India - Policy Dilemmas

The instability in domestic equity markets and the pressures that it is exerting on the entire financial system induced two significant policy decisions on Monday. The Securities and Exchange Board of India (Sebi) retracted a set of constraints that had been imposed on the issue of Participatory Notes (PNs) last October, while the Reserve Bank of India (RBI) signalled the beginnings of a change in its policy stance by reducing the cash reserve ratio (CRR) by 50 basis points, freeing about Rs 20,000 crore for banks to lend out. Both measures illustrate the dilemmas that policymakers face in dealing with the global financial crisis. The compulsions of survival often over-ride longer-term priorities. Lord Keynes’ famous statement “… in the long run, we are all dead” undoubtedly weighs heavily on the minds of the people entrusted with the responsibility of saving and reviving global finance.

PNs are essentially a means of investing into a country without disclosing one’s identity. They allow for anonymous intermediation by foreign institutional investors (FIIs) who are registered in India by Sebi. Although the controversy about PNs emerged in the context of large capital inflows and the need to put some brakes on them (only a couple of years ago!), the fundamental issue was not one of capital controls; rather it was about transparency — Know Your Customer, or KYC — and the management of counter-party risk. The October 2007 announcement recognised this. It initiated a transition from anonymous intermediation to open investment by liberalising and speeding up the registration process. As a transition measure, it put a cap of 40 per cent on the proportion of investments being routed through PNs by any FII. This was a welcome structural change in the foreign investment regime, because it contributed to transparency, using an appropriate phasing-in process. That priority remains unchanged; however, in the past few weeks, the direction of funds has overwhelmingly turned. Now, the compulsion is clearly to use any means available to stem the flow. If removing limits on PNs will induce some investors to look more favourably at India, Sebi believes it was worth a shot. Whether it will make a difference is an open question. The fact that Sebi’s position has been reversed without waiting for a full review suggests that the finance ministry’s view (which was always in favour of PNs, unlike Sebi and RBI under their previous heads) has now found greater receptivity in Sebi.
The reduction in the CRR also reflects a dilemma. It is not the sort of thing one would expect a central bank to do when the benchmark inflation rate is 11.99 per cent. Again, given the abnormality of the circumstances, with liquidity being squeezed by a number of factors, the RBI saw the risk worth taking in order to keep the system afloat. Its statement that the step is ad hoc and temporary indicates that the move is not a decisive change in its policy stance. However, having acted in response to the sharp decline in equity markets and the sustained selling by FIIs, it will inevitably impact expectations about similar responses in the future. In this particular instance, the trade-off may not be particularly significant, because inflation is moderating, even if it takes a few months to get back into the comfort zone. Still, the RBI would also do well to come out with a paper on how it plans to balance the potential contradictions between macro-economic and financial stability.