Kavaljit Singh

In March 2020, foreign investors pulled out a record Rs.1182 billion (US$16 bn) from the Indian financial markets as the spread of coronavirus (COVID-19) pandemic triggered panic selling across all emerging markets. As per official data released by the National Securities Depository Limited (NSDL), foreign portfolio investors (FPIs) and foreign institutional investors (FIIs) together pulled out Rs.619 bn ($8.3 bn) from the equity segment and Rs.603 bn ($8.1 bn) from the debt segment in March (see Table 1).

The capital outflows from the Indian markets in March alone were larger than the outflows witnessed during the entire year of 2008 – when the global financial crisis erupted – and during the 2013 “taper tantrum.”

Table 1: FPI/FII Net Investments in Indian Financial Markets in March 2020 (Rs. million)

Even though foreign investors became wary of investing in Indian markets in recent months amid concerns of slowing economic growth and social tensions, the coronavirus-led panic selling intensified in March as the 21-day nationwide curfew brought all economic activity to a standstill. In March, Indian stocks and bonds worth $1 billion were sold in a single day.

Such a massive selling spree was never seen before in the Indian financial markets. It not only battered the financial markets but also weakened the Indian rupee as foreign investors rushed to safe-havens such as the US dollar. The panic selling in the domestic equity market dragged India’s stock benchmark indices into a massive correction. On March 23, Bombay Stock Exchange’s Sensex witnessed its biggest one-day fall of 3,934 points (13 percent), and the Indian rupee touched a record low of 76.32 against the US dollar.

Of course, India is not alone currently experiencing high levels of capital flight. All major EMEs (particularly South Africa, Brazil, Mexico, Indonesia, Turkey, and Colombia) are also experiencing large portfolio outflows (both in equity and debt segments) with the unabated spread of the coronavirus outbreak. The International Institute of Finance has estimated that the outflows from emerging market securities were $83.3 bn in March 2020.[1]

Unlike advanced economies such as the US, India cannot undertake deep interest rate cuts as it could further trigger capital outflows and weaken the rupee. Portfolio investment is a major source of foreign investment in India. The FPIs and FIIs are among the biggest drivers of Indian financial markets. Over the years, the successive Indian governments have encouraged portfolio investment on the expectations that it leads to liquid and deep financial markets.

In addition to capital outflows, there are some other potential signs of India’s external sector vulnerability. As the global economy is heading into a full-fledged recession, India’s merchandise and services exports would be negatively affected and the inward remittances ($78 billion in 2018) would also slow down in the coming months. India’s tourism and travel sectors may take considerable time to recover even if travel restrictions are fully lifted by mid-2020. On the other hand, the lower international crude oil prices would certainly help in reducing India’s oil import bill, but the domestic demand for oil products will remain subdued due to the economic slowdown. Hence, this time the benefits from lower crude oil prices will not be as significant as earlier episodes of fall in crude oil prices.

Easing of Capital Controls on Inflows

In a knee-jerk reaction to massive capital outflows, the Indian authorities removed restrictions imposed on foreign investment in specific categories of government securities.

On March 30, the Reserve Bank of India (RBI) announced a separate channel, Fully Accessible Route (FAR), under which the foreign investors can invest in specified government securities up to 100 percent.[2]

At the time of writing, details of the government securities that shall be eligible for investment under the FAR are not available, but media reports suggest that this move would help in the inclusion of Indian bonds in global bond indices such as the JPMorgan Emerging Market Bond Index.[3] Besides, the government may be able to raise additional money to fund twin deficits – current account and fiscal.

The RBI further stated that “The revised limits for FPI investment in central government securities and state development loans for FY 2020-21 will be advised separately.”[4] Apart from government securities, the RBI has also raised the limit for FPI investment in domestic corporate bonds from 9 to 15 percent for the fiscal year 2020-21.

An Unwise Move

The move to allow full foreign ownership in specific categories of government securities is not only imprudent but also unprecedented. Till now, India has always enforced strict quantitative restrictions on foreign ownership of government securities with a policy objective to maintain overall macroeconomic and financial stability. For instance, foreign portfolio investment cannot exceed 6 percent of the outstanding stock of central government securities and 2 percent of the state development loans in the fiscal year 2019-20.

It seems that the Indian government has not carefully weighed the pros and cons of allowing full foreign ownership of specific government securities. Given the fickle nature of short-term portfolio investments, it is unwise to remove caps on the level of foreign ownership in government debt instruments. It would make the Indian debt markets more (not less) vulnerable to global shocks.

It is well-known that the portfolio flows to emerging markets are procyclical, reinforce boom-bust cycles, and increase financial volatility as witnessed during several episodes of financial crises since the 1990s. That is why even the IMF nowadays endorses the imposition of temporary capital controls to tame volatile capital inflows, and its forthcoming New Integrated Policy Framework may further encourage EMEs to impose more restrictions on the capital account.

Outflows Overstretch Forex Reserves

Since the late 1990s, India and many other EMEs are accumulating large foreign exchange reserves to self-insure against potential external shocks. Although India’s forex reserves may appear comfortable at $469 bn (as on March 20), but if large outflows are sustained over the next six months, reserves may not be adequate to act as a credible buffer.

The RBI occasionally intervenes in spot and forward markets to curb excessive volatility in the foreign exchange market. Still, such interventions have their limitations, and therefore, policy actions should move to other fronts.

Explore Currency Swaps

Going forward, one option for India is to approach the US Federal Reserve to seek a US dollar-rupee swap line of $60 bn for at least six months, similar to what the Fed has offered to Singapore, South Korea, Brazil, and Mexico in March 2020. So far, the Fed has not shown any inclination to provide a similar swap line to India even though officially, the US considers India a key strategic partner.

Another option is to explore currency swaps via the Contingent Reserve Arrangement (CRA) established by India and other BRICS countries in 2015. Under this facility, India can potentially access up to $18 bn out of a total pool of $100 bn (see Table 2).

Table 2: The BRICS Contingent Reserve Arrangement

However, as other member-countries of BRICS are also experiencing severe liquidity
pressures this time, it remains to be seen whether India (or South Africa) could get
short-term liquidity support under this facility.

Introduce an Exit Tax on Outflows

India has considerable experience in deploying a wide range of exchange controls on
both capital and current account transactions. Although India has been gradually
liberalizing its capital account since the 1990s, the country still maintains the legal
framework and administrative capacity to deploy capital controls on both inflows and
outflows. To reduced financial fragility posed by large capital outflows, the Indian
authorities should not hesitate to enforce controls on outflows, similar to what
Malaysia (1998), Iceland (2008), and Ukraine (2008) did during the crisis episodes.
In this context, the Indian authorities could consider imposing a price-based capital
control in the form of an exit tax on the repatriation of portfolio investments that
would discourage FPIs to pull out money immediately from the country. The exit tax
can be imposed initially for one year. The tax rate can vary depending on the type and
holding period of the investment.

Besides, strict regulatory controls should be imposed to curb offshore rupee trading
in the non-delivery forward (NDF) market concentrated in London, Singapore, and
Hong Kong.[5] The offshore NDF market exerts considerable pressure on onshore
currency markets, particularly when the market sentiment is fragile for the rupee.
Being an offshore market, the RBI has no power to enforce regulations on it.
To conclude, the Indian government should proactively use all available tools to
safeguard macroeconomic and financial stability threatened by massive capital
outflows.

(The above article has been published with the authorisation of the
author, Kavaljit Singh – Policy Brief # 6 | April 3, 2020)
Endnotes
[1] Jonathan Fortun and Benjamin Hilgenstock, “IIF Capital Flows Tracker: The
COVID-19 Cliff,” Institute of International Finance, April 1, 2020. Available
at: https://www.iif.com/Publications/ID/3829/IIF-Capital-Flows-Tracker-TheCOVID-19-Cliff.
[2] “‘Fully Accessible Route’ for Investment by Non-residents in Government
Securities,” Notification, Reserve Bank of India, March 30, 2020. Available
at: https://rbidocs.rbi.org.in/rdocs/notification/PDFs/DIRECTION3619B5C52DDD
4542A40C86D4B6B9F66D.PDF.
[3] Arup Roychoudhury, “RBI notifies special series of G-Secs under ‘fully accessible
route’,” Business Standard, March 31, 2020. Available at: https://www.businessstandard.com/article/economy-policy/rbi-notifies-special-series-of-g-secs-underfully-accessible-route-120033100087_1.html.
[4] “Investment by Foreign Portfolio Investors (FPI): Investment limits,”
Notification, Reserve Bank of India, March 30, 2020. Available
at: https://rbidocs.rbi.org.in/rdocs/notification/PDFs/APDIR199CBCDC327BD3543
47821544014A340B27.PDF.
[5] For more information on the NDF market, see Kavaljit Singh, “Why is the Indian
Rupee Depreciating?,” Briefing Paper No. 11, Madhyam, September 2013. Available
at: https://www.madhyam.org.in/wp-content/uploads/2014/07/Why-is-the-IndianRupee-Depreciating.pdf.