The finance minister said it all when he acknowledged that the Securities and Exchange Board of India’s move to phase out participatory notes (PNs) was part and parcel of the government’s attempt to moderate the pace of capital inflows. The steps against PNs have little to do with ascertaining their place of origin or to make the flows more transparent, but have everything to do with easing the inexorable upward pressure on the rupee caused by an avalanche of dollars landing on our shores.
It’s hurting exports, creating a big headache for the Reserve Bank of India, and threatens to throw people in the textiles industry and in small-scale industries out of their jobs; so the government will do everything possible to limit these inflows. First they tried lowering interest rates on non-resident Indian deposits, then they tried limiting external commercial borrowings and now they’re trying to plug inflows through PNs.
Will they succeed? They could, in the short run, because the move coincides with the tapering off of the first heady rush of capital fleeing the badlands of the US credit markets for a more salubrious home in emerging markets. Of course, if the US Federal Reserve goes in for another rate cut at the end of October, inflows may once again accelerate.
It’s no coincidence that the International Monetary Fund’s (IMF) World Economic Outlook contains lots of advice to developing nations on how to live with large capital inflows. Gross capital inflows to emerging markets, in dollar terms, are now higher than in the mid-1990s, just before the Asian crisis. The figure is not so high on a net basis, but it’s still pretty large. So what else can the government do to curb inflows? Well, it can learn from what Chile did in the 1990s or what Thailand, Colombia and Argentina have done more recently, and mandate setting aside a portion of short-term inflows in interest-free reserves, which basically amounts to a tax on inflows.
What’s the risk? IMF says: “Experience suggests that such measures tend to have a diminishing impact over time, as ways are found to elude the controls, and can, if sustained, also have negative consequences for financial system development.” Or the government could adopt measures aimed at cooling down overheated equity and property markets, such as China’s recent increase in stamp duty on stock market transactions and Singapore’s increased property redevelopment charge. IMF also points out that countries have used fiscal incentives to offset some of the implications of exchange rate appreciation, such as Brazil’s introduction of import tariffs on certain sectors. In India, the commerce ministry’s rather inadequate sops to exporters would also fall in this category.
The more important question is: why the rush of money to countries like India? There are several reasons. One of them is increased global liquidity. Now global liquidity can mean lots of different things, which is why the discussion about it in the World Economic Outlook report is very helpful. One way of looking at liquidity is to consider it as a function of monetary policy. It can then be measured by considering either real interest rates or by focusing on quantitative factors such as money supply or the build-up of foreign exchange reserves. Monetary policy, which had been very loose, was being slowly tightened until the credit crunch hit the developed markets. IMF says that “notwithstanding the reversion to a neutral monetary policy stance in the United States and the euro area, real long-term interest rates on government securities in advanced economies have remained low compared with their historical average”. If the money supply plus forex reserves measure is used, “global liquidity shows elevated growth rates until very recently”.
It’s hurting exports, creating a big headache for the Reserve Bank of India, and threatens to throw people in the textiles industry and in small-scale industries out of their jobs; so the government will do everything possible to limit these inflows. First they tried lowering interest rates on non-resident Indian deposits, then they tried limiting external commercial borrowings and now they’re trying to plug inflows through PNs.
Will they succeed? They could, in the short run, because the move coincides with the tapering off of the first heady rush of capital fleeing the badlands of the US credit markets for a more salubrious home in emerging markets. Of course, if the US Federal Reserve goes in for another rate cut at the end of October, inflows may once again accelerate.
It’s no coincidence that the International Monetary Fund’s (IMF) World Economic Outlook contains lots of advice to developing nations on how to live with large capital inflows. Gross capital inflows to emerging markets, in dollar terms, are now higher than in the mid-1990s, just before the Asian crisis. The figure is not so high on a net basis, but it’s still pretty large. So what else can the government do to curb inflows? Well, it can learn from what Chile did in the 1990s or what Thailand, Colombia and Argentina have done more recently, and mandate setting aside a portion of short-term inflows in interest-free reserves, which basically amounts to a tax on inflows.
What’s the risk? IMF says: “Experience suggests that such measures tend to have a diminishing impact over time, as ways are found to elude the controls, and can, if sustained, also have negative consequences for financial system development.” Or the government could adopt measures aimed at cooling down overheated equity and property markets, such as China’s recent increase in stamp duty on stock market transactions and Singapore’s increased property redevelopment charge. IMF also points out that countries have used fiscal incentives to offset some of the implications of exchange rate appreciation, such as Brazil’s introduction of import tariffs on certain sectors. In India, the commerce ministry’s rather inadequate sops to exporters would also fall in this category.
The more important question is: why the rush of money to countries like India? There are several reasons. One of them is increased global liquidity. Now global liquidity can mean lots of different things, which is why the discussion about it in the World Economic Outlook report is very helpful. One way of looking at liquidity is to consider it as a function of monetary policy. It can then be measured by considering either real interest rates or by focusing on quantitative factors such as money supply or the build-up of foreign exchange reserves. Monetary policy, which had been very loose, was being slowly tightened until the credit crunch hit the developed markets. IMF says that “notwithstanding the reversion to a neutral monetary policy stance in the United States and the euro area, real long-term interest rates on government securities in advanced economies have remained low compared with their historical average”. If the money supply plus forex reserves measure is used, “global liquidity shows elevated growth rates until very recently”.
But the IMF report also talks of another kind of liquidity—market liquidity. It says that the liquidity of global equity markets has also increased substantially since the mid-1990s, with the rise in emerging markets being particularly impressive. True, this market liquidity is cyclical, with ebbs and flows, “but the cycle is only weakly related to movements in real policy rates and is unrelated to quantitative measures of the global monetary policy stance, suggesting that secular factors underlie improvements in global market liquidity”. In short, the improvement in global market liquidity is the result not just of cyclical factors, but also of structural ones. Globalization, securitization, derivatives and financial deepening have all contributed to this market liquidity. This, says IMF, is “strongly suggestive of an implied historical decrease in liquidity premiums, likely contributing to the overall decline in risk premium”. What this means is that higher market liquidity can reduce the risk associated with a given asset portfolio. As a result, a larger portion of investors’ wealth may be invested in “risky” assets, in spite of risk tolerance remaining at the same level. Put another way, the widening, maturing and deepening of capital markets has led to greater liquidity that has reduced the risk premium. This is particularly true of emerging markets and it has made them more attractive investments. The other reason for the huge inflows into the Indian market is best brought out by one statistic: India, China and Russia accounted for one-half of global growth in the past one year. Look at IMF’s forecasts of growth next year: the US is expected to grow 1.9% in 2008, the euro area 2.1%, Japan 1.7% and Britain 2.3%, while the forecast for China is 10% and India 8.4%. When you combine high growth and a reduced risk premium, the choice for investors couldn’t be clearer.
