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.