India and its two giant hedge funds

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.