I like to think of what has been happening to India on the external front in recent months in terms of the two giant hedge funds that we as a country have been running. The first hedge fund is the product of our (Foreign Institutional Investors) FII regime and the Reserve Bank of India’s policy of reserve accumulation. Up to 1997, FIIs bought stocks in India and the RBI stashed away the dollar inflows in its foreign exchange reserves in the form of US Treasuries and other assets. As a nation therefore we were short Indian stocks and long US Treasuries.
During the past year or so this has been an immensely profitable trade for India. Think of an FII that brought a billion dollars into India when the exchange rate was say Rs 40/$ and the stock market index (Sensex) was say 20,000. The billion dollars fetched Rs 40 billion and these rupees in turn fetched 2 millions “units” of the Sensex. Today, the FIIs are stampeding out of the exits when the Sensex is say 10,000 and the exchange rate is say Rs 50/$ (let us choose nice round numbers). The 2 million Sensex “units” can now be sold for Rs 20 billion and these rupees fetch $400 million. The RBI sells $400 million of US Treasuries and pays off the FIIs. The remaining $600 million of US Treasuries are now ours to keep as they will never have to be paid back. India as a nation makes a cool profit of $600 million through our “FII hedge fund”. And that is not counting the profits that we made on the US Treasuries as the global turmoil pushed their yields down to ridiculously low levels. This is a fabulous return and any hedge fund anywhere in the world would give an arm and a leg for this kind of performance.
But India has been running another giant hedge fund which is doing very badly indeed. Unlike the open door policy that we had towards FII investments in Indian equity, we kept our corporate bond markets largely closed to foreigners. In a policy regime which can only be described as incredibly perverse, we did however allow the Indian corporate sector to borrow practically unlimited amounts in foreign currency in global markets. We did have a cap on External Commercial Borrowings (ECBs), but in practice, this cap was simply raised whenever it was approached. This coupled with the inefficiency of the domestic financial system (because of incomplete deregulation) drove the Indian corporate sector to borrow large amounts overseas. Consumed by some amount of hubris, Indian companies splurged billions of dollars on buying marquee companies around the world even when the domestic stock market told them in clear terms that they were overpaying.
This is the second giant hedge fund (the “ECB hedge fund”) that we as a nation have been running – long cyclically sensitive assets in India and around the world, short US dollars. A large part of the dollar borrowings were also in relatively short term funding which has to be renewed at today’s punitive interest rates. The credit spread on Indian paper has risen by around 500 basis points (5 percentage points), the dollar has risen, cyclical assets have been hammered down due to global recessionary fears – the “ECB hedge fund” has been living through a nightmare. Aziz, Patnaik and Shah estimate that the Indian corporate sector will require at least $50 billion of dollar liquidity in the coming year. This is one reason why there is so much shortage of liquidity in India today: with dollar borrowing next to impossible, dollar borrowings are being repaid our of rupee borrowings.
So all in all, the “ECB hedge fund” has performed disastrously and could conceivably end up losing more money for us as a nation than the “FII hedge fund” makes for us.
In the fullness of time, when we come around to reviewing our capital account policy frameworks, we will hopefully keep this in mind.