Foreign institutional investment, it has been proposed, should be subjected to a six-month lock-in period. This may or may not be a good idea. But the context in which it has been mooted is important. The background is the east Asian currency crisis, which has thrown up an awesome truth: every country is vulnerable to the flu, and strong economic fundamentals are no prophylactic.The immediate provocation was the sudden outflow of foreign institutional investment from India, the outstanding amount of which has fallen in recent months to $9 billion from $11 billion. At the lower perch, foreign institutional investment is sizable enough to jolt foreign currency reserves (which have dropped to $23 billion from $26 billion in the course of a few months), should portfolio investors turn bearish. A lock-in will brake outflows.
But from the viewpoint of the foreign institutional investor (FII), the lock-in prevents him from adjusting for risks not earlier perceived. This means the effective risk of investing inIndia will go up sharply. In other words, the perceived return on investment will have to be high. New investment will slow down even as old investment will fall short of risk weighted return and consequently move out over an extended period.
Lock-in will be self defeating. An alternative could be a stiff withholding tax on the gross outflows. It is a sort of TDS where tax in excess of that owed on actual income is refunded. The immediate cost of taking out money goes up (though not the final cost). This can deter knee-jerk outflows.
But neither lock-in nor a withholding tax addresses the real problem which can be best understood by posing the question, how large should FII inflows be in relation to the country's foreign currency reserves? The larger the proportion of outstanding portfolio investment to the forex reserves, the greater the vulnerability.
This point was not raised in the initial episode of reform when portfolio investment inflows bloated forex reserves. But today other inflows haveincreased reserves. Besides, there is a realisation that portfolio investment inflows can also turn into outflows. Reliance on FII inflows to overcome the foreign exchange shortage must be brought down substantially.
There is a case for an annual cap on foreign portfolio investment inflows. The cap should be related to the capacity of forex reserves to cope with haemorrhage. It should be revised every year. True, FII inflows bring supply-driven, may remain below the cap. But without a cap, the vulnerability to outflows becomes acute. This is the moral of east Asia.
It is true that short term borrowings were very high in east Asia. In India, these are no more than 7 to 8 per cent of total external borrowings. Short term credit is principally in the nature trade credit, which no country can do without. These do not pose a threat, but the authorities must keep a wary eye on their growth, since domestic industry prefers to tap cheap credit abroad and avoid high cost domestic credit.
It is better to go forexternal commercial borrowings (ECB) than rely on FII inflows. Portfolio investment flows into the stock market whose linkage with the real economy is weak. Remember, how share prices soared when the real economy was in the dumps? ECBs on the other hand, support investment growth. Besides, ECB repayments are predictable; their pay-back stream is well defined. This is because ECB inflows are regulated, subject to an annual cap. Portfolio investment on the other hand, can zip in and zip out.
It is different with foreign direct investment. It comes into the real economy. The equity contribution brings in foreign exchange. FDI should be the preferred alternative to portfolio investment. The role each plays, the benefits and costs of each, need to be examined carefully instead of putting barricades against FDI.
FDI must be allowed freely into infrastructure, but why should it be confined to this sector? A whole range of imports -- capital goods and intermediates - are freely allowed under open general licence.If the country can import these, why the aversion to their manufacture within the country by foreign capital?
There is a case for channelling FDI into priority areas. But FDI is supply-driven and may not be attracted by domestic priorities. The twin objectives of ensuring adequate forex inflows and prioritising investment will need to be finely balanced.
The Asian crisis has alerted the country to the uncertainty associated with inflows into the money and stock markets. This should not blind us to the desirability of FDI which the real economy can use to advantage. paradoxically, instead of FII, FDI is viewed with suspicion.
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
