EDITORIAL

Unwise move on FII debt

Posted on September 26, 2010 | View 180

Hike Absorptive Capacity First  

The governments decision to raise the limit for investment by foreign institutional investors (FIIs) in the debt market by $10 billion is unfortunate.Surplus global liquidity is already leading to a rush of portfolio investment into the equity market.In such a scenario,any action that increases the attractiveness of debt instruments only compounds the problem of managing capital flows without destabilising the real economy.Capital flows are not an unmitigated blessing.Unless there is a corresponding rise in absorptive capacity,inflows will only end up as reserves with the Reserve Bank of India (RBI),as the central bank buys dollars in a bid to limit the damage to the real economy through excessive appreciation of the rupee.The resultant increase in rupee liquidity is bound to add to inflationary pressures.Sterilisation also imposes a cost the difference between the rate of interest paid on rupee funds mopped up by the RBI and the return on deployment of forex reserves.Hence,any policy that looks only at the immediate benefit in terms of increased inflows,disregarding the long-term costs,is seriously flawed.


Unfortunately,an increase in absorptive capacity alone will not suffice;especially if it leads to an excessive widening of the current account deficit (the difference between national saving and investment).There is the related but vitally important issue of how the deficit will be funded.Thanks to strong growth and hence strong import demand,our current account has already widened sharply.Today,capital flows may be more than sufficient to fund this wider deficit.But FII flows are known to be fickle.As the recent financial crisis has shown,FIIs are quick to turn tail at the first sign of trouble.Hence,depending on them to fund the current account deficit on a sustained basis would be both nave and unwise.If the government is really desirous of augmenting resources for infrastructure development,it would be far better to address policy lacunae hampering foreign direct investment,as also the institutional underdevelopment of Indias financial sector that hinders mediation of our considerable domestic savings to investment opportunities.

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