People's Democracy(Weekly Organ of the Communist Party of India (Marxist)
January 29, 2006
Liberalisation And Economic Sovereignty
C P Chandrasekhar
INDIAíS economic policy today is driven by an indiscriminate desire to integrate the country with the capitalist world system. More than a decade and a half of accelerated economic reform has substantially increased Indiaís integration, even if in a subordinate position, with the developed world. Cross-border merchandise and services trade has increased substantially. The annual level of foreign direct investment in the country has risen significantly, increased the domestic presence of foreign firms and the control they exert over domestic assets. Finally, the stock of portfolio investments in Indiaís stock and debt markets, especially the former, which had risen gradually over the 1990s, has surged over the last three years.
These developments are by no means the result purely of external forces. Rather, domestic pressures to adjust policies to ensure greater integration have been substantial, Part of that pressure is the result of the insidious penetration of international finance into the domestic economic policy-making apparatus reflected in the growing presence in government of those who have internalised policies of the kind being advocated by developed country governments and multilateral institutions like the IMF and World Bank.
But these players have been successful because of the transformation of the capitalist class dominating industry and services. The transformation in industry occurred as traditional monopoly groups unable to expand during the 1965-80 development impasse, chose to look to subordinate partnership with foreign firms as a means to expansion. These business groups were also keen to move into the space occupied by the public sector or smaller bourgeoisie; and hence they demanded an opening up of that space through liberalisation. This was achieved through the elimination of anti-monopoly legislation, the removal of licensing requirements, the dilution of legislation "reserving" certain sectors for small capitalists, the adoption of a credit regime that squeezes agriculturalists and small capitalists, the privatisation of profitable public sector units, and the delinking of the public sector from budgetary support of any kind. In short, big business which, to start with, was the beneficiary of State controls of various kinds, revolted against those very controls when it felt confined for space. Its demands for greater space formed a component of the package of demands made by multilateral institutions like the Fund and the Bank; hence it extended support to the Fund-Bank "liberalisation" programme, no matter how uneasy it felt about some other parts of such programmes.
The transformation was also related to the emergence of new areas of accumulation outside industry for relatively new capitalists. A typical example of this was the financial sector. With the nationalisation of the major banks in 1969, the ability of domestic capital to use the financial sector as a site for accumulation was undermined. However, matters changed substantially in the late 1970s, when starting with the process of dilution of equity by FERA companies, the stock market came into its own. The subsequent periods of speculative boom in the stock market have allowed some insiders within the erstwhile financial community and new operators in Indiaís markets to accumulate substantial sums of capital, most often at the expense of the small middle class investor. Nothing reflected this possibility more than the stock market scandal of 1992 engineered by a few operators from within the financial community.
The pressures that stemmed from forces like these account for the rapid liberalisation of recent years. It is to be expected that the resulting global integration has restricted domestic economic policy space. Trade liberalisation aimed at enhancing the countryís integration involves continuous reductions in import tariffs that erode the revenues of the government. Efforts to attract foreign investment involve liberalising rules and regulations governing the operations of foreign firms. These include removal of requirements regarding the utilisation of indigenous inputs or undertaking exports to meet foreign exchange expenditures. This limits the linkage effects of expansion of foreign firms, reduces the multiplier and spin-off effects of such investments and results in a net outflow of foreign exchange over time. And the effort at creating an ambience conducive to foreign portfolio investment requires adjusting policies with regard to taxation and deficit spending which reduces the ability of government to finance crucial expenditures including those on physical and social infrastructure.
SURGE IN FOREIGN INSTITUTIONAL INVESTMENTS
It is the last of these that is proving to be the most destabilising. Since April 2003, India has witnessed an extraordinary surge in foreign institutional investments. Having averaged $1776 million a year during 1993-94 to 1998-97, net FII investment dipped to an average of $295 million during 1997-99, influenced no doubt by the Southeast Asian crisis. The average rose again to $1829 million during 1999-2000 to 2001-02 only to fall $377 million in 2002-03. The surge began immediately thereafter and has yet to come to an end. Inflows averaged $9599 million a year during 2003-05 and are estimated at $9429 million during the first nine months of 2005-06. Going by data from the Securities and Exchange Board of India (SEBI), while cumulative net FII flows into India since the liberalisation of rules governing such flows in the early 1990s till end-March 2003 amounted to $15,804 million, the increment in cumulative value between that date and the end of December 2005 was $25,267 million.
It is not surprising that the period of surge in FII investments was also one when, despite fluctuations, the stock market has been extremely buoyant. The market in India lacks width and depth, with few investors, few companies whose shares are actively traded, and a small proportion of those shares available for trading. Hence any new capital inflow does trigger price increases. The Bombay Sensex rose from 3727 on March 3, 2003 to 5054 on July 22, 2004, and then on to 6017 on November 17, 2004, 7077 on June 21, 2005, 8073 on November 2, 2005 and 9323 on December 30, 2005. The implied price increases of more than 80 per cent over a 17-month period and 50 per cent over just more than a year are indeed remarkable. Market observers, the financial media and a range of analysts have concurred that FII investments have been an important force, even if not always the only one, driving markets to their unprecedented highs.
Underlying the current FII and stock market surge is, of course, a continuous process of liberalisation of the rules governing such investment: its sources, its ambit, the caps it was subject to and the tax laws pertaining to it. It could, however, be argued that the liberalisation began in the early 1990s, but this surge is a new phenomenon which must be related to the returns now available to investors that make it worth their while to exploit the opportunity offered by liberalisation. The point, however, is that while the good profit performance of domestic firms may partly explain the high returns of recent times, there were other factors that may have been more crucial. To start with, current account surpluses, higher remittances and rising inflows on account of exports of software services had ensured a strengthening of the Indian rupee, despite the RBIís effort to manage the exchange rate with large purchases of foreign currency. A stronger rupee implies better returns in dollar terms, encouraging foreign investors looking for capital gains. This possibly even triggered a speculative surge in inflows because of expectations that the rupee would rise even further. Given the role of FII investments in increasing the supply of foreign exchange, such expectations tend to be self-fulfilling at least for a period of time.
SUSTAINING STATE POLICY
Returns on stock market investment were also hiked through state policy. Just before the FII surge began, and influenced perhaps by the sharp fall in net FII investments in 2002-03, the then finance minister declared in the Budget for 2003-04: "In order to give a further fillip to the capital markets, it is now proposed to exempt all listed equities that are acquired on or after March 1, 2003, and sold after the lapse of a year, or more, from the incidence of capital gains tax. Long term capital gains tax will, therefore, not hereafter apply to such transactions. This proposal should facilitate investment in equities." Long term capital gains tax was being levied at the rate of 10 per cent up to that point of time. The surge was no doubt facilitated by this significant concession. Once the FII increase resulting from these factors triggered a boom in stock prices, expectations of further price increases took over, and the incentive to benefit from untaxed capital gains was only strengthened.
The dangers of a surge of this kind need no emphasising. There have been too many instances in East Asia, Latin America, Turkey and elsewhere where a financial crisis was preceded by a surge in foreign financial flows and a simultaneous boom in stock and/or real estate markets. Independent of their inclinations, the exact causal mechanisms they identify and where they place the burden of blame, analysts of those periodic crises have accepted the reality that liberalised financial markets are prone to boom-bust cycles.
VULNERABILITY TO SPECULATIVE ATTACKS
The case for vulnerability to speculative attacks is strengthened because of the growing presence in India of institutions like hedge funds, which are not regulated in their home countries and resort to speculation in search of quick and large returns. These hedge funds, among other investors, exploit the route offered by sub-accounts and opaque instruments like participatory notes to invest in the Indian market. Since FIIs permitted to register in India include asset management companies and incorporated/institutional portfolio managers, the 1992 guidelines allowed them to invest on behalf of clients who themselves are not registered in the country. These clients are the Ďsub-accountsí of registered FIIs. Participatory notes are instruments sold by FIIs registered in the country to clients abroad that are derivatives linked to an underlying security traded in the domestic market. These derivatives not only allow the foreign clients of the FIIs to earn incomes from trading in the domestic market, but to trade these notes themselves in international markets. By the end of August 1995, the value of equity and debt instruments underlying participatory notes that had been issued by FIIs amounted to Rs 78,390 crore or 47 per cent of cumulative net FII investment. Through these routes, entities not expected to play a role in the Indian market can have a significant influence on market movements. In October 2003, The Economist reported that: "Although a few hedge funds had invested in India soon after the country began liberalising its financial markets in the early 1990s, their interest has surged recently. Industry sources estimate that perhaps 25-30 per cent of all foreign equity investments are now held by hedge funds."
ERODING RBIís ABILITY
The problem does not end here. For some time now, the capital surge has been eroding the ability of the central bank to pursue its monetary policy objectives. The foreign exchange assets of the central bank rose sharply, from $42.3 billion at the end of March 2001 to $ 54.1 billion at the end of March 2002, $76.1 billion at the end of March 2003, $113 billion at the end of March 2004 and $142 billion at the end of March 2005. The process of reserve accumulation is the result of the pressure on the central bank to purchase foreign currency in order to shore up demand and dampen the effects on the rupee of excess supplies of foreign currency. In Indiaís liberalised foreign exchange markets, excess supply leads to an appreciation of the rupee, which in turn undermines the competitiveness of Indiaís exports. Since improved export competitiveness and an increase in exports is a leading objective of economic liberalisation, the persistence of a tendency towards rupee appreciation would imply that the reform process is internally contradictory. Not surprisingly the RBI and the government have been keen to dampen, if not stall, appreciation.
Unfortunately, the RBIís ability to persist with this policy without eroding its ability to control domestic money supply is increasingly under threat. Increases in the foreign exchange assets of the central bank amount to an increase in reserve money and therefore in money supply, unless the RBI manages to neutralise increased reserve holding by retrenching other assets. If that does not happen the overhang of liquidity in the system increases substantially, affecting the RBIís ability to pursue its monetary policy objectives. Till recently the RBI has been avoiding this problem through its sterilisation policy, which involves the sale of its holdings of central government securities to match increases in its foreign exchange assets. But even this option has now more or less run out. Net Reserve Bank Credit to the government, reflecting the RBIís holding of government securities, had fallen from Rs 1,67,308 crore at the end of May 2001 to Rs 4,626 crore by December 10, 2004. There was little by way of sterilisation instruments available with the RBI.
There are two consequences of these developments. First, though the financial reform has involved a ban on government borrowing from the central bank to finance its expenditures so as to delink monetary from fiscal policy, the central bank is no more independent. More or less autonomous capital flows influence the reserves position of the central bank and therefore the level of money supply, unless the central bank chooses to leave the exchange rate unmanaged, which it cannot. This implies that the central bank is not in a position to use monetary levers to influence domestic economic variables. Secondly, the country is subject to a drain of foreign exchange inasmuch as there is substantial difference between the repatriable returns earned by foreign investors and the foreign exchange returns earned by the Reserve Bank of India on the investments of its reserves in relatively liquid assets.
DILUTING ROLE OF FISCAL POLICY
Further, the effort to attract foreign investors to the country has forced the government to curtail its fiscal deficit even as the tax-GDP ratio falls. Financial interests are against deficit-financed spending by the state for a number of reasons. First, deficit financing is seen as being potentially inflationary. Inflation is anathema to finance since it erodes the real value of financial assets. Second, since government spending is "autonomous" in character, the use of debt to finance such autonomous spending is seen as introducing into financial markets an arbitrary player not driven by the profit motive, whose activities can render interest rate differentials that determine financial profits more unpredictable. Third, if deficit spending leads to a substantial build-up of the stateís debt and interest burden, it may intervene in financial markets to lower interest rates with implications for financial returns. Financial interests wanting to guard against that possibility tend to oppose deficit spending. Finally, the use of deficit spending to support autonomous expenditures by the state amounts to an implicit legitimisation of an interventionist state, and therefore, a de-legitimisation of the market. Since global finance seeks to de-legitimise the state and legitimise the market, it strongly opposes deficit-financed, autonomous state spending. In the event, crucial expenditures, including those on education, health, employment and food subsidies, are cut in an irrational and obsessive pursuit of deficit reduction.
These developments imply that there has been a major loss of policy space since liberalisation began. It was to create and protect that policy space that in the early years of the Indian Republic, the government chose to limit imports, regulate foreign direct investment and not permit foreign portfolio investment. That policy regime was based on the premise that political freedom in an ex-colonial, underdeveloped country could be meaningful only if the State had an area of control insulated from the predatory influence of foreign capital. In the desperation to integrate indiscriminately with the world system and collaborate with foreign capital even in a subordinate position the Indian state and the classes it represents have chosen to dilute that freedom even if it has damaging effects on the working people and could imply a "recolonisation" of the Indian economy.