those that have the
temperament and competence, and the resources and the right appetite for risk will be
eroded by the controls. The influence of the so-called hot-money investors could actually
rise. The quality of inflows could decline. Such a measure would overlook the existence
of a well-structured, well-managed and reliable equity futures and options market in
India. The RBI Governor has, perhaps, been impressed by Mexico's exit tax.
FIIs in Mexico pay the higher of a tax of 20 per cent on their gross sale proceeds or 25
per cent on the net gains. Mexico offers opportunities for transactions in equity futures
and options. FIIs have conveniently shifted part of their attention to futures and options.
Thereby, they have protected themselves from the 20 per cent on their gross sale
proceeds. Portfolio investments in Mexican stocks have declined. But the rising
magnitude of FDI in Mexico has made up for the decline in FII. FIIs in India would
replicate their Mexican strategy, if India's investment laws allow full latitude for such a
strategy.
They will then continue to earn their profits from futures and options. But there will be a
flight of capital since the margins and option prices will require lower outlays. FII funds
will move in and out of futures and options. It would be difficult to regard such flows as
high quality flows.
Hot myths
Hot money's detractors argue it ignores the economic fundamentals of financial assets.
They assert that it pursues quick rewards. That is why it is hot money. It impulsively
rushes in and rushes out. It triggers economic distortions and disequilibria. The
hypothesis is that hot money irrationally pushes up stock prices and strengthens the
rupee when it rushes in.
It exerts a downward pressure on stock prices and weakens the rupee when it rushes
out. Moreover, it distorts interest rates both when it enters and when it exits.
Hot money makes macroeconomic management a difficult task. This explains why the
RBI has an interest in discouraging poor-quality inflows. It can be argued that the tax on
inflows, given the RBI's demanding responsibilities, discourages the entry of hot money.
Stock prices, inflation and the rupee will not rise to uncomfortable levels. There will be
fewer asset-price bubbles. The tax on sales by FIIs will discourage impulsive sell-offs.
There will be fewer asset-price blowouts. Interest rates and inflation would be more
stable and less volatile as a result. Stock prices and the rupee would be less volatile too.
That is, India would better secure its macroeconomic stability by keeping hot money out.
Debunking some myths
Hot money strikes fear among policy-makers. But why it strikes fear needs explanation.
The prevalent assumption is that it unsettles macroeconomic equilibrium.
But this assumption is wholly naive. It mixes up cause and effect. Hot money strikes fear
because it takes advantage of unsettled macroeconomic equilibrium.
If macroeconomic variables are in a state of unrest, hot money rushes in to seek quick
rewards. The magnet is the prospect of quick rewards. The prospect of quick rewards is
strongest when prices, money supply, interest rates, inflation and the value of the
currency are in a flux.
Risky and volatile financial prices spur hot-money investments. But investors cannot
assume big risks if money supply, interest rates, inflation and the value of the currency
are not in unrest. Risks can be assumed only if they exist.
If this precondition is met, and if an investor has the appetite to assume the big risks
over the short-term, investments made by that investor will be regarded as hot money.
Therefore, hot money is not poor-quality money. It is normal money that exploits poorquality macroeconomic situations. It is normal money from normal investors who can
spot macroeconomic instability. It is normal money that is invested by rational investors
who have a big appetite for big risks, especially over the short term. But there is a
precondition for success. Investors that earn quick rewards over the short term with
unfailing consistency should be very familiar with the macroeconomic conditions of an
economy.
Familiarity requires thoroughness and painstaking research into an economy's financial
lattice. It is no be a surprise that investors who exploit macroeconomic abnormalities are
those that have dug in for the long term in an economy. They will pass with ease every
rigorous test aimed at determining if they are the high- quality investors that India wants.
Arming the defenders
FIIs that set store by patient, long-term rewards are quite clearly India's most desired
foreign investors. But they too would face the adverse consequences of the restrictions
on how much they can invest and where they can invest. Some high-quality grains may
go away with the poor-quality chaff.
There may not be enough high-quality FIIs to buy stocks when hot- money investors sell
impulsively and push down stock prices. There will be fewer high-quality investors to sell
stocks when hot-money investors buy impulsively and push up stock prices. The impact
on the volatility of the rupee would be considerable. When stock prices fall and when hot
money exits, the rupee could weaken dramatically. But high-quality foreign investors
may have insufficient foreign exchange resources to buy stocks when prices fall. This
will be a direct result of any quantitative restrictions. High-quality foreign investors will be
powerless to defend the falling rupee.
On the flip side, high-quality foreign investors may have insufficient asset holdings to sell
stocks when their prices rise insanely. This too will be a direct result of the quantitative
restrictions. When hot money gushes in, the rupee could strengthen dramatically. Highquality investors are India's best defence against hot-money marauders. But controls on
FII inflows lock out one or more high-quality investors. Controls will have an adverse
impact on prices, trading volumes, the timing of trades and, therefore, on liquidity. India
cannot afford to weaken its best defence against hot money. This redoubtable defence
against poor- quality inflows has already been erected and fortified by India Inc.