Made for each other

Will foreign institutional investors (FIIs) finance Indian government programmes on education, health and employment? Not a chance, you might think. Yet something of the sort is in the works.

Chidambaram faces the classic dilemma (or trilemma) of finance ministers. He faces demands to increase spending, cut taxes, and reduce his fiscal deficit simultaneously. This is difficult, often impossible.

One way out, favoured by Chidambaram, is to raise billions by selling minority stakes in public sector companies. This is possible only if FIIs bring in additional billions of dollars. They are needed both to buy chunks of shares themselves, and to create a bull run that will encourage participation by small investors.

Step back and look at Chidambaram’s trilemma in detail. The Common Minimum Programme (CMP) requires additional annual spending of at least Rs 60,000 crore on education, Rs 50,000 crore on health and Rs 30,000 crore on employment. Further, the Finance Commission has just decreed that an additional one per cent of central tax revenue should go to the States. This will bleed Chidambaram of thousands of crores.

So, how to raise the money? The Left front wants to soak the rich, but the failure of Indira Gandhi’s Garibi Hatao programme should warn all finance ministers of the perils of such populism. Chidambaram’s long-term aim is to match the tax rates of ASEAN (Association of South East Asian Nations). That means reducing customs duty, excise duty, corporate tax and income tax.

Chidambaram can hope for growing revenues from an expanding service tax, and from IT-enabled income tax enforcement. Even so he needs additional tens of thousands of crores.

The only possible source is the sale of public sector shares. He would obtain the highest prices if he sold majority stakes: business houses will pay a big premium over market price for control. But the CMP has ruled out selling majority stakes in profit-making companies.

Selling minority stakes is hazardous. When the stock market has a bull run, anything will sell at sky-high prices. But in less exuberant times, Indian buyers are few and far between. No business house will pay high prices for minority stakes. The Indian public remains chary of investing in shares: it has been burned too often by stock market scams.

That is why the stock markets are dominated today by FIIs. They brought in $7 billion in 2003, $8.4 billion in 2004. When they buy, the markets shoot up. When they sell, the market slumps. When the BJP was beaten in the elections in May, the sale of a tiny fraction of FII holdings (around $750 million) was enough to cause blue chips to fall 20%, and mid-cap stocks to fall by up to 50 per cent In 1998, the only year when FII inflows turned negative by a modest $ 350 million, the stock markets sank to record depths.

The subsequent return of FIIs to the markets was crucial for the BJP’s limited success in selling public sector shares. They caused the bull run of 2003, which enabled the BJP government to sell over Rs 10,000 crore of minority stakes in early 2004. Chidambaram will need the FIIs to sell similar quantities at similar prices in coming years. This, I think, is widely known. What is less well-known is that, in some important ways, the FIIs need public sector sales too. By now, FIIs already own the majority of floating stock in the market. In large companies like ICICI Bank they have reached the limit of 74 per cent and cannot buy more. Nor can they buy much more in companies where Indian promoters want to remain in control. FIIs avoid buying shares in small companies, whose trading volumes are very low.

They place great emphasis on investing in liquid stocks, that can be bought and sold in bulk.

Given the limited scope for buying more shares of existing companies, where will FIIs invest future billions of dollars? In pubic sector shares, of course. Public sector issues are large, and provide a the huge trading liquidity that FIIs need.

The public sector companies are blue chips that could gain in profitability with liberalisation. This explains why FIIs have lapped up share issues of NTPC, ONGC, Power Trading Corporation and other profitable public sector companies.

So, Chidambaram needs the FIIs, and they need him. You might say (as in Wills cigarette advertisements) that they are made for each other. Both have needs that only the other can fulfil.

This explains why Chidambaram acted so swiftly when the RBI Governor wondered loudly whether taxes or controls should be placed on FII inflows. These would in effect be taxes and controls on the thousands of crores that Chidambaram himself needs. He will not allow any RBI Governor to spoil his love-affair-of-convenience with FIIs.

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