India – right to be cautious

DSCN5118Narendra Modi came to power on a business-friendly ticket, determined to market India to the rest of the world as the Asian country to do business in. Well, he needed to do something after his predecessor, Manmohan Singh, instigated a number of perplexing moves that seemed to thwart foreign business interests in the country – the retrospective Vodafone tax is perhaps the best known example.

And it seems to be working – with the bulls singing India’s praises, and foreign investment in the country definitely on the up.


But Modi’s government has a tricky balancing act to follow.

The country badly needs foreign cash to flow in – “this is an investment-starved country”, Ananth Narayan, head of financial markets at Standard Chartered, told me, citing a 2012 government report that said infrastructure alone needed an extra 1 trillion USD by 2017.

But, on the other hand, too much cash could upset the rupee’s exchange rate, which for the time-being is faring pretty well in what are pretty turbulent FX markets. When former US Fed chairman Ben Bernanke hinted at a possible end to quantitative easing, Indian currency markets went haywire, forcing the then-Indian government to slam on the brakes to foreign investment. Modi’s government certainly don’t want a repeat of this.


Which is why the regulators are trying to make it easier for foreigners to invest in the country – but only up to a point.

To a large extent, the country’s central bank, the RBI, has reversed some of the curbs on foreign exchange derivatives that were imposed under the previous regime. FX derivatives are necessary for companies on the Indian market that have both rupee and foreign – usually US dollar – exposure, as many foreign entrants do.

Many players currently hedge their currency exposure in the offshore market and, despite the easing of restrictions by the RBI, may continue to do so, simply because the cost of onshore hedging is prohibitively high.

The RBI is visibly frustrated by the lack of foreign participation in the onshore FX derivatives market, and has been forced to admit that, despite its best efforts, market participants are still hedging their exposure via Singapore, London or New York. This isn’t good for developing the market and bringing costs down; but then the RBI is being cautious about the incentives it could give. It could for example, reduce the risk weight for foreigners using derivatives to (safely) hedge their currency exposure. But it doesn’t look as though it is about to do this.

The next big change is likely to be allowing foreigners to use commodity derivatives, which is imporant for import/export companies who want to limit the fluctuation of the price of the commodity that they are trading in. But it is determined that this will only be a tool of risk mitigation – the possibility to speculate will most definitely be out. Some might welcome such caution, though detractors say that this will also limit participation and thus the development of an efficient market (making it, of course, more expensive).

But Modi and his henchmen are doing the right thing.

Macro stability – which the RBI is sworn to uphold – is crucial to the success of India as an investment destination. and allowing foreigners to meddle too much in Indian affairs will not achieve this.

A recent report from Standard & Poor’s, a rating agency, says: “The stable outlook for the next 24 months reflects our view that the new government has both the willingness and capacity to implement reforms necessary to restore some of India’s lost growth potential, consolidate its fiscal accounts and permit the Reserve Bank of India to carry out effective monetary policy.”

But it cautions: “We may lower the rating if the government’s structural reform agenda stalls such that economic growth does not accelerate, or fiscal and debt ratios fail to improve.”

A lower rating from the world’s leading rating agencies could see capital suddenly take flight, particular as many institutional investors (e.g., pension funds) are not allowed to invest in sub-investment grade debt.

“Given the backdrop of what has been happening in global markets over the last few years – specifically the run on the currency we saw in 2013, with the movement in the rupee from 60 to 68 – some regulatory caution is warranted, particularly as the macro situation is improving right now,” Tushar Mahajan, head of derivatives at Nomura India, told me. “But what is the right amount of caution? It is tough to say where you draw the line.”

The right amount of caution is probably where we are now.

I wrote a feature piece for Asia Risk on this last month – but you can only access it if you have a subscription.

You can see me briefly talk about the piece here:


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