Objective View of Capital Controls: Financial Express: 22nd October 2007

Indians as a rule are crazy about cricket, but this is overshadowed by our obsession with the stock market. Understandably so, as several interest groups—the salaried class, politicians, investment banks, mutual funds, banks, brokers, bureaucrats, the media (some TV channels survive on stock markets)—have investments in this market and would like to see the Sensex move upward without a correction.
This helps everybody, as money being invested keeps multiplying while changing hands. It is but natural that investors have taken umbrage to the move by the Securities & Exchange Board of India (Sebi) to control funds coming into the country through participatory notes (PNs). Even the finance minister had to placate markets the following day (though there was no need to do so) and clarify that the government was not against the concept of PNs, who have a very important role to play.
The decision to come down on PNs is probably controversial, but it will help the government control two nagging problems that have been quite elusive. The first relates to controlling the quality of funds coming in, while the second is exercising control over capital inflows, which have created innumerable problems for the Reserve Bank of India (RBI). By accomplishing these two objectives, the government would have also managed to control the proverbial bubble, which we all know is going to burst, though we never know when. PNs are basically investments used by foreigners not registered in India. They operate through foreign institutional investors (FIIs), who are registered with Sebi. FIIs buy Indian shares and issue PNs, which are purchased by entities whose names remain unknown. It is also suspected that Indians themselves could be making such investments to eschew identity as well as find a tax shelter. Also, a lot of laundered money could come in and RBI has always been critical about such money.
But investors don’t like such announcements, even though it seems quite logical to have some discipline in these operations. While the legitimacy of these funds has not come up this time, the government fears that these funds are looking for short-term gains (and could destabilise the markets when they withdraw) and hence provide some kind of irrational boost to share prices.
In fact, the Sensex has risen by over 35% in the last two months, ostensibly due to a large flow of FII funds, with PNs contributing significantly. If this were true, then any responsible regulator would take pre-emptive action lest it be caught napping when things go awry. This should be remembered by critics, who always feel markets should be allowed to work freely—they are never perfect to be allowed this luxury.
What exactly did Sebi do? Firstly, it issued a discussion paper seeking to ban any issue of PNs of FIIs against underlying derivatives, ie, futures and options, while restricting the issue of PNs in the cash segment. This has quite naturally hit the market hard as it has been interpreted as being regressive. The notional value of PNs is around 52% of the FIIs’ account assets. Excluding underlying derivatives, the share was 35%.
Is this a good move? Probably not for the market or FIIs, as they are directly affected by these measures. The stock market fell by over 330 points by the end of the first day, echoing this sentiment after recovering from a fall of over 1,700 points (that means a major erosion of market capitalisation!). But if one looks at this dispassionately, one will realise that there was inherently nothing amiss in the thought process. Funds of a short-term nature tend to be destabilising and given that the ascent witnessed in this market in the last month was due to these funds, it is natural to be concerned.
The other issue, which the finance minister claims to be the more important one, is even more interesting and relates to trying to stem the flow of capital. This comes on top of the curbs placed by RBI not a long time ago on the external commercial borrowing channel of finance. However, the major source of these forex flows into the country in the last year was on account of foreign direct investment rather than portfolio investment.
To the extent that PN investment would come down by these announcements, there would definitely be some clamp down on such inflows. This move, hence, brings to the forefront an interesting theme being tested by the government relating to capital controls. One is not too sure if capital controls are a solution, or even part of the solution, but given that liberalising capital outflows has not helped, the imposition of controls could be worth a try.
Coincidentally and ironically, just one day after this explanation was given, the International Monetary Fund placed on its website its latest World Economic Outlook, which says global experience reveals that capital controls do not really work. If this is the case, then placing curbs on both the ECB and PN routes may not really serve the purpose, though RBI can always say that it cannot be blamed for not trying.