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Capital inflows: a major issue for the regulators

It may be too much of a coincidence but barely days after the capital market regulator, the Securities and Exchange Board of India, finalised its important guidelines on foreign institutional investment, the Reserve Bank of India is likely to look at the same issue, but from a monetary policy perspective.

The half yearly review of the monetary and credit policy is slated for October 30 while SEBI’s decisions were announced on October 25. That two financial sector regulators — the SEBI and the RBI — are preoccupied with one key aspect of India’s external economy, namely the huge foreign inflows into Indian stock markets, is hardly surprising. Ever since the opening up of the capital market to foreign investors, the prospect of large inflows has become a key ingredient in determining the contours of macroeconomic policy as well.

The results are there for everyone to see. Not just investors but even ordinary people have been obsessed with the level of Sensex. Stock market watching has obviously become a national pastime, second only in popularity to the shorter versions of cricket.

Such overwhelming interest need not necessarily make for a level headed discussion. When the SEBI circulated a discussion paper on the role of participatory notes (PNs), its contents caused a market upheaval. Even by recent standards, stock trading became highly volatile. More important, perhaps everyone took a ‘position’, not on specific stocks or indices but on the dire consequences if the SEBI implemented its proposals. In the event, when on October 25 the SEBI board by and large stuck to what was stated in its discussion paper, the markets responded with gusto.

Large capital inflows have propped up the country’s balance of payments, bridging the current account deficit. In recent months, aided by a strong economy, India has become a particularly favourite destination for foreign investors. So much so the inflows have grown in volume, causing a sharp rupee appreciation and, with the RBI’s attempts to sterilise a part of the flows, a jump in domestic liquidity as well .These are issues that the RBI has been tackling for some time now. Undoubtedly they will figure again on October 30.

Certainly the context will be significant. For at least four years now, the RBI has been uncomfortable with certain types of capital inflows. Participatory notes in particular have become a contentious issue. The anonymity the route conferred on the investor looks particularly odd at a time when the financial sector is striving towards greater transparency.

With the new regime in place there can be a moderation in capital inflows but more importantly Indian regulators will be enabled to ascertain the genuineness of the overseas investor. For the RBI, capital inflows will be one of the major topics of discussion. Obviously the developments here impinge on all other areas covered by monetary management. Price stability, liquidity management, exchange rate policy, strength of the external economy, are all subjects that have amore than direct connection with capital inflows.

The SEBI’s recent decisions will also influence the interest rate policy, arguably the most watched item in the monetary policy and its review. Huge capital flows have certainly posed a challenge as they have a potential to wreck price stability. But despite their importance — and contextual significance this time — they will be discussed in conjunction with other factors.

There are a number of positive factors though. Inflation measured on the WPI index has been at its lowest levels recently, down to almost 3 per cent recently. That is well below the RBI’s target of 5 per cent. There is continuing optimism on the growth front as well .The RBI is likely to retain its GDP forecast at 8.5 per cent. However, global oil prices are at record levels with no prospect of coming down in the near future. Indian consumers may have to bear the brunt sooner or later. The global economy is growing, albeit slower than last year. However, in the biggest economy of the world, the U.S., there are distinct signs of a slowdown though not, as feared, of a recession. Much will depend on whether the U.S. Federal Reserve will cut its benchmark interest rates at its next meeting, on October 31, a day after the RBI’s mid-year review.

C. R. L. NARASIMHAN

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