'Paying To Feel Good', 1 March, 2004.

Perhaps a little more than remonstrance is required as a credible response to the BJP's muscular feel-good mantra. After all, India is among the world's fastest growing economies currently. Abstracting from what economists term distribution, or how the laddoo is being shared, this macroeconomic statistic is not without relevance. No matter that India has been in the top league of the growth tables for about two decades by now, there is something special this time round, a feature that the Finance Minister was quick to refer to in his Budget Speech. There is now an international perception that the country is doing well, surely a relatively recent feature in the country's economic history. As crucial evidence this government has advertised, notably through its India Shining campaign, that our foreign exchange reserves have crossed the one hundred billion-dollar mark. As with the growth figures, this too is noteworthy, and something that we would have given our right arms for in mid-1991. My point though is that we would be wise to appreciate exactly what the cost of these reserves is.  

Let us look over the accretion of reserves over the past couple of years or so. Recently, as we can see from data in the Reserve Bank's Report on currency and Finance 2002-3, the capital inflow has been of a non-debt-creating kind as external commercial borrowing is relatively low now. Specifically, in this past year most of the inflow has been in the form of portfolio investment and NRI Deposits. While NRI Deposits are debt creating in that they are these days repatriable, they have risen by little in 2003-4. On the other hand, close to half the increase in this period is accounted for by portfolio investment by the foreign financial institutions (FIIs), provisionally estimated at 4 billion dollars.  

It would be a folly to assume that as portfolio investment is not debt creating it comes without a cost. So what are the costs? They are not generic, and can therefore only be inferred by observing both the public policy stance towards the FIIs and their own practices. The public policy stance towards the FIIs is nothing short of craven. It is not at all clear that these agents should be exempt from taxation of their proceeds and their funds not be subject to a lock-in period. The loss in terms of tax on dividend from all FIIs and that due to capital gains tax foregone on FIIs registered in Mauritius is the cost to the economy of the reserve accretion due to portfolio investment. That the FIIs are enjoying capital gains must be evident to any observer of the stock market during the past nine months or so. Observing the relationship between price movement and FII activity also tells us what the objective of these agents is and thus how if at all it benefits the economy. First bulk buying drives up the price. Next a judicious booking of profits shaves off some points from the Sensex but not before the institutions have captured the capital gains that they are then free to repatriate. That we say negative portfolio investment in 2002-3 shows that the FIIs are not here to necessarily stay.  

It is only by studying the practices of economic agents that we can evaluate their role. Economic theory has a limited role here. The current gyrations of the stock market help us appraise the role of the FIIs in the economy. Quite simply, they leverage their size to move the market to their advantage. While this is by no means illegal, it can hardly serve as a paean to the market mechanism. The market is an optimal economic arrangement only as far as there are no large players able to influence the outcome. To many of my readers this must appear as just onion chopping. So let me try another tack. Let us take a widely understood criterion by which financial markets ought be judged, the facilitation of investment. The RBI report I had cited earlier sees little evidence of a rise in capital formation in 2003-4, stock market rally, capital inflow, and all. So, feel good if you must; but remember to check out the cost.