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Friday, Jan 21, 2005

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TALKING DOWN PORTFOLIO FLOWS

THERE ARE BOUND to be different answers to the question whether the Reserve Bank of India Governor's recent statements on portfolio flows into the stock markets were inappropriately timed. Movements of stock market indices attract enormous attention that sometimes masks and sometimes exaggerates their true significance. Capital flows from abroad, especially from the foreign institutional investors, have been the key drivers of the stock markets. Recently the benchmark stock indices climbed to record levels. It was perhaps inevitable that when on the evening of January 12 Dr. Y.V. Reddy hinted at some kind of fetters on portfolio flows market players should react adversely. It was Finance Minister P. Chidambaram's categorical assertion within hours that there was no move to either limit or tax foreign institutional investor inflows that calmed the market. The question has been raised whether it is prudent for the RBI Governor to air publicly certain views that are likely to have an adverse impact on stock prices. The critics assert that his statements would have aggravated a market decline that began a week earlier. The BSE Sensex had already fallen by some 600 points and the need of the hour, it has been contended, was to soothe the markets, not discourage key investors.

What has been missed out in the breathlessness over the controversy is that Dr. Reddy's policy prescriptions, as expounded in an academic forum (where several other macro economic issues were discussed), are neither radical nor unorthodox. For now, portfolio flows, as the Finance Minister noted recently, might be orderly. But in the recent past there have been several instances of malfeasant acts, including money-laundering masquerading as legitimate capital flows. In any case the Governor's eminently sober advocacy of certain policy-induced restraints is contingent on FII-induced stock market volatility becoming excessive in the future. Many other countries already have quotas and ceilings for portfolio flows and a few levy a tax on short-term capital flows. Within India, there is near unanimity on the pitfalls of depending almost exclusively on just one category of investors. On the larger issue of such inflows boosting the country's forex reserves, the central bank has consistently pleaded for developing new yardsticks to measure their stability. Implicit in that type of reasoning is the realisation that FII flows, unlike the more permanent flows arising out of foreign direct investment (FDI), will move in and out of the country purely on short term considerations. Some of these might not have any direct relevance to India.

In its recent Report on Currency and Finance, the RBI has discussed in detail the issues arising from the conduct of monetary policy in an open economy. Living with large cross border capital flows is one key issue that has invited many types of responses from the emerging economies. In India, it will be highly inappropriate to evaluate FII flows purely in terms of stock market prices. Apart from adding to reserves (which, in the view of some experts, have become excessive), the capital flows affect exchange rate management and, in a broader sense, price stability as well. It is decidedly the prerogative of the central bank to initiate a long overdue debate on FII flows. It is also necessary to debunk the argument promoted by special interests that a high stock market valuation is a necessary condition for a vibrant economy and that nothing, not even policy prescriptions to check the pitfalls of unrestrained capital flows, should be publicly aired by those in authority. Dr. Reddy's sober thinking on the subject must be appreciated, not viewed through a special interest lens.

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