The Tandav of Forex Flows & its Governance in India

Recent phenomenon of high velocity of forex inflows is a new paradigm in

financial landscape of the country. Our response to the situation leaves everyone

pondering about the reality of India's growth story and even its managerial prowess to

manage the situation & the economy. Let's analyze how our attempts to defuse the

situation fare.

The response, if anything, seems incredible. Till recently our media was

paying high tributes to the skills of Indian management who has been consistently

delivering a high level of growth in productivity & profits. It cited the swelling market

capitalization of Corporate India's fortunes and the stock market as signs that India has

arrived on the global scene. However as US Fed reserve decided to open up its kitty to

tackle a domestic situation in US (or the sub-prime crisis, which was threatening to

destabilize its economy & making US asset valuation appear too fragile for comfort of its

investors), a section of International investors decided that its safer to bet on the emerging

markets. An ever swelling Indian & Chinese stock prices suddenly found an even larger

number of new takers. The resultant deluge of dollars resulted in an appreciation of the

humble Indian Rupee & stock indices. The government which had been haunted with a

'Run on India' just 18 years back, when all sort of foreign currency was leaving its shore,

was more than surprised to the new situation of a 'Run to India' act of these currencies.

The government & regulators were all, taken aback by the turbulence of
the inflow of foreign exchange as they never anticipated such a situation. The RBI was

first to move with its concern on Inflation, Real Estate prices (which it terms as asset

bubble) & stability of the Indian currency. It decided to put barriers to raising of External

commercial borrowings by Indian corporates, curbing domestic money supply & making

domestic loans more expensive in the hope that it shall 'prick the asset bubble.' It also

made some feeble attempts to liberalize forex outflows which it thought, might help to

counter inflows to some extent. And when these attempts proved insufficient, it rolled up

its sleeves for open market intervention i.e. outright buying of foreign currencies to

maintain the value of Indian currency within a stable range.

Now, Capital Markets regulator SEBI in next off the block. It has suddenly

realized that Indian markets are in dire need of a better Investor disclosure norms

especially for Investments routed through FII & ODI route. Thus, it has proposed curbs

on Participatory Note (or P-Notes) through which much of money coming in off late was

routed. While the Finance Ministry & much of the executive machinery of the

government is busy explaining that the quantum, velocity & speculative intent of the

incoming funds was the crux, the Regulator has maintained a stoic silence on these issues

while stating its objective remains to establish an order in which there is a greater

transparency on the identity of the investors.

To understand more on how SEBI proposal effect the Capital Inflows, we

need to understand the questions which SEBI's proposals raises. The action has been

proposed by it in order to identify clearly as to who is investing in the markets. By

design, the actions seems to be directed against a particular set of investors who prefer to

remain anonymous. This also raises the specter of 'Bad money' in the Indian Capital

Markets & thus gives investor's confidence a big jolt. Now, if we ponder 'who' the

anonymous investors could be, we shall zero upon three sets of Investors. First, are the

international political & other celebrities who shall not prefer the world to know about

the quantum of wealth they have or what they are buying (or how they keep their money).

Second, are Indians who have laundered there black money to foreign shores & want to

bring it back to advantage from the market situation & off course without the authorities

identifying them. And, the third are those FIIs which didn't find enough time to register as

FIIs owning to our cumbersome procedures.

From SEBIs submission, it is clear that it wants to avoid/manage the first

two set of Investors who it fears have been responsible for the current volatility of the

market while it clearly leaves the third set of investors with a choice to register & invest

in the market. While much of our media's energy is focused on evaluating the resulting

volatility or the fall of the stock markets, & making calibrated noise to defang the

proposal at the behest of 'The Aggrieved Indian Small Investor', it clearly avoids the

debate on what other questions such an act i.e. the fall of the markets, indicates. The fall

of the markets indicates that the quantum belonging the first two sets of investors is

significant thus proving SEBI correct which any seasoned regulator ought to be. The

other indication it gives is regarding transparency & efficiency of the market itself. This

is so because quite a chunk of the first two set of investors can be privy to insiders

information & if these set of investors were driving the market, then the so call
'Aggrieved Indian Small Investor' has little chance.

It also begs a few questions that need to answered by SEBI; why does it

continue to leave a window open for these investors for another 18 months. And also why

FIIs should continue to be allowed to issue P-notes up to 40% of their own investments

also need to ponder who the proposed regulation shall ultimately benefit & what effect

shall it have on the shape or health of our market. On the face of it, it appears that SEBI

or the Finance Ministry is not overly worried about the first set of Investors as well,

otherwise a swift action as simple & much less controversial as mandatory KYC

declaration by FIIs for all their direct market investors (read P-Note investors), if

implemented, could have solved the problem. In fact it seems that a window has been left

open for them to benefit from our markets. It seems SEBI was worried about the second

set of Investors. This leaves us to ponder about the quantity of Indian money sloshing in

International arena & the impact it could on our markets. If this money can swell our

capital markets beyond SEBI's expectation & test RBI's bandwidth to manage its inflow,

then such amount should be humongous. We need to seriously ponder about our policies

that have resulted in such a situation & how we as a nation should tackle the issue

especially so when we need a lot of investments for our infrastructure & development.

We also need to ponder whether the window that has been left open in the

form of issue of P-Notes issue up to a limited extent of 40% of investments by FIIs, &

shall it be effective to keep the unwanted 'Bad Money' at bay. And, if after this episode,

the investors whether domestic or foreign feel confident about investing in our markets,
its efficiency, transparency & ability to generate adequate returns for them. We also need

to ponder why our regulators seem to be inclined to believe that anonymous foreign

investors are better then domestic anonymous investors & why has SEBI left the P-Note

window open i.e. why not shut it down completely over a period of time. By gut feel, it is

apparent that the 'Unwanted Bad Money' shall be able to afford a higher entry premium

then the 'Normal Bad Money' & thus shall be back in action to continue manipulations of

sections of our market.

Now to think why the entire situation arose i.e. to manage Forex Inflows.

Should such action result in restricting forex inflows. The answer to it is probably no.

This is so because even though our market's transparency & our managerial capability are

now in some doubt but still India's ability to deliver a better growth that most of the

competing economies is not in question. So, for some time the International portfolio

investor shall wait, to let the dust over the P-Note issue to settle, however, chances are

that he might continue to pour more investment since its safer to expect return from this

market then places elsewhere. This especially so because US Fed is likely to continue on

its easier liquidity stance to ease domestic Sub-Prime loans situation and also because the

fall of Indian Markets shall make it a more attractive buying opportunity. Our masters

need to seriously look at ways to build institutions & systems that can effectively tackle

Forex inflows & resulting volatility without hurting Domestic real economy & the

common man. This should be done by making a long term forecast about what might

happen rather than making tackling situation as it evolves in piecemeal fashion as our

different regulators have demonstrated in the recent situation.