Easing capital controls; maybe igniting a corporate bond market

Business Standard, 1 March 2006

The budget speech has announced some important decisions on the question of capital controls. They suggest that India will continue on the path towards liberalisation of the capital account. While each is small, taken in isolation, they do help overcome fears about reversal of reforms in this area.

For many years, there have been discussions about outbound investment by Indian mutual funds. Global diversification is a big step forward in terms of reducing risk. As the latest Economic Survey has pointed out, the volatility of the Nifty index fund was 2.85% per week, but the volatility of the S&P 500 index fund was just 1.4% per week. The volatility of a globally diversified equity portfolio is less than half of that faced by a portfolio that is constrained to only be in India. The Indian economy will become more stable when Indian households are deriving income streams from assets spread all over the world. The budget speech announced that the limit on outbound investment will be raised from $1 billion to $2 billion.

More importantly, the nuisance rule seeking to block this effort - restricting investment to companies which had a "reciprocal 10% shareholding" - has been removed. With this irritant out of the way, the modernisation of Indian asset management can genuinely commence. The mutual funds that offer globally diversified portfolios will deliver better returns per unit risk (Sharpe's ratios) as compared with autarkic, inward-looking funds.

A key aspect of this process, as emphasised in the budget speech, should be the use of exchange traded funds (ETFs). Indian mutual funds are in the process of constructing ETFs based on Indian assets, such as Nifty or gold, which are then traded on exchanges. The logical implication of outbound investment is that an Indian mutual fund can construct an ETF on global indexes such as the S&P 500 in the US or the FTSE in the UK. The mutual fund would then issue S&P 500 units which would trade on Indian exchanges.

The second area of progress is on debt inflows. India has laboured under an contorted policy framework, where on one hand, we are supposed to be averse to debt inflows, but on the other hand, the most non-transparent route possible (external commercial borrowing) is utilised on a big scale. The budget speech has raised the limit on FII investments in GOI bonds by $0.25 billion and on corporate bonds by $1 billion.

Both these moves ease capital controls. India is moving forward from the obsolete macroeconomics of 1991 vintage, towards a modern monetary policy framework.

The stage has also been set for a big push on the corporate bond market. For years, the corporate bond market has languished with a non-transparent telephone market plagued by mundane problems. The R. H. Patil committee report has shed important light on solving a full range of problems of this market. The budget speech has focused on the core bottleneck - that of financial architecture. It says that the corporate bond market will not be fragmented across a telephone market and an exchange market: there will only be an exchange market.

If SEBI gets its act together, corporate bond liquidity could get ignited. Two big pieces are now at hand: the policy clarity on shifting from telephone market to exchange-traded market, and a billion dollars of additional FII money in the play. The ball is now in SEBI's court to execute, and the devil is all in the execution.

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