Why did the RBI governor want a ceiling and tax on FII inflows? Uday Chatterjee explains.

As if a choppy market was not enough, it now appears that one arm of the market system does not know what the other arms are up to. Commenting on the recent massive intra-day fall of the Sensex, SEBI chairman G N Bajpai said that some 'unusual' price movements were observed in the markets.

Finance minister P Chidambaram, however, with his customary cool said that there was nothing unusual about the fall, which he said had been orderly. This would have surely had the ordinary investor wondering whether it was the SEBI chairman or the finance minister who knew better.

It happened again this week. Speaking at the release of the India Development Report of Indira Gandhi Institute of Development Research, Y V Reddy, the RBI governor had a few strong words about the quality and quantity of FII inflows. He suggested that it was time to consider ceilings and a tax on FII inflows.

All hell broke loose in the investor community for the next couple of hours till Chidambaram came on air to clarify that there was no proposal to cap or tax FII inflows. He added that he had spoken to Reddy and Reddy has been misunderstood.

Close on the heels of Chidambaram's statement, Reddy, in a hurriedly called press conference clarified that the effectiveness of these measures could be arguable and hence undesirable.

The next day, Bajpai made a statement saying that the final authority on taxing FII inflows was the finace minister.

Bajpai is absolutely right but don't we see a sense of disconnect between the SEBI, the RBI and the finance ministry?

The RBI governor is supposed to be an independent authority (statutorily, at least) and his job is to oversee the monetary management of the country - a heavy burden, indeed. And, at a time when dollars are flowing-in in billions, the concern that they could also flow out in billions is weighing, quite rightly, on Reddy's mind.

When a governor of the RBI speaks, he speaks in a language, which is difficult to decipher. The speeches are loaded and one has to read between the lines, but this time he has been relatively plain.

In his speech, Reddy had observed that the magnitude of FDI / FII inflows were tending to be large and volatility had, perhaps, increased. "A view needs to be taken on the quantity and quality of FII inflows. While quotas or ceilings, as practised by certain countries may not be desirable at this stage, there is merit in our keeping such an option open and exercising it selectively as needed, after due notice to the FIIs."

He added that price-based measures such as taxes could be examined though their effectiveness is arguable.

According to Reddy, there is scope for enhancing the quality of forex inflows through a review of policies relating to eligibility for registration as FIIs and assessment of risks involved in flows through hedge funds, participatory notes, sub-accounts, etc. Strict adherence to `know your investor' principle, especially in regard to flows from tax-havens, including beneficial ownership would enhance quality. In simple terms, Reddy was hinting that unknown entities were pouring in money into India - a perilous situation.

"FDI flows, as currently defined, also include transfer of equity from residents to non-residents and a disaggregated analysis of FDI through several routes could enable a policy-intervention, as appropriate on quantities and quality," he said. What he meant was that money was being sent out of India and then being routed back as FDI. Hence, there could be a case for intervention to stop these inflows.

The governor also called for a mechanism for assessing the aggregate shares of residents and non-resident in larger corporates and in sensitive sectors in particular. Moreover, as there are several routes by which non residents can hold shares and voting powers over Indian corporates, such monitoring could help timely responses on several fronts.

He said that a view could be taken on the relative policy emphasis on sources and types of investment that need to be encouraged. For example, offering better incentives to foreign investors over domestic investors opens the doors to `round-tripping' (the term used for Indian money being sent abroad before being brought back as foreign investment).

Similarly, if avenues for portfolio flows or equity-transfers from domestic to foreign investors are easily available and attractive, the flows under FDI-defined (in terms of adding to domestic production capacities) will tend to be smaller. Attention to these may simultaneously address micro or institutional issues relating to capital flows and financial markets ensure high-quality inflows of foreign savings, which is more important to the country at this stage of its development.

Lastly, he signed off by pointing out that nearly 60 per cent of the reserve accretion in the current financial year has come in two months (November and December 2004) which indicated perhaps the volatility in the stock markets.

The overriding concern in his speech was the flight of capital out of the country. India is sitting on a foreign exchange reserves base of over $130 billion. Of these, roughly $22 billion comprise FII money, which ultimately will go out of the country when the FIIs book profits.

About 30 per cent of the reserves comprise of external commercial borrowings, which will have to be repaid one day or the other. Out of the balance reserves, the government is considering using a portion for infrastructure financing. Further, the prices of oil are extremely volatile and oil constitutes about 70 per cent of our imports.

So, the long-term reserves base is not as comfortable as they are made out to be. In such a scenario, a punter like George Soros could easily bring in money in January and exit in March, leaving the currency and the economy reeling for years - just as he did in the Asian 'tiger' economies a decade back. The currency collapse in these countries led to a foreign exchange crisis from which these economies have yet to recover

Earlier, Soros had done that to the pound. He and his ilk could easily do it again - to India.