The Hindu : Business : Stock markets and FII inflows

Online edition of India's National Newspaper
Monday, Jan 24, 2005

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Business

Stock markets and FII inflows

Should stock prices be supported at all costs, by even desisting from a long overdue debate on capital flows?

CERTAIN COMMENTS made recently by the Reserve Bank of India Governor, Y. V. Reddy, on foreign institutional investor (FII) inflows, especially to the stock market, have become controversial. At a function to release the India Economic Report at the Indira Gandhi Institute in Mumbai on January 12, the Governor had called for a debate on the quantum and quality of FII flows into the stock market.

Other countries have fixed quotas and ceilings for FII inflows. Although for India such options may not be necessary at this stage, it will be good to have them in reserve and use them at some future date if and when the FII induced stock market volatility becomes excessive .In any case the restraints should be applied selectively and after giving notice to the overseas investors.

Useful options

There is also a need to enhance the quality of such inflows. Strict adherence to the "know-your-investor'' principle, especially regarding flows from tax havens, will help in establishing the bonafides of the investors. "Price-based'' measures such as taxes could be examined though their effectiveness is arguable. The Governor also touched upon the procedural aspects that need to be tightened: for instance, the eligibility norms for registration as FII and assessment of risks from inflows through hedge funds, promissory notes and sub-accounts.

The RBI Governor's statement on FII inflows is hardly novel. The central bank has not been alone in advocating caution in the matter of cross-border flows. In fact, there is a growing volume of literature on the subject. Every credit policy statement of the RBI in recent years has highlighted the danger in assuming that these FII flows would be permanent. For instance, on the larger issue of accumulating forex reserves, the RBI has pointed out the dangers of assuming that the money that has come in will remain for a long time. New parameters to measure the liquidity-risks have been designed by the central bank.

All the above are well known. Besides, there is no reason to think that the Governor while airing his views at an academic institution (where other macro economic issues were discussed) was making any policy statement: the intent, most likely, was to stimulate a debate on what everyone agrees is a highly topical issue.

The market fallout

The reason as to why the Governor's views became so controversial is the timing and the fact that they immediately concerned the stock markets. Only to be expected, any statement of the RBI Governor is avidly listened to and analysed and this one even more so because of its focus on the financial sector. Inevitably the markets reacted adversely although Dr.Reddy's statements were made after the closure of the stock exchanges on January 12. In fact, stock prices had already been falling in the previous week and the decline was as much as 600 points over a week. The Governor's statement would have aggravated the decline. But the Finance Minister's categorical statement that no policy measures to restrict FII flows were in the offing helped stabilise the markets the next day.

In the opinion of many stock market analysts, even if the Governor was well within his rights in saying what he did, he should have done so in private. Others (admittedly a smaller number) would even question the RBI's assumptions on FII flows. But both the groups will agree that nothing should be done to discourage the all important FIIs, on whom the stock markets have so overwhelmingly come to depend. In the interests of stock market's "buoyancy'', therefore, policy makers should avoid airing their views in public.

Broader issues at stake

The episode brings to the fore several important issues. The independence of the central bank in monetary matters is acknowledged in many countries. The observations of the heads of the world's leading central banks — as has been the case in India too — on all aspects of their economies are closely followed. The RBI has been in the forefront in championing some orthodox macro economic viewpoints. The need to rein in fiscal deficit is one such. Its views on the FIIs and other portfolio flows are also mainstream.

Since the RBI's views, by themselves, are not controversial, the question arises as to why they should create a ruckus at least in stock market circles. Unfortunately there are no straightforward answers. It will take time to dispel the notion that nothing, not even a policy debate, should be done if it is not in the interests of market buoyancy.

C. R. L. Narasimhan

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