The UPA government and Reserve Bank of India (RBI) are singing different tunes on hot money inflows from abroad. And the discordant notes are being struck when the relevant policy is under review and dubious investments including Koda-type laundered money continue to creep in the Indian economy.
Investment by foreign institutional investors (FIIs) in the equity and debt markets is considered fair-weather investment by all rationalists. It surges in any economy that is either going strong or has the potential to generate assets bubble, stock market boom or real estate price spiral. The investments fly away when the economy is in doldrums.
Stock market-centric FII is easier and faster to secure as compared to project-focussed foreign direct investment (FDI). The UPA government has found FII investment as easy option to improve liquidity in the Indian economy and to multiply the feel-good factor through surge in share prices.
Finance Minister Pranab Mukherjee thus ruled out imposition of any tax on capital inflows while replying to a question in Lok Sabha on December 11. Last month, he stated large FII inflows are not a matter of concern to the government.
RBI is, however, treading cautiously on the issue as it had done in the past. RBI Governor D Subbarrao said on December 7 that capital controls should not be ruled out if foreign fund inflows surge.
According to Securities and Exchange Board of India (SEBI), the number of FIIs is 1,706 and the number of FII sub-accounts is 5,346 as on December 16, 2009. Their cumulative net investment in equity shares since November 1992 till December 16 stands at Rs 31,49,117.8
crore. Their cumulative net investment in debt instruments is Rs 2,08,226.1 crore for the same period.
There has been surge in FII investments following the tax sops-triggered recovery of the Indian economy. The Indian Express thus splashed a news story on November 21, 2009, with a screaming headline “Faceless foreign funds flooding India”. It pointed out that a third of total FIIs money inflows came through participatory notes (PNs).
PNs are a dubious form of investment that can be easily misused by money-launders and terrorists. PNs are derivative instruments whose value is linked to price of equity shares, stock indices, etc.
On November 19, Finance Ministry notified setting-up of a working group on foreign portfolio investments by foreign institutional investors (FIIs), non-resident Indians (NRIs) and other alien investors such as private equity funds.
The 16-member group does not have any representative of Reserve Bank of India (RBI). RBI’s exclusion is a clear attempt to sideline the apex bank as it has always argued for caution on hot money inflows.
The lop-sided working group has seven representatives of Finance Ministry and only one of SEBI. The remaining members and permanent invitees are professionals drawn from different entities.
The working group’s mandate is to review existing policy on foreign inflows other than FDI and suggest initiatives to reduce policy hurdles while maintaining the Know Your Customer (KYC) requirements.
KYC is bedrock of anti-money laundering and anti-terrorist funding the world over.
The group is also required to study arrangements relating to the use of PNs and suggest changes in the policy, if required from KYC.
The group’s composition and its terms of reference clearly suggest Finance Ministry is pushing for major liberalisation of non-FDI foreign inflows.
In the past, both the Finance Ministry and RBI had separately set up experts’ groups on under varied terms of reference that substantially covered hot money inflows. They have also differed on PNs.
RBI-appointed Committee on Financial Sector Assessment, which included officials of Finance Ministry, showed the divergence of opinions on PNs between the Ministry and the banking regulator.
In its report submitted in March 2009, the Committee noted: “The Government in this regard is of the opinion that since FIIs maintain records of the identity of the entity they issue PNs to and SEBI can obtain this information from the FIIs, there does not appear to be any cause for concern from the ‘Know Your Customer’ (KYC) angle. Further, PNs can be issued or transferred only to persons who are regulated by an appropriate foreign regulatory authority. The Reserve Bank’s concern is that as PNs are tradable instruments overseas, this could lead to multi-layering which will make it difficult to identify the ultimate holders of PNs. Furthermore, the transactions of the FIIs with the PNs are outside the real-time surveillance mechanism of SEBI.”
SEBI is belatedly showing its surveillance capacity. On December 9, it banned Barclays Bank PLC, which is a registered FII, from issuing new Offshore Derivative Instrument (ODI)/PNs till such time as it satisfies SEBI that it has put adequate systems, processes and controls in place to ensure true and correct reporting of its ODI transactions to SEBI.
The SEBI order stated: “Barclays has not only failed to provide true, fair and complete details of the ODI activity undertaken by it but also prima facie violated the provisions of FII Regulations by furnishing false and incorrect information to SEBI. Full and fair disclosure forms the cornerstone of FII regulation by SEBI. As the source of funds available with an FII comes from offshore, by its very nature SEBI has no direct access to verifying the nature of the funds or whether the funds will be misused for the purpose of market manipulation or for perpetrating any type of fraud in the market. The very essence of the amendments to the FII Regulations in Regulations 15A and 20A reflects this pressing regulatory concern on the part of SEBI.”
An earlier RBI-appointed committee on Fuller Capital Account Convertibility (FCAC) had recommended ban on fresh investments by FIIs in PNs. In its report submitted in July 2006, the committee observed: “In the case of Participatory Notes (PNs), the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. These PNs are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner. It is also not possible to prevent trading in PNs as the entities subscribing to the PNs cannot be restrained from issuing securities on the strength of the PNs held by them.”
Mr. Mukherjee’s posturing is at variance with the growing global swing towards taxation of cross-border capital flows popularly referred to as Tobin tax. Brazil has introduced such a tax.
The other day European Union has proposed social tax on banks, insurance companies and financial markets to recoup government investment in bail-out of capital markets during the global meltdown.
Even the votaries of financial globalisation are admitting the risks of hot money inflows to developing countries. A Working Paper released by International Monetary Fund (IMF) in August, for instance, concluded: “Liquidity shocks are more severe for emerging economies that have a higher pre-crisis exposure to foreign portfolio investments and foreign loans, but less severe for countries that have a higher pre-crisis exposure to foreign direct investments. This empirical pattern suggests that one should not lump different capital flows together when one wishes to understand the connection between capital flows and a liquidity crunch in a crisis.”
The Finance Ministry-appointed committee on Liberalisation of FII had made a strong case for step-up in inflows. In its report submitted in June 2004, the committee said: “Given the necessity of boosting agricultural growth through development of agro-processing, and expanding industry by at least 10% per year to integrate not only the surplus labour in agriculture but also the unprecedented number of women and teenagers joining the labour force every year, there is an urgent need to scale up investment in the economy. FII inflows can help in augmenting the investible resources in the economy.”
The subject of FII investment has also been dealt with by two other committees in the recent past. The Finance Ministry-appointed committee on “Making Mumbai an International Financial Centre” recommended that there should be “no policy hostility” to PNs and other offshore derivatives.
In its report submitted in February 2007, the committee said: “These offshore derivatives markets are a positive development for the Indian economy. When Indian financial regulation obstructs derivatives, offshore production of these products helps end-users to obtain these services and thus undertakes better risk management of their securities portfolios.”
Yet another committee on Financial Sector Reforms, constituted by Planning Commission, recommended radical liberalisation of inflows.
In its report submitted in September 2008, the committee said: “One concrete measure would be to eliminate restrictions on foreign institutional investors’ participation in corporate and government bond markets. This could help improve market liquidity and pricing, and introduce more market discipline on government borrowing. It would provide more funding for government-aided infrastructure projects.”
It recommended: “Remove the ceilings on foreign portfolio investment in all companies, with a narrow exception for national security considerations—treat foreign investors just like local shareholders. Remove restrictions on capital inflows based on end-uses of funds. These do not serve much purpose anyway, since they are difficult to monitor.”