Implications of the Hang Seng ETF traded in India

Financial Express, 17 February 2010

In March 1940, the British introduced the first capital controls in India under wartime conditions. These grew into full fledged controls in 1948 and thereafter, culminating in the draconian FERA, where all aspects of capital account transactions were closed down. A few old timers recall the time when households in India held globally diversified assets, but for most of us, the only memories we have of India are those of a pervasive array of capital controls.

As a consequence of these controls, Indian household portfolios suffer from `home bias': the mistaken emphasis on home country assets in the household portfolio. Home bias leads to greater fluctuations of portfolio value, and drives up the cost of capital for domestic risk capital. If this home bias were alleviated, households would get reduced risk in their financial portfolio, and would be more comfortable with bearing risk in domestic ventures. Households would be happier (since risk is lower) and would be more willing to engage in risk-taking and entrepreneurship (since the risk premium is lower).

Capital outflows are sometimes seen in a negative light by those who would like to invest all Indian capital in India. But the best risk-sharing scheme is one where foreigners own domestic assets and Indians own foreign assets. India has only begun on the former (foreigners owning domestic assets). This imbalance induces uncomfortable problems: where domestic and foreign buyers both chase domestic assets, and capital inflows put pressure on the balance of payments. Greater capital outflows would make India look more like the other countries which have convertibility.

A few years ago, these controls were opened a chink when Indian households were permitted to diversify their portfolios internationally by taking money out of the country. This seemed like a revolutionary move at the time, given the 65 years of rigid controls. Much less was done than meets the eye, given that a system of quantitative restrictions remains in place, and (more importantly) given that financial firms are prohibited from actually interacting with households and enabling the process of international diversification.

As every finance professional knows, there is a big gap between households being able (in principle) to take money out of the country, and households being able to walk up to local branches of financial firms and actually handle globally diversified portfolios with a network of supporting services such as information, advice, transactions, safekeeping, etc. Until this full suite of financial services is available to Indian households, home bias will afflict Indian household portfolios. It is not surprising that India's liberalisation of outflows has, thus far, resulted in negligible amounts of money leaving the country.

The answer primarily lies in removing the restrictions that prevent financial firms (whether domestic or foreign) from being able to sell this full array of financial services to Indian households. The typical neighbourhood NSE/BSE member in India, who serves the financial needs of the typical Indian household, should be advising the household that they are better off with global diversification, showing them how this is to be done, and taking instructions from them to obtain internationally diversified portfolios.

Until this is done, the second-best answer lies in having Indian mutual funds and other institutional investors (e.g. insurance companies, pension funds, banks) reduce risk through global diversification. The mindset of Indian socialism runs deep, and there is a thicket of rules and restrictions which force institutional investors to be autarkic. Detailed work is needed in identifying and removing rules that hinder risk reduction through global diversification.

One area where progress has begun is mutual fund investment outside the country. Yesterday, Benchmark launched a particularly interesting product: an exchange traded fund (ETF) on the Hang Seng index which trades on NSE and will soon trade on BSE also. This strikes in two directions. First, it gives a mechanism through which an index fund of mostly China-related assets can be easily placed into Indian portfolios. This product is accessible throughout India without constraints: the same NSE/BSE members who advise households on holding Nifty or Nifty Junior ETFs will talk with them about this Hang Seng ETF.

There is a second dimension, one emphasised by the Percy Mistry report, and underlined by Dr. Subbarao's recent comments on steady movement towards convertibility: India is now competing in an international market. Foreigners now have a choice between buying a Hang Seng ETF in Hong Kong, or of buying it in India. The Indian offering is presently uncompetitive. The price that Benchmark Mutual Fund is charging (100 bps on assets per year) is a big one by global ETF standards. But unbanning export is a big step forward. We have gone from complete autarky -- where Indian mutual funds were prohibited from exporting -- to a world where Indian mutual funds are looking at global offerings and asking themselves how they can become competitive. In the long journey to a globally competitive financial system, this is an important milestone.

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