Indian policy-makers have illustrated clearly the unintended consequences of bad regulation. The government limits foreign investment in the domestic bond market to just 1%, as a guard against the country becoming victim to hot money flows. India is also notorious for its restrictions on foreign direct investment, with vast areas of the economy off limits to international companies, and so denied their technology and capital. Unfavourable comparisons between Indian and Chinese economic performance usually highlight the low levels of FDI in India.

Equity anomaly


However, India’s equity markets are open to foreign investment. Since overseas companies cannot invest directly, they have turned instead to portfolio investment (FII), in the form of share purchases, making India’s annual FII flows nearly three times as high as its net annual FDI flows.

The result is that India’s economy is exposed to the sudden removal of portfolio capital and has the very hot money problem it wants to avoid in the debt market in the equity markets instead. And by not attracting FDI, India loses out on the most appealing kind of capital, one that directly produces jobs and growth.

Indian prime minister Manmohan Singh, speaking to industry captains in Mumbai on March 18, promised more steps towards capital account convertibility soon, which could take some pressure off the burgeoning inflows by opening up more avenues for overseas investment by Indian companies and savers.

India’s big challenge in achieving its huge economic potential will be to come up with sensible and coherent regulations for foreign investors in general, and the financial sector in particular.

Bureaucratic horrors

Sometimes even when good regulations are in place, bad implementation can push investors into nightmarish situations. Horror stories about investors’ entanglements with Indian bureaucracy show that the country has a long way to go to create a conducive investment environment. Take, for example, the experiences of HSBC, which responded to the government’s announcement (about two years ago) that foreigners were permitted to invest up to 74% in privately held banks. Taking its cue, HSBC decided to buy a minority stake of about 14% in a profitable private bank.

The banking regulator, however, objected to the purchase, and in new rules issued soon after, it said that foreigners may only buy weak private banks, and that all other purchases were subject to a limit of 5% unless specific approval had been received. A disgruntled HSBC nevertheless agreed to trim its investment and recently sold part of its stake in the bank, booking a handsome profit in the process.

Unintended effect

It was another case of unintended consequences, where a reputed foreign bank was unwelcome as an FDI investor, yet welcome to profit as a portfolio investor.

When local regulations are obstructive, markets move offshore. Indian companies searching for new investors and cheaper borrowing costs overseas have begun issuing bonds in foreign currency, including foreign convertibles.

Opening up the local bond markets, with adequate safeguards in place, would diversify sources of funding the government’s large deficit, says R Ravimohan, managing director at Crisil, a credit rating firm and the Indian partner of Standard & Poor’s. “If the intent is to attract long-term debt investors, it could be achieved by the use of appropriate tax incentives, such as granting an exemption from withholding tax to investors who hold securities for a longer period,” says Jayesh Mehta, head of debt markets at Merrill Lynch.

Paul Rawkins, a sovereign analyst at rating agency Fitch, adds: “Easing restrictions on foreign investment in government bonds would be helpful insofar as it would give foreign investors sovereign exposure and the government a new pool of savings to draw on. It would also bolster the balance of payments and reserves.”

The Indian government’s aversion to foreign debt can be traced back to 1991, when a sudden pull-out by short-term creditors pushed the country into a balance of payments crisis. Foreign exchange reserves plunged to about $5bn and the country’s gold reserves had to be pledged to raise emergency loans. Translated into policy, the 1991 crisis made policy-makers treat all short-term foreign debt and debt-creating capital inflows with the utmost suspicion.

India is also among the few countries in Asia that refuses to borrow commercially in its own name. When there has been a need to raise external funds (such as in 1998 when economic sanctions were imposed on India after it tested nuclear bombs) this was done through issuing high interest bearing bonds to overseas Indians – such as the Resurgent India Bonds issued by the state-owned commercial bank State Bank of India.

The exchange rate risk was borne partly by the government, making this an expensive way to borrow. If the government were to act like a company, it would simply borrow where the cost of capital is cheaper, and it would sell sovereign bonds overseas where interest rates are lower, as indeed several other Asian governments have done.

Bankers point out that a sovereign bond would also set a benchmark rate that Indian companies could price off.

“One reason why India has been able to largely ignore international capital markets is that it has near unlimited access to a captive domestic market, chiefly through small savings schemes and the banks,” says Mr Rawkins. Indian savers cannot freely invest abroad because of capital controls; a large chunk of their savings is invested in bank deposits and government-guaranteed post office schemes.

The burden of financing the Indian government’s large deficit falls squarely on Indian public sector banks; about 36% of their asset portfolio is invested in government securities. Access to such a large pool of captive savings has proved a moral hazard of sorts, allowing the government to run up large fiscal deficits.

Now that the economy is growing at 8%, and bank loans are growing at more than 30%, there is a risk that private sector borrowers will be squeezed out of the market unless the fiscal deficit shrinks faster than it has been.

Interest rate hike

“In the short term, the only way the central bank can square the circle is by raising interest rates,” says Mr Rawkins. In January, the Reserve Bank of India raised interest rates, prompting lending rate hikes by banks.

Current trends in international capital inflows into India pose a dilemma for policy-makers. In the year ended March 2005, the net foreign portfolio investment was significantly higher, at nearly $9bn, than the net FDI of about $3.2bn. Even accounting for the larger outward flow of FDI by Indian companies today, total FDI is only about $5.6bn. In the six months to September 2005, net FDI inflow at $ 2.3bn was less than half the net FII inflow of $5.1bn. The share of net foreign portfolio investment in total foreign investment is much higher at 79% in the year ended March 2004 and 68% in the year ended March 2005, and that trend could be sustained for the fiscal year ended March 2006.

Portfolio inflows accounting for a large part of capital inflows may not be what policy-makers intended to happen. “In this sense, India is more exposed than it was to sudden shifts in investor sentiment, and is likely to become increasingly so, now that a current account deficit has re-emerged and the authorities have set their sights on ever higher growth,” says Fitch’s Mr Rawkins.

Crisil’s Mr Ravimohan says: “Having climbed to the top of the mountain, we are looking at the other side of the slope. The worry is that even if foreign portfolio inflows slow down, the equity market will correct in a large bout of volatility. Filling the gaps in our FDI policy is a matter of great urgency.”

The government’s response has been sanguine. The official Economic Survey, released in February this year, notes: “Notwithstanding a quantum jump in volume of FII flows in recent years, low levels of short-term debt as a proportion of total external debt, and adequate reserve coverage mitigate the risk of potential reversals.”

Admittedly, India’s large pile of forex reserves (totalling about $144bn) buys a lot of insurance against external shocks. But it is expensive insurance if one considers that those forex reserves are invested, in large part, in US treasuries and deposits with foreign banks, which offer a much lower return compared to the cost of sterilising dollar inflows by selling higher yield rupee bonds.

Discussion at the official level over the risks that large portfolio inflows pose has centred around the issue of participatory notes (PNs), or derivative instruments based on underlying Indian equities owned by offshore investors, which comprise as much as a quarter of net foreign portfolio investment.

The Ministry of Finance (MoF) set up a high-level panel – chaired by Ashok Lahiri, chief economic adviser to the government – to look into capital inflows. Its report, released last November, endorses current policy, which is to try to regulate PNs rather than ban them.

In February 2004, the securities regulator directed foreign institutional investors registered in India, which issue PNs to their overseas clients, that they may sell PNs only to regulated entities, and it began seeking regular disclosures of PNs issued by them.

However, in a note of dissent in the panel’s report, the Reserve Bank of India has strongly urged that PNs be banned, pointing out that the anonymity that shrouds such investment makes it a possible tool for money laundering.

Over-regulation has already taken its toll on FDI flows. Limits on foreign investment are imposed in various ways, either by a composite ceiling for both FDI and FII as is the case in banking, insurance and telecoms; or a separate ceiling for both as in direct-to-home broadcasting; or a complete ban on foreign investment in industries such as gambling and the lottery business.

The MoF panel has suggested that portfolio investment should be separated from FDI for the purpose of limits imposed on foreign investment. This, it says, will prevent strategic investors or FDI-type investors coming in as portfolio investors.

However, the practical difficulty in separating the two was evident in HSBC’s recent purchase. The banking regulator viewed it as an FDI-type strategic investment because HSBC has local operations, while the bank maintained that it was a financial investment.

Asked about his view on the Lahiri panel’s report, the finance minister Palaniappan Chidambaram conceded in a television interview in early March that since capital is fungible and “every FDI investor has an FII arm”, it is hard to distinguish between the two.

The gradual opening-up of each sector to foreign investment through a series of higher limits is inconvenient for both the ‘majority’ Indian owner, who has neither the capital nor skills to run the business, and usually only ‘warehouses’ equity, and a foreign partner, who has both deep pockets and expertise but is reduced to the role of bit player.

Highly leveraged

Most Indian partners tend to cash out as soon as regulations change. The only way the Indian company can bring extra cash to the table is by borrowing, and typically the business tends to become a highly leveraged one, says Nandini Chopra, director, corporate finance, at KPMG.

In the rapidly expanding, capital-intensive telecoms sector, a foreign investment limit of 49% was imposed soon after it was deregulated. As a result, a complex web of cross-holdings evolved, which gave the foreign partner (who on paper was a minority investor) control over the business. This was eventually untangled once regulations eased to allow 74% FDI.

However, the uncertainty over when regulations could change can pose business risks: the newly deregulated private insurance sector, which has a 26% limit for foreign investors, faces an acute shortage of capital because the Indian partners are cash-strapped. The ventures are not yet profitable, making borrowing difficult.

“It’s two years since the government announced the limit would be raised to 49%, but the decision is yet to be taken. As a result, some insurance ventures have decided to go slow on writing new policies,” says Ashvin Parikh, head of the financial services division at consultancy Ernst & Young.

Foreign insurance companies such as Allianz, Sun Life, New York Life, Standard Life and Prudential have millions of dollars invested in India. Their experience shows that the country has a long way to go to create a conducive investment environment.