The Link between Exchange and Interest Rates and the Balance of Payments


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FIIs are attracted by returns calculated in foreign currency, say for example, in US dollars. Thus, what is relevant is the return on their investment in rupee terms and the movement of the exchange rate of the rupee. A high rupee return on equities can be neutralized,at least in part, by a depreciation of the rupee. For example, a 15 per cent rupee return on equities with a 7 per cent depreciation of the rupee results in an effective dollar rate of return of about 8 per cent only. Similarly, a relatively unattractive low rupee rate of return on equities can become attractive in dollar terms if the rupee appreciates vis -à-vis the dollar. Given everything else, FII flows go up (down) when there are expectations of domestic currency appreciation (depreciation).

Interest rate

FII investment in debt instruments depends on the relativity of the domestic interest rate vis-à-vis the world rate, adjusted for the exchange rate movement. Many developing countries, including India, have high nominal interest rates compared to developed countries. For example, in India, the rate of interest on 10-year Central Government bonds was 7.15 per cent on October 3, 2005, when the corresponding rate on 10-year gilts in the US and Japan were 4.39 per cent and 1.57 per cent, respectively. The relevant differential, however, is not the difference between the nominal rates of interest, but the exchange rate adjusted differential or uncovered interest rate parity condition. For example, an investor can invest US$1 in the US and obtain (1+ rUS )^T with zero risk in T years, where rUS is the annual yield from the US zero coupon yield curve for T years. Alternatively, the investor can convert US$1 into Rs.E at the going exchange rate of Rs. E per US$, invest the proceeds in India, and obtain E(1+ rIN )^T in rupees with zero risk in T years, where rIN is the annual yield from the Indian zero coupon yield curve for T years, convert it back into US$ at the expected future exchange rate. If the expected future exchange rate indicates a higher (lower) return on investment in India, inflows (outflows) of debt capital can be expected to reduce (increase) rIN until both investments yield the same rate of return. While there are quantitative restrictions on FII investments in debt instruments, the equity derivative market provides an alternative route for the FIIs to benefit from the interest rate differential.

Equity derivatives arbitrage constitutes a way for anyone to obtain quasi-GOI-bond

riskless positions. With the 'domestic' cost of arbitrage determined by domestic rates of interest, FIIs have an opportunity through arbitrage operation to obtain a riskless rate of return on investment equal to the domestic rate of interest, which is higher than the 'world' rate of interest. It appears that some 'indirect' debt investments in India by FIIs have been implemented using cash-and-carry arbitrage. For example, if an FII buys Infosys shares on the spot and simultaneously sells them at a future date, the operation gives a locked-in return equal to the spot -futures basis on the Infosys futures. The return is independent of what happens to Infosys price in the future during the holding period. The return on this cash-and-carry arbitrage is much like the return on a debt instrument. In 2004, FIIs accounted for a total of 3.3 per cent of equity derivatives turnover. Arbitrage activities would be a subset of this total. This suggests that arbitrage by FIIs is a relatively small facet of the Indian equity derivatives market.

Balance of payments

India's balance of payments has strengthened almost continuously since the crisis of 1990-91, mainly because of a limited current account deficit more than compensated by a buoyant capital account. The external sector responded well to the liberalisation of trade and current account, removal of quantitative restrictions and a steady reduction in customs duty rates from a peak rate of over 300 per cent in 1990-91 to 20 per cent in 2004-05. The current account deficit as a proportion of GDP, after a high of 3.1 per cent in 1990-91, remained contained below 1.8 percent of GDP until 2000-01, and actually turned into a surplus from 2001-02. The strength of the capital account, on the other hand, reflected the success of a cautious approach to liberalisation with an opening up of the economy to FDI and FIIs, and restricting debt flows. FII flows have made an important contribution to the balance of payments.

FII inflows contributed US$ 40.33 billion between 1992-93 and September, 2005 to the balance of payments. This corresponds to 28.3 per cent of the foreign exchange reserves of US$ 143.1 billion at end-September 2005. In cumulative terms, between 1992 and December 2004, FII investment has been 1.06 times FDI inflows of US$ 34.5 billion. In 2004-05, gross portfolio flows amounted to as much as 1.48 per cent of GDP and was 1.85 times gross FDI inflows of

US$ 5.54 billion.

After net FII inflows (net) averaging around US$ 1.91 billion annually during 1993-94 to 1996-97, there was a sharp decline in such flows in 1997-98, and the flows turned negative in1998-99. The decline in FII flows coincided with several adverse exogenous developments in the form of the East Asian crisis in mid-1997, imposition of economic sanctions subsequent to nuclear detonations at Pokhran (May 1998), and the Kargil War (June 1999). Partly as a response to this slowdown in FII inflows, during 1997-98 and 1998-99, quite a few significant policy decisions were announced. These included: enhancement of aggregate FII investment limit (April 1997), and permission to FIIs to invest in debt securities (April 1998) and equity derivatives (June 1998). It would not be incorrect to state that liberalisation of FII policy, starting from 1992, has in general coincided with weaknesses in the balance of payments. It is only in the early part of the new century, when there were vigorous signs of durable strength in the balance of payments, that the force of arguments - independent of balance of payments reasons - in favour of encouraging FII flows started to get tested.

Simultaneously, however, rather than being a convenient tool for financing the balance of payments deficit, FII flows started to complicate the pursuit of the triple objectives of maintaining orderly conditions in the exchange market, price stability and interest rates. After the Gujarat earthquake (January 2000), terrorist attack on the Indian Parliament (December 2001), the issue of travel advisories by Western nations due to tense situation in the country's neighborhood (May -June 2002), and a severe drought (July -August 2002), with overall growth

of over 8 per cent, capital markets became heavily bullish in 2003-04. Buoyed by the positive

sentiments, FII inflows shot up to an unprecedented US$9.95 billion in 2003-04. While the

Government of India issued Market Stabilisation Bonds to the RBI to mop up excess liquidity

flowing in through the balance of payments, questions regarding the need to 'encourage' FII

flows started to be asked

Benefits and costs of FII investments

Here is a summary of the benefits and costs for India of having FII investment.



Reduced cost of equity capital

FII inflows augment the sources of funds in the Indian capital markets. In a common sense way, the impact of FIIs upon the cost of equity capital may be visualised by asking what stock prices would be if there were no FIIs operating in India. FII investment reduces the required rate of return for equity, enhances stock prices, and fosters investment by Indian firms in the country.

Imparting stability to India's Balance of Payments

For promoting growth in a developing country such as India, there is need to augment domestic investment, over and beyond domestic saving, through capital flows. The excess of domestic investment over domestic savings result in a current account deficit and this deficit is financed by capital flows in the balance of payments. Prior to 1991, debt flows and official development assistance dominated these capital flows. This mechanism of funding the current account deficit is widely believed to have played a role in the emergence of balance of payments difficulties in 1981 and 1991. Portfolio flows in the equity markets, and FDI, as opposed to debt-creating flows, are important as safer and more sustainable mechanisms for funding the current account deficit.

Knowledge flows

The activities of international institutional investors help strengthen Indian finance. FIIs advocate modern ideas in market design, promote innovation, development of sophisticated products such as financial derivatives, enhance competition in financial intermediation, and lead to spillovers of human capital by exposing Indian participants to modern financial techniques, and international best practices and systems.

Strengthening corporate governance

Domestic institutional and individual investors, used as they are to the ongoing practices of Indian corporates, often accept such practices, even when these do not measure up to the

international benchmarks of best practices. FIIs, with their vast experience with modern corporate governance practices, are less tolerant of malpractice by corporate managers and

owners (dominant shareholder). FII participation in domestic capital markets often lead to

vigorous advocacy of sound corporate governance practices, improved efficiency and better

shareholder value.

Improvements to market efficiency

A significant presence of FIIs in India can improve market efficiency through two channels. First, when adverse macroeconomic news, such as a bad monsoon, unsettles many domestic investors, it may be easier for a globally diversified portfolio manager to be more dispassionate about India's prospects, and engage in stabilising trades. Second, at the level of individual stocks and industries, FIIs may act as a channel through which knowledge and ideas about valuation of a firm or an industry can more rapidly propagate into India. For example, foreign investors were rapidly able to assess the potential of firms like Infosys, which are primarily export-oriented, applying valuation principles that prevailed outside India for software services companies.


Herding and positive feedback trading

There are concerns that foreign investors are chronically ill-informed about India, and this lack of sound information may generate herding (a large number of FIIs buying or selling together) and positive feedback trading (buying after positive returns, selling after negative returns). These kinds of behaviour can exacerbate volatility, and push prices away from fair values.

BoP vulnerability

There are concerns that in an extreme event, there can be a massive flight of foreign capital out of India, triggering difficulties in the balance of payments front. India's experience with FIIs so far, however, suggests that across episodes like the Pokhran blasts, or the 2001 stock market scandal, no capital flight has taken place. A billion or more of US dollars of portfolio capital has never left India within the period of one month. When juxtaposed with India's enormous current account and capital account flows, this suggests that there is little evidence of vulnerability so far.

Possibility of taking over companies

While FIIs are normally seen as pure portfolio investors, without interest in control, portfolio investors can occasionally behave like FDI investors, and seek control of companies that they have a substantial shareholding in. Such outcomes, however, may not be inconsistent with India's quest for greater FDI. Furthermore, SEBI's takeover code is in place, and has functioned fairly well, ensuring that all investors benefit equally in the event of a takeover.

Complexities of monetary management

A policymaker trying to design the ideal financial system has three objectives. The policy maker wants continuing national sovereignty in the pursuit of interest rate, inflation and exchange rate objectives; financial markets that are regulated, supervised and cushioned; and the benefits of global capital markets. Unfortunately, these three goals are incompatible. They form the "impossible trinity." India's openness to portfolio flows and FDI has effectively made the country's capital account convertible for foreign institutions and investors. The problems of monetary management in general, and maintaining a tight exchange rate regime, reasonable

interest rates and moderate inflation at the same time in particular, have come to the fore in

recent times. The problem showed up in terms of very large foreign exchange reserve inflows

requiring considerable sterlisation operations by the RBI to maintain stable macroeconomic

conditions. The Government had to introduce a Market Stabilisation Scheme (MSS) from April

1, 2004

With the foreign exchange invested in highly liquid and safe foreign assets with low rates of return, and payment of a higher rate of interest on the treasury bills issued under MSS,

sterilisation involves a cost. With a rapid rise in foreign exchange reserves, and the need for having an MSS-based sterilisation involving costs, questions have been raised about the desirability of encouraging more foreign exchange inflows in general and FII inflows in particular. While there is indeed the issue of timing the policy of encouragement appropriately, to avoid the pitfalls of throwing the baby with the bath water, there can not be a turnaround from the avowed policy of gradual liberalization, including the cap ital account. All modern market economies have evolved policies to reconcile prudent monetary management with the benefits of a liberal capital account. There is no scope for any diffidence in India also moving in the same direction.


I. Encouraging FII flows

In terms of encouraging FII flows, one aspect of difficulty lies in the treatment of FDI sectoral limits and FII sectoral limits. The Committee on Liberalisation of Foreign Institutional Investment has proposed reforms aimed at separating these two. Any potential abuse of the FII route by strategic investors of foreign direct investors should be prevented by strictly enforcing the broad-based nature of the FIIs through appropriate regulation of PNs and subaccounts

Thus, FII investment ceilings, if any, may be reckoned over and above prescribed FDI sectoral caps. The 24 per cent limit on FII investment imposed in 1992 when allowing FII inflows was exclusive of the FDI limit. The suggested measure will be in conformity with this original stipulation. As a transitional arrangement, the current policy of a composite cap, wherever it exists, for both FDI and FII investment limits, may be continued. However, attempt should be made, in consultation with the Ministries concerned, that this composite cap is at a sufficiently high level.

Non-availability of good quality equities in adequate volume appears to impede FII flows. FII flows would be encouraged by greater volume of issuance of securities in the Indian market. This would be assisted by PSU disinvestment. Companies executing large projects in the infrastructure sector and telecom sector should also be encouraged to access the domestic capital markets.

II. Vulnerability to FII flows

Strengthening domestic institutional investors

The participation of domestic pension funds in the equity market would augment the

diversity of views on the market. This would also end the anomaly of the existing situation

where foreign pension funds are extensive users of the Indian equity market but domestic

pension funds are not.

Participatory Notes

The current dispensation for PNs may continue. SEBI should have full powers to obtain

information regarding the final holder/beneficiaries or of any holder at any point of time in case

of any investigation or surveillance action. FIIs may be obliged to provide the information to


Hedge Funds

Regulatory developments with regard to hedge funds in the US and elsewhere, including Europe, may be closely watched to formulate policy on the basis of experiences of these countries at a later date. Only those funds which are otherwise eligible to be registered as FIIs/sub-accounts under SEBI (FIIs) Regulations, 1995 may be continued to be allowed.

Ceiling on FII and sub-accounts

The existing limit of 10 per cent holding in any one firm by any one FII may be extended to cover the sum of the holdings of any one FII and all such sub-accounts coming under that FII which have common beneficial ownership as the FII. The onus for establishing that a sub-account does not have a common beneficial ownership will lie with the FII. This requirement may be phased in over a five-year period, with a limit of 20 per cent by December 2005, 18 per cent by 2006, 16 per cent by 2007, 14 per cent by 2008, 12 per cent by 2009 and 10 per cent by 2010

Broad basing of eligible entities

With the policy of market regulation being the encouragement of broad-based funds to invest in the country, high net-worth individuals fall outside the category of diversified investors. In order to address the market integrity concerns arising out of allowing some entities, which do not have reputational risk or are unregulated, there is merit in prohibiting such entities from getting registered. Such existing entities may be given sufficient time to wind up the position.

Operational flexibility to impart stability to the market

The stability of foreign investment in India will be enhanced if FIIs are able to switch between equity and debt investments in India, depending on their view about future equity returns. Greater flexibility for FIIs to participate in the bond market will induce more "balanced" strategies, and mixing of equity and debt. Such FII investment in debt will indeed be a part of India's external debt, but with an important difference, namely that such debt will be in domestic currency. Keeping this important difference in mind, the quantitative restriction upon debt flows may be progressively amended to a cap on the annual flow from the present ceiling on the aggregate portfolio value

Negative list of tax-havens

Consistent with the recommendations of the Financial Action Task Force (FATF), it must be ensured that only clean money through recognized banking channels is permitted in the securities. There should be a negative list of tax havens, whereby entities registered in these jurisdictions are prevented from attaining FII status.

Episodes of Volatility in India

There have been four episodes of vulnerability in India, which are negative shocks affecting the economy, and influencing the behavior of investors. These are: the East-Asian crisis in 1997, the Pokhran Nuclear explosion (May 1998) and the attendant sanctions, the stock market scam of early 2001, and the Black Monday of May 17, 2004. The investment behavior of the FIIs vis-à-vis the movements of the stock market indices during these episodes are given in Tables below

Table 1.India: FII Behaviour During East Asian Crisis






(Rs. crore)

July 1997



August 1997



September 1997



October 1997



November 1997



December 1997



January 1998



February 1998



March 1998



Table 2. India: FII Behaviour in the aftermath of Pokhran Nuclear Explosion






(Rs in crores)

May 1998



June 1998



July 1998



August 1998



September 1998



October 1998



Table 3. India: FII Behaviour during the Stock Market Scam 2001




(Rs in crores)

November 2000



December 2000



January 2001



February 2001



March 2001



Table 4. India: FII Behaviour around Black Monday, May 17, 2004






May 2004



June 2004



July 2004



FII investment behavior during these four specific events indicates that these events did affect the behaviour of the foreign portfolio investors. But, these events did affect domestic investors' behaviour as well. The critical question to ask is: whether there was any perceptible difference, particularly with a bias towards destabilization, in the behaviour of the FIIs vis-à-vis that of domestic investors?

These experiences show that FII outflow of as much as a billion dollars in a month -which corresponds to an average of $40 million or Rs.170 crore per day - has never been observed. These values - Rs.170 crore per day - are small when compared with equity turnover in India. In calendar 2004, gross turnover on the equity market of Rs.88 lakh crore contained Rs.5 lakh crore of gross turnover by FIIs. This suggests that as yet, FIIs are a small part of the Indian equity market. Transactions by FIIs of Rs.5 lakh crore in a year might have been large in 1993, but the success of a radical new market design in the Indian equity market have led to enormous growth of liquidity and market efficiency on the equity market. Through this, India's ability to absorb substantial transactions on the equity market appears to be in place.

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