Bloomberg Columnists
Andy Mukherjee is a columnist for Bloomberg News.
The opinions expressed are his own.
India Mustn't Treat Inflows as Bad Cholesterol: Andy
Mukherjee
Jan. 18 (Bloomberg) -- It was a perilous idea that
could have cost investors billions of dollars and set
back the clock on India's progress by a decade if it
lingered a few more hours.
``A view needs to be taken on the quality and quantity
of foreign institutional investment flows,'' Reserve
Bank of India Governor Y.V. Reddy said in a Jan. 12
speech in Mumbai. ``Price- based measures such as
taxes could be examined though their effectiveness is
arguable.''
Luckily for investors, the speech came after market
hours and Finance Minister P. Chidambaram was quick to
control the damage. The governor had been
misunderstood, he said, and there was no plan
whatsoever to cap or tax foreign inflows.
Following the minister's remark, Governor Reddy
modified his speech the same evening. ``Price-based
measures such as taxes could be examined though their
effectiveness is arguable and hence may not be
desirable,'' the expanded sentence read.
End of the matter? For now, yes.
Still, support for Chilean-style controls on portfolio
flows has been strong since the 1997-98 Asian
financial crisis, which reinforced the commonly held
belief that unlike foreign direct investment, which
leads to new factories and jobs and stays for the long
haul, foreign institutional investment is a fickle
friend, which does nothing for the recipient nation.
Is there really a clear-cut hierarchy of capital
flows, with foreign direct investment at the top? Not
if you believe Harvard University economist Ricardo
Hausmann, whose research has shown that a preference
for foreign direct investment is nothing more than a
``good cholesterol'' fallacy.
`Good Cholesterol' Can Kill Too
Here's how the erroneous notion works: Foreign direct
investment, drawn by a country's strengths and
bringing with it technology and managerial skills, is
beneficial, just like some cholesterols are good for
the body. On the other hand, short-term overseas debt,
which results from speculative considerations like
exchange-rate differentials, is akin to bad
cholesterol. Foreign equity investment falls somewhere
in between.
>From a study of Latin America in the 1990s, Hausmann
concluded that there's no ``good cholesterol.'' The
share of foreign direct investment in total capital
flows is larger in countries that are riskier, more
distant, financially underdeveloped and
institutionally weak, Hausmann found. An overseas
investor starting a factory isn't superior to one
who's simply lending money or buying shares in the
local market.
India's own experience should prove this point.
Gas Leak
No action by any hedge fund has hurt India nearly as
much as the 1984 gas leak from Union Carbide Corp.'s
factory in central India. Union Carbide, one of the
first American companies to invest in India, set up
the Bhopal factory to ``help the country's
agricultural sector increase its productivity and
contribute more significantly to meeting the food
needs of one of the world's most heavily populated
regions.''
All India got from that investment was the dubious
distinction of having hosted the world's worst-ever
industrial disaster that killed between 16,000 and
30,000 people and injured 500,000 others.
And what about Enron Corp.'s $3 billion power plant
near Mumbai, the biggest foreign direct investment in
India? The 740- megawatt plant has been shut for more
than three years, and Indian banks are scrambling to
get back some of the $1.4 billion Enron and its
partners borrowed to fund the project.
When overseas investors buy shares in Bangalore-based
Wipro Ltd., India's third-biggest exporter of computer
software, they do much more than bid up the company's
share price and make chairman Azim Premji the richest
Indian. The money that institutional investors bring
into a capital-starved country like India allows
interest rates to fall. Lower interest rates make it
possible for local companies to expand and create more
jobs.
Sudden Stop?
Inflows do create challenges. In the year to March 31,
2004, India received $11.4 billion in portfolio
investments from overseas investors, compared with
$3.1 billion of foreign direct investment in the same
period.
If Governor Reddy doesn't manage the flows, the rupee
could become overvalued. And that could lead to a
painful devaluation later. On the other hand, if the
central bank continues to neutralize the inflows by
buying them up for reserves, and then selling bonds to
``sterilize'' the liquidity released in the process,
the nation incurs both quasi-fiscal and economic
costs.
So, what's Reddy to do? An investment recovery is
already under way in India and that will take care of
a good part of the liquidity surge. The central bank's
priority ought to be to strengthen the banking system,
which is dominated by inefficient state-owned banks. A
modern banking system will reduce the risk of bubble
formation in the local property and financial markets.
Strength, Not Weakness
``Ultimately, domestic strength, including a robust
and prudent financial sector, will protect a country
from the volatility induced by capital flows,''
concluded a World Bank study by researchers Deepak
Mishra and others in 2001.
India needs to fix its crumbling infrastructure, adopt
more flexible labor policies and end all unnecessary
government controls on businesses. After all that, if
India still receives more overseas investments in the
shares of local companies than in factories, it'll be
a sign of India's own entrepreneurial strength -- a
cause for cheer, not despondency.
To contact the writer of this column:
Andy Mukherjee in Singapore [EMAIL PROTECTED]
To contact the editor responsible for this column:
Bill Ahearn at [EMAIL PROTECTED]
Last Updated: January 17, 2005 20:22 EST
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