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| October 22, 2007 | Monday | Shawwal 9, 1428 |
Record foreign fund inflows
VOLATILE stock markets – whether heading northwards, or diving south – always cause unease in government circles in India. The last few weeks have seen indices zooming ahead on the fast lane, shattering records, and breaching new goalposts within days.
Though the prospects for mid-term polls appear to have receded – with the Congress having been forced, by its leftist supporters, to delay the implementation of the Indo-US nuclear deal – there is a lot of nervousness in Delhi these days about volatile stock movements, or for that matter about soaring oil prices.
Domestic bulls have been aided by foreign institutional investors (FIIs), who have ploughed in about $4.6 billion in October alone and $8.5 billion since the US Fed cut interest rates just a month ago. FIIs have injected a whopping $18 billion into India in 2007, beating all previous records.
This has had a steroidal impact on the Indian rupee, which has appreciated by 12.5 per cent, hurting exporters, including the country’s burgeoning information technology sector. Regulators, including the Reserve Bank of India, the central bank, and the Securities and Exchange Board of India (SEBI), the capital market regulator, have been watching the unfettered in-flow of funds with something akin to horror.
All hell broke loose in the stock markets for a few minutes last Wednesday, hours after SEBI announced the previous night that it planned to impose restrictions on ‘participatory notes’ (PNs), which could effect the in-flow of FII money. In less than three minutes, the Sensex, the benchmark index on the Bombay Stock Exchange, plunged by over 1,500 points, shedding nine per cent and triggering off lower circuit-breakers and forcing the authorities to stop trading for an hour.
It was only after Finance Minister P. Chidambaram’s assurance that the government had no plans to ban PNs, and SEBI’s objective was merely to moderate capital inflows that the markets bounced back. Chidambaram also clarified the government would not discourage FIIs from investing in the capital markets.
Indian stock markets have been firing on all cylinders over the past few weeks. The Sensex, for instance, took six trading days to reach the 17,000-mark from 16,000. It crossed 18,000 in seven trading days, and broke all previous records by touching the 19,000-mark in a mere four trading sessions.
FIIs, of course, have been sold on the India ‘success’ story, and are bullish on the country’s economy. Gross domestic product (GDP), which expanded by 9.4 per cent last year, has clocked 9.3 per cent in the first quarter of the current fiscal (April-June). Even conservative estimates have projected a GDP growth rate of 8.5 to nine per cent this year.
THOUGH India opened up its capital markets for overseas investments in the early 1990s, it allows only one class of investors – FIIs. All others, including hedge funds, have to invest through FIIs, who in fact, act as brokers.
FIIs, many of who are registered in Mauritius – with which India has a double taxation avoidance treaty, so investors registered there don’t have to pay capital gains tax in India – issue PNs or offshore derivative instruments (ODIs), to other investors.
The system of PNs has evolved in a strange way over the years, and FIIs are not forced to disclose the identity of their clients to local authorities in India, unless specifically asked by them. This has resulted in growing opacity in ODIs and the inflow of foreign funds into the stock markets.
There have been frequent allegations that PNs are ideal instruments for laundering funds. Black money flows out of India to offshore financial centres, and are laundered in through PNs. But the government has not been able to do much to curb such flows.
When India’s foreign exchange reserves were low, it made sense for unrestricted inflow of funds to the capital markets, but with the country sitting on a pile of foreign exchange (about $250 billion), the central bank feels there is need to regulate the inflow.
Of course, several experts have urged the government to go in for full-convertibility of the rupee on the capital account, but the RBI is reluctant to accelerate the pace, and has sought a 10-year period to achieve the goal. But with ballooning foreign exchange reserves, it has been forced to liberalise; Indians are now allowed to invest up to $200,000 every year in overseas properties and shares, and there are virtually no restrictions for companies acquiring other firms abroad.
According to M. Damodaran, the SEBI chairman, the move to impose curbs on the issuance of PNs has been initiated to ensure that FIIs “come in through the front door,” instead of back-door entry. FIIs are being encouraged to register afresh, instead of issuing PNs to themselves through sub-accounts, he argues.
And foreign investors who are ineligible to register as FIIs can trade in simpler products like equities or debt, through the PN route, but will not be allowed to trade in derivatives, he says. FIIs have now been asked not to issue fresh ODIs where the underlying instrument is also a derivative.
According to SEBI, PNs with derivatives as their underlying instruments add up to a $30 billion.
GOVERNMENT moves to impose curbs on PNs have in the past also resulted in wild fluctuations in the market. With FIIs having such a major presence in the Indian capital markets, the government has been cautious in dealing with these instruments, for any moves perceived by the markets as imposing curbs on international investors, could have a disastrous impact on the stock markets – as witnessed during the opening session on Wednesday.
Expert committees, including the S.S. Tarapore committee – which produced a report on full capital account convertibility – have recommended a gradual phasing out of the PN regime. But the share of PNs – as a percentage of total foreign portfolio flows – has risen dramatically in recent months. It has topped the 50 per cent mark, from 32 per cent towards the end of last year.
The surprising thing is that both FIIs and domestic investors have not been rattled by the political crisis in Delhi – when Prime Minister Manmohan Singh dared the leftists to withdraw support to the United Progressive Alliance government. Nor have they been worried about the impact of the rising oil import bill, with crude prices almost touching the $90 a barrel rate. India Inc continues to churn out excellent results. About 150 major companies have already announced their Q2 (second-quarter of financial year 2007-08) results, which indicates a nearly 25 per cent topline growth and a whopping 40 per cent bottomline growth.
Most of these companies have been witnessing similar growth for the past nearly five years. There has no doubt been a slowdown in the rise in profits of infotech giants, following the strengthening of the rupee, but most other sectors continue to witness frenetic growth.
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