On Wednesday, RBI governor YV Reddy spoke of capping or taxing purchases by foreign institutional investors (FIIs) on our stock markets. Finance Minister Chidambaram quickly denied any such policy change, and forced Reddy to retract.
Some people fear that Reddy disclosed truths that Chidambaram seeks to hide. Some think FII dollars are hot money that will flow out and wreck the economy in times of need, as happened to many countries during the Asian financial crisis of 1997-99. Some say Reddy is right to want to impose a Tobin tax-named after Nobel Laureate James Tobin-on FII inflows.
Alas, these apprehensions range from muddled thinking to falsehood. Tobin never sought a tax on FIIs or stock market transactions: he sought to tax transactions in the foreign exchange market, which are something else altogether. Some will say that the last budget has already imposed a tax on all stock market transactions. True, but that is a revenue-raising measure applying to all trades, and is not targeted at FIIs or hot money.
The plain fact is that FII inflows are not hot money. Just see what happened during the Asian financial crisis. In the first year of the crisis, 1997-98, there was a large FII net inflow of $ 1,828 million. In the second and worst year, 1998-99, there was a tiny outflow of $ 68 million. And in the last year of the crisis, 1999-00, there was again a net inflow of $ 3,024 million. This money was not hot, it was astonishingly cool.
FIIs are not soft-hearted do-gooders wanting to save us. They stayed put in India during the crisis for a hard business reason: they could not exit without paying a penalty so huge that exit looked riskier than staying on.
Let me explain that. There are five types of foreign capital inflows: foreign direct investment (FDI) in factories; FII investment in shares; FII investment in bonds; long-term forex loans; and short-term forex loans. Of these, FDI is not hot at all. Foreigners cannot pick up a factory and flee.
The second coolest inflow is FII investment in shares. FIIs would love to sell at high prices and exit during a panic, but find this impossible. As we saw last week, even a small net sale of $ 100 million by FIIs caused the Sensex to sink 10%, and mid-cap shares to sink by 20%. Indian buyers are few and fragmented, and do not buy in crashing markets. The total FII investment in India is over $ 35 billion. If FIIs try to dump even one-tenth of this, $ 3.5 billion, there will be no buyers and the stock market will crash by 80 per cent or more. FIIs find it cheaper to stay put than exit at such a huge loss.
The bond market represents somewhat hotter money. Bond prices also fall in a panic, but less than shares. FIIs are very modest purchasers of bonds, and such purchases are capped anyway.
Long-term loans are hotter money, because the markets do not levy a penalty on exit: loans are repaid at full face value on maturity. Long-term loans cannot suddenly be recalled. But old loans mature week after week, and lenders can refuse to renew them. The mere refusal can steadily drain the forex reserves.
Hotter still are short term forex loans. These mature quickly and can be withdrawn as quickly. When these short-term inflows stop, countries can go bust. Dependence on this sort of hot money must be avoided: everybody agrees on that.
But the hottest money of all, paradoxically, can be that owned by citizens. This is not so in India: Indians cannot freely convert rupees into dollars. But in south-east Asian countries, citizens can freely buy dollars with few restrictions. They rushed to do so in 1997, draining their national reserves. Large forex reserves can defend a country against exit by foreigners, but nothing can defend a country against mass exit by its own citizens.
Why did India survived unscathed in 1997? Because Indians were absolutely forbidden to convert rupees into dollars. By contrast, foreign investors had complete freedom to exit. Yet they did not leave.
India’s policy was based on the implicit assumption that foreigners could be trusted with freedom to exit, but Indians could not. Nobody dared put it quite so baldly: it would have been a slur on our patriotism. But this “unpatriotic” policy was a thumping success.
The lesson is clear. We do not need to cap FII inflows, since they constitute cool money. But, even as we liberalise dollar purchases by Indians in good times, we should retain the option to clamp controls in an emergency. In a panic, nothing will be hotter than Indian money.