National Council of Applied Economic Research
Opinion: K P Krishnan
Our goal should be to achieve a low cost of capital for Indian firms which calls for liquid and efficient markets accessible to all investors
Many firms require capital in tiding over the pandemic. In recent months large amounts of portfolio capital have come into the country helping to fill this need. This includes an increase in the use of participatory notes (PNs). Old debates about FDI (foreign direct investment) FII (foreign institutional investor) flows and PNs have resurfaced.
In the India of old it was argued that FDI was welcome because it helped build factories and provide jobs but portfolio investment was fickle chasing short-term returns. In that India it was argued that policymakers would determine the nature of investors investees and financial instruments that were considered desirable and those that were considered not desirable and establish a system of capital controls which enforced these views.
The primary market for equity is important because it provides risk capital for firms. The benefits associated with this are instantly grasped by all. But what happens to an investor who buys shares in the primary market? Is this investor going to be stuck holding these shares for ever? If investors have no flexibility to exit would they ever invest? For an analogy if an employer is told that sacking a worker is infeasible would that not change the propensity to hire?
A liquid market is one in which an investor can effortlessly sell large quantities of shares as and when desired. When the secondary market is liquid capital is attracted to the primary market. There is a “liquidity premium”: More liquid shares get higher valuations. In particular institutional investors who command large pools of capital avoid investing in illiquid assets. Both foreign and domestic institutional investors have thumb rules about liquidity by which they will just not invest in companies where a certain level of secondary market activity is lacking. These interconnections emphasise that policymakers cannot pick and choose based on emotional considerations what parts of the financial system they consider desirable. The entire ecosystem has to thrive: The various parts of finance require one another.
The secondary market is thus not something to look down upon or denigrate as “speculative”. It is essential for primary investment to happen in the first place. Policymakers need to infuse greater liquidity — i.e. more trading activity — into the secondary market so as to increase the confidence of investors and harness the liquidity premium. This is the motivation for an array of policy reforms aimed at fostering secondary market equity transactions.
Foreign investors are often able to provide capital at better prices to the Indian firm. A large Indian steel company consumes (say) iron ore and coking coal as raw materials and economic policy must ensure access to these raw materials at world prices in order to be able to compete (in India or elsewhere) against global steel companies. But equally capital is an input that is used by an Indian steel company and global competitiveness requires that Indian firms should have access to capital at world prices. This requires foreign investors fully operating in the Indian secondary market. And in turn this requires that the Indian secondary market is liquid or else global investors will shun it.
This intellectual framework for the participation of FIIs in the Indian financial markets was led by C Rangarajan in the 1990s. The Report of the High Level Committee on BoP led by him suggested a gradual movement towards full access to the Indian financial market for FIIs. Over time in keeping with the changes in the legislative framework FIIs have been allowed to invest in shares debentures and warrants issued by companies which are listed or are to be listed on the Indian stock exchanges and in schemes floated by domestic mutual funds. The process has moved towards greater openness with only a few reversals of reform.
Participatory notes are financial instruments issued by FIIs to any investor seeking India exposure but who for a variety of reasons does not want to go through the time-consuming and onerous (in a continuing regulatory sense) process of registering with every individual jurisdiction in the world. For example university endowment funds and civil service pension funds in the US have been investors in India through PNs for decades. Typically they invest very small proportions of their corpus in any one emerging market which implies that the overheads associated with establishing a formal legal presence in each country are not justified.
Global investors often think in terms of investment ideas that cut across countries. For example they trade in derivatives on an index of pharmaceutical companies that would do well by selling medicines and vaccines which combat Covid-19. Such instruments are created by financial firms and impinge upon shares of some Indian companies. There is then a three-part relationship with the end-investor a financial intermediary and capital flows into India where the end-investor gets the desired exposure and the financial intermediary is seen as a PN investor. By some estimates the major portion of the world’s investment flows is done through such mechanisms.
In the past the Union government had encouraged these pathways. As an example reporting on the success of an ONGC disinvestment the front page of Financial Express of March 21 2004 said “the government had earlier approached the market regulator Securities & Exchange Board of India to allow merchant bankers for the offer to issue participatory notes an instrument for attracting foreign investment from funds not registered in India. The reason was that the government did not want to leave any stone unturned to meet the divestment target for a shortfall would have dented the feel-good factor”.
Tax administrators are keen to improve tax compliance in India and a sophisticated financial system imposes more work upon them. This calls for greater skills and capacity in the tax and enforcement machinery. The convenience of tax administrators should not be a major consideration in financial economic policy. Our goal should be to achieve a low cost of capital for Indian firms which calls for liquid and efficient markets accessible to all investors.
The writer retired as a secretary to GoI and is now a professor at the National Council of Applied Economic Research. Views are personal