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Step out and woo

Published in The Week, October, 25th, 1992

In the past India has flashed come hither looks at international investors. Yet when amorous advances were made, she has always lost nerve and reverted to being prim, proper and traditional going behind a curtain of red tape, clearances and sovereignty inhibitions.

Today, however, there are strong signs that the thinking in North Block is changing. The door to foreign investment has opened a crack and soon the trickle, it is hoped, will become a flood.

The guidelines for Foreign Institutional Investment (FII) in the Indian capital market announced recently have succeeded in raising expectations dramatically. Many economists feel that this is the precursor of a more open approach to foreign investment. But expectations alone are inadequate to generate hard currency flow into our economy.

The FII scheme indicates a clear departure from the past. Hitherto any investor who, despite the formidable barriers, had the faith to park his funds in India was faced with almost impossible conditions on repatriating capital, interests and dividends. The FII, in one stroke, enables investors to withdraw or repatriate their funds. This would, no doubt, create a feeling of security in the minds of potential investors. That no lock-in period has been prescribed also augurs well for the inflow of investible funds.

The FII scheme's stipulations on tax, on capital gains as well as on dividend and interest income are attractive even though they will find legislative support only in 1993-94 (investments in 1992-93 will also be covered). The government's preference for long-term investment is clear from the fact that capital gains accruing over a period of one month or so under this scheme will qualify for a highly concessional ten per cent tax.

To prevent foreign portfolio managers from staging corporate takeovers, the FII scheme has laid down protective ceilings for overall share ownership of all FIIs in a company (24 per cent) and investments by a single FII group (five per cent). Initially this condition may not cause undue concern to portfolio investors. However, when the economy grows at six per cent to eight per cent yearly, (hopefully from 1993), and the reform process accelerates, the takeover, mergers and acquisitions game will also be actively played in India. The pressure will then definitely be on the easing of these ceilings on share ownership.

The FII scheme has no doubt aroused interest abroad and excitement within. International investors who operate in the global financial markets are an extremely savvy lot. They will not risk any money unless they are sure that their investments are not only safe, but also guaranteed an internationally comparable base return.

The ongoing financial sector reform, especially stock market reform, and the progress of the JPC investigation into the securities scam are consequently being monitored in global financial capitals. Under the circumstances, it would be foolish to expect billions of dollars to come in the wake of the FII scheme. Somewhere in the region of $600 to $800 million in a full year is probably a safe estimate.

The FII scheme raises certain broad issues. It is widely agreed that the Indian share market is neither wide nor deep. The number of participants and the number of products are limited. Accordingly, knowledge and influence relating to the financial market are limited to a select group of intermediaries. We therefore have all the trappings of an oligopolistic financial market, which often approaches the contours of an exclusive cartel, operating to serve narrow interests. Insider trading, price fixing and market making, funds diversion and plain dishonesty are all endemic to this environment. The stock scam is classic example of what can happen in such a market.

It is vital to create an open and transparent financial sector, if capital formation is to be encouraged and harnessed. Though perfect competition is a chimera, our endeavor has to be in that direction as far as the capital market is concerned. Viewed from this angle, the advent of the FII is timely. The arrival of pension and mutual funds and other investors will not only increase the number of players on the market place - it will also increase competition in the financial markets. Innovative products will become available and a greater openness in trading will ensue. The FII scheme's requirement that disinvestments will only be through stock exchanges (barring exceptions) is particularly welcome.

Secondly, FII has important implications for stock valuations. The blue chips will henceforth find it difficult to compete for buying support. Many less known but higher performing scrips will no doubt be unearthed by the research that will inevitably precede any actual investment by the foreign institutional investors. We are thus on the threshold of witnessing the emergence of a new generation of blue chips. Perhaps the entire cause of more openness will be better served if the FII scheme is extended to its next logical state-permitting foreign entities to commence stock broking and merchant banking on the lines of international markets.

Thirdly, the FII scheme will, hopefully, increase the volume and complexity of trading in the Indian stock and securities markets. Given the recent experience, nobody can be confident that the processing and administration systems currently employed will be adequate to ensure quick and faultless recording of reconciliation of transactions. Though the RBI has recently computerized its public department service, the financial system as a whole is primitively manual. Stock exchanges are nowhere near international standards in the application of information technology. If we do not rapidly computerize, the entire FII scheme could look Stock exchanges are nowhere near international standards in the application of information technology. If we do not rapidly computerize, the entire FII scheme could look and feel like a spaceship mounted on a vintage car chassis.

The FII scheme is, of course, laudable. The real necessity, however, is to invite Foreign Direct Investment (FDI) on a massive scale. Over the last 12 months, or BoP has received an infusion of hard currency. This has mainly been the result of savage import compression acting in concert with aid and IMF and IBRD lending. Our forex reserves are today touted as being healthy at $5.6 billion. But consider this: our external debt is approximately $70 billion. Our debt service ratio is almost 27 per cent and most of the forex reserves are contributed by the inflow of multilateral and other borrowed funds. Not altogether a pretty picture.

The prospects of toppling into debt trap are indeed real. If we are to regain our balance, finance our current account deficit and generally consolidate our BoP position, a two-pronged strategy is a must.

On the one hand we have promote exports aggressively. We must shred our inhibitions and take on the global market boldly by pursuing quality and productivity. In 1992-93, official projections of export growth are pegged at around 9-12 per cent.

Given the generally depressed state of the recession-hit European and American markets, a 6-8 per cent growth is probably more realistic. The writing is therefore clearly on the wall; over pitched expectations of record growth will not materialize in the next 12 - 14 months. Thereafter, the prognosis is better for a 12-15 per cent or higher growth.

On the other hand, we have to make strong efforts to reduce our debt burden. This can be done firstly by pursuing debt-reduction and rescheduling negotiations, and secondly by relying more on FDI to finance our current account deficit. We must also seriously evaluate debt/equity swaps to reduce the debt burden. This strategy is of particular relevance in the context of privatization.

Foreign direct investment is a whole new ball game. Pious platitudes and bureaucratic tinkering will not bring one-cent worth of investment. As Makarand Dehejia, vice-president of the International Finance Corporation, emphasized recently, countries must project themselves to foreign investors, just as companies sell themselves to customers. We have to understand that we are competing for FDI alongside eastern Europe, east Asia and to some extent South America. Our investment climate, regulatory framework and investor protection mechanisms must be good, if not better, than the FDI-hungry competitors. But are they really good? FERA, outdated tax laws and a labyrinth of sanctions and approvals loom forbiddingly over investors. In reality, the conditions governing FDI are more like a moat than a gateway.

If we are really serious about foreign investment, we must build on the FII scheme, and extend it to cover stock broking and merchant banking. Wholesale financial sector reform has to be launched in tandem with tax reform. Privatization, rupee convertibility, infra structural improvement and downsizing of the government must all proceed apace. The remedies are available but will the doctor prescribe them fearlessly?

In the meantime foreign investors attracted by India's fluttering eyelashes can only wonder …Will she? Or won't she…?

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V.K.Madhav Mohan - The Leader : Mentoring Services, Mentoring Workshops, Mentoring products- Articles / Audio / Video/ Posters, Lectures