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27 December 2013, Gateway House

Curbing India’s dependence on FII flows

The extent of the rupee’s depreciation in 2013 demonstrates the Indian market’s dependence on overseas portfolio investments. Can developing domestic institutional bulwarks allay anxieties during similar crises? Is tapping into India’s deep pool of domestic savings, by modifying archaic regulations, an option?

Former Senior Fellow, Geoeconomics Studies

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Strange are the linkages of globalisation. The spectre of the Federal Reserve rolling back its quantitative easing (QE) programme – also known as tapering – in faraway U.S. has thrust the issue of Indian pension reforms back to centre-stage.

Let’s link the pieces together. From April 2013, different governors of the Federal Reserve System, the U.S.’s central bank, started hinting that the time had come to start reeling QE back in, or slow down the bond-buying programme through which the Fed injects cash into the dormant U.S. economy. In the days preceding a scheduled meeting of the Federal Open Markets Committee (the Fed’s rate-setting body) on June 19, these disparate voices reached a crescendo.

The prospect of tapering – real or imagined – shook up the investment agenda of most global fund managers. If the Fed was going to slow down its liquidity infusion, it would immediately mean a dip in demand for Treasuries (bonds issued by the U.S. government). The monotonous regularity of the QE programme–under which the Fed bought $45 billion Treasuries every month – had created a sustained demand for these bonds. But the prospect of this ebbing soon sent bond prices downwards. This resulted in bond yields rising (the prices and yields of bonds are inversely related).

Consequently, U.S. Treasuries started looking relatively attractive, compared to some emerging market assets, including Indian equities and bonds. Investors started dumping investments in bonds and equity in different emerging markets, including India. In their rush for the exit, they had to sell the emerging market currency and buy dollars. This saw the rupee depreciating (along with many other emerging market currencies, such as the Turkish lira).

Unfortunately, the extent of rupee depreciation was the sharpest among all emerging nations. According to data from Bloomberg, the traded value of the dollar-rupee on 1 January 2013, was Rs. 54.69. By August 28, it had touched Rs. 68.83, reflecting a depreciation of over 25% in just nine months. Using the Reserve Bank of India’s reference rate, the exchange rate went from Rs. 54.83 on January 1 to Rs. 68.36 on August 28, down 24%. It showed how Indian markets were vulnerable to inflows and outflows of overseas portfolio investments.

This creates a dilemma for policy makers. With a widening CAD (4.8% of GDP for FY13 compared with 4.2% in FY12), the government does need foreign financial flows, especially portfolio investment, to finance the deficit. But, given the capricious nature of such funds, they are prone to rushing out herd-like and wreaking havoc on markets. An initial blip in market indices prompts other FIIs to also look for exit routes, which then precipitates a free-fall in all indices, as witnessed recently.

Indices are important because they send signals to all categories of investors about an economy’s health and direction. A depreciating currency, sliding stock indices, rising bond yields – these are all indicators of an economy in turmoil.

One option is to develop domestic institutional bulwarks, which can allay apprehensions during times of similar crises. And, the solution is not far to see.

India has a deep pool of domestic savings that is regulated by archaic regulations. According to a recent joint study by CII and Ernst & Young, titled ‘Pensions Business in India’, the pension corpus is estimated around Rs. 15,00,000 crores, with roughly one-third being managed by the Employees Provident Fund Organisation (EPFO), which caters primarily to the workforce in the organised sector.

But a set of outdated rules circumscribes the investment of these funds by either the EPFO or other pension managers, with the ostensible objective of reducing risk and protecting subscribers’ capital. The outcome is sub-optimal from a number of viewpoints. One, these funds have ended up providing negative returns – for instance, the EPFO provides 8.5% at a time when the Consumer Price Index for November is 11.24%.

The EPFO’s investment rules are the following:

  • 25% in central government securities
  • 15% in state government securities
  • 30% in public sector bonds and bank deposits
  • 30% in any of the above
  • Trusts created by private companies, which manage their employees’ contributions in line with EPFO guidelines, can invest up to 10% in corporate bonds.

According to the EPFO’s annual report for 2011-12 (the latest available), total funds under its administration were invested in the following manner as on March 31, 2012: Central government securities (Rs. 98,576.28 crores), state government securities (Rs. 58,814.66 crores), government guaranteed securities (Rs. 5368.1 crores), special deposit scheme (Rs. 54,063.25 crores), public sector financial institutions (Rs. 129,971.27 crores), and public account (Rs. 62,967.74 crores). The special deposit scheme was discontinued some years ago. The funds under that head are the carry-forward from an earlier period.

The finance ministry proposed to the EPFO that it can allow 15% of the funds to be invested in equities, but the EPFO has resisted this so far.

In fact, apart from the EPFO’s investment schedule (which has been drawn up by the  Ministry of Labour and Employment), the financial sector is replete with such normative guidelines – the insurance sector regulator Insurance Regulatory and Development Authority has four sets – a separate one each for life insurance, general insurance, unit-linked insurance plans and group annuity & pension schemes). The pension fund regulator Pension Fund Development and Regulatory Authority has two sets – for government employees and for non-government subscribers, and, one is from the Ministry of Finance.

This anachronistic methodology is failing in its objective to provide an enhanced corpus that will allow for a steady income stream during the post-retirement years. By consistently registering negative real returns it is also contributing to a diminution of original capital stock. The world over, most jurisdictions have moved away from such directed investment structures.

A shift from normative guidelines should of course be accompanied by a tighter regulatory and monitoring environment, as well as improved corporate governance structures within pension fund management units. In any case, advocacy for pension sector investment reforms also seeks to limit it to 10-15% of the total corpus. Imagine what 10% of 15,00,000 crores can do – Rs. 150,000 crores will not only provide a counter-balance to FII depredations, it will also be enough to invest in long-gestation infrastructure projects.

Rajrishi Singhal is Senior Geoeconomics Fellow, Gateway House: Indian Council on Global Relations.

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