The report of the working group on foreign investment (UK Sinha Committee Report) is yet another step in the process of rationalising India?s capital markets, the lens focused this time on foreign portfolio flows. Over a longer time frame, this process will help India gain greater access to the global capital pool, critical to funding the investment required for sustaining a high growth trajectory. The discussion should segue in nicely with the larger discussion on capital flow controls that have acquired a new lease of life with the volatility in the aftermath of the financial crisis.
In the short term, we have recently been reminded of the need of foreign capital to provide systemic liquidity. We had become used to a largesse of foreign capital, which had overflowed into munificent foreign currency reserves, giving us an aura of impregnability to volatility in capital flows and a boost to our national confidence in our economic prowess. The recent inability of capital flows to compensate for the presumed high current account deficit comes as a bit of reality check. It would be belabouring the obvious to emphasise that all avenues to make India an attractive destination for sustained capital flows need to be explored and implemented.
While it is always useful to rationalise and simplify the financial, regulatory and tax incentive distortions, compounded by often inconsistent legal structures that govern the investment ecosystem, there will invariably be wider underlying economic dynamics that will be the predominant driver of flows, damn the tax icebergs. Money being fungible, if the underlying economic profit drivers are attractive, the smartest folk on earth will find a way of getting around these impediments. Whether India, Chile, Brazil or Russia is ?overweight? will depend, for instance, on the relative attractiveness of consumption, aluminium, industrial commodities or oil. Making these economic drivers the centrepiece will ensure a more sustained inflow of stable foreign capital.
This pace of deepening of capital flows, as has been pointed out by the present and earlier groups, should have set off warning signals on the need for getting a more accurate grasp of the implications of a large and sudden shift in financing channels. For instance, a scan of FDI and portfolio flows in India over the past 5 years shows that the latter have been far more volatile, as indeed would have been our a priori expectation. Although the debate on the volatility of portfolio capital during the Asian crisis still surfaces periodically, certain aspects of capital flows have become more crystallised over the past couple of years and these are as follows.
First, the experience of the past couple of years has led to a dramatic turnaround in thinking on managing capital flows, even at that redoubt of free market thinking, the IMF. Volatility is considered to be the bane of excessive dependence on foreign capital. There are economic and fiscal costs in controlling these, sure, but there are ancillary benefits as well, in development of domestic financial markets. For instance, the benefits of implementing an appropriate architecture to mitigate currency and interest rate risks by developing futures and options markets will offset multiple fold these costs. In addition, various debt and equity instruments have become linked. There have to be limits on the extent of external indebtedness considered prudent and these will inevitably have an effect on equity flows.
Second, as the emerging creative accounting practices of global financial firms have emphasised over the past years only what had been increasingly evident, fungible funds are impervious to administrative segmentation. Transfer pricing, just one of the repertoire of tools in the absence of rigorous accounting standards and end-use monitoring procedures, will facilitate the diversion of funds almost at will. The work of Guy Pfefferman, at the International Finance Corporation, and others had brought into public consciousness the matter of classification of FDI, which resulted in a significant overhaul of classification of flows. Similarly, there remain wide grey areas, in which definitions of direct and portfolio flows overlap. Stringent adherence to global accounting standards is one safeguard.
Third, the focus needs to shift to the more tractable components of what is loosely described as ?absorptive capacity?. RBI?s latest Annual Policy Statement had emphasised that freeing up logistics bottlenecks was the single most important component of capital flow management. The least capital intensive but most politically difficult, this aspect of encouraging and sustaining stable capital flows will be the force multiplier.
The report is a wonderful treatise on methodological, procedural and discursive aspects of portfolio flows, in line with the remit of the Group?s Terms of Reference. But a strong analytical case articulating a broader, integrated economic perspective on capital flows is still awaited.
The author is senior VP, business & economic research, Axis Bank. Views are personal