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Has UPA goofed up on stock market management?

By M R Venkatesh
October 13, 2008 14:03 IST
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The word 'reserve' in the English language implies a sense of comfort. To an accountant like me it would technically mean an appropriation of profits - necessitating the existence of profits in the first place. To a common man it would imply savings or excess that is held back to be used on a rainy day.

Strangely, these definitions and understandings get turned on their head when it involves foreign exchange reserves (forex). For instance, if a country has $100 billion of forex with it, it is assumed that these are 'reserves', never mind even if that particular country has begged, borrowed or even stolen it! Naturally, we are in nebulous ground, debating the surreal and attempting to defend the indefensible.

Readers may be aware that forex flows into a country could arise through two broad sources - one, when the net exports of that particular country exceed its imports and two, when it receives debt or equity. While the former is called current account surplus, the later is called capital account surplus.

Put briefly, the aggregate of the surplus on both the capital and current accounts constitute the forex reserves of a country. What is crucial to understand here is that the inflows in the capital account could reverse anytime on account of any adverse domestic or global events.

To amplify further, forex flows, especially when built on capital flows are merely cash flows. Yet it gives us all a false sense of comfort, thanks to the misuse of the term 'reserve'.

That makes the build-up of forex reserves by a country on account of the Capital Account that much suspect. It may be noted that the issue with capital flows has always engaged the attention of economists as sudden reversal of flows could dynamite an economy, especially when they are for short term purposes and in effect hot money.

With this brief understanding let us turn to India. Readers may be further aware that in 1991 India had virtually zero forex reserves. In contrast to those trying times today India sits on a seemingly healthy Forex Reserves of approximately $300 billions. This is where things get a bit interesting as well as worrying.

According to the report on the foreign exchange reserves issued by the RBI for the period till March 2008, India's forex build up is predominantly on the capital account front and not on the current account front. The following table extracted from this RBI report clearly demonstrates that India's build-up of forex reserves is largely on account of capital account. In the process the surplus in the capital account has compensated for the deficits in the current account.

Sl No


In USD Billions


Reserves as at 31st March 1991



Aggregate Current Deficit till March 2008



Capital Account



Valuation gains





Skating on thin Ice 

This build up of Forex Reserves through the capital account by India, especially through the hot money into our stock markets by the FIIs, is in direct contrast to the Chinese build-up of their forex reserves which is rooted in a judicious mix of capital as well as current account surplus. And that is not all. China has relied more on Foreign Direct investment rather than Forex flows into its stock markets.

The reasons for the same is obvious - FDI flows are more stable as one cannot sell business and factories  overnight and exit a country as in the case of FII which can exit by a mere click of a mouse. This approach to Forex flows - first to rely on current account surplus and only on FDI as against FII - became more or less institutionalised world over in the aftermath of the East Asian currency crisis.

An analysis of the sources of our forex reserve accretion since 1991 reveals that the aggregate FDI flow into the country has been a mere $60 billions till March 2008. In contrast, FII investments in the Indian capital market, aggregated to $67 billions by March 2008. What is interesting to note here is that the net FII flow during 2007-2008 was a staggering $20 billion.

In effect, one-third of the aggregate FII flow of the past fifteen years was just in one year. No wonder India witnessed an unprecedented boom in her stock markets during 2007-08. Yet this is hot money which can exit India at the hint of a crisis, domestic or global.

What accentuates India's problem is that NRI deposits at $44 billions - another source of hot money that can well exit the country at the slightest pretext - accounted for a significant portion of our forex reserves.

What is interesting to note that while the going was good at the global level, the economic managers appropriated the credit for such successes without explaining the underlying risks involved in this approach to build our Forex reserves. Anyone who pointed out the inherent risks in this model was ridiculed, lampooned and dismissed not only by the establishment but even by many in the media and the intellectual circles.

In contrast to the popular belief that the boom in stock markets was a direct consequence of the boom in the real economy, the fact of the matter remained that it was unrestrained Forex inflow into the economy that created the boom in the first place - not otherwise. The cause was the effect; the effect was not linked to the cause. Surely, oblivious to all these we were all skating on thin ice.

As the flow reverses, India faces a huge struggle

What is interesting to note here is that as per press reports the aggregate FII flows as at 10th of January 2008 stood at $67 billions when the BSE index peaked in excess of 20,000 points. In the ensuing ten months the BSE index has since then crashed by approximately 50 per cent.

In the process FIIs have sold approximately $11 billions in these ten months. While the cause-effect seems to work on a linear scale on the way up, it seems to work exponentially on the way down.

What makes the FII flow driven stock market rise as a yardstick of economic growth extremely risky in the Indian context is that according to experts less than three percent of the national household savings find their way into the stock market.

No wonder, it is this FII-flow that provided the necessary liquidity that drove our stock till 2007 and its subsequent reversal that is causing the steep fall of the stock markets, liquidity crunch and steep depreciation of the rupee.

Yet oblivious to these fundamentals everyone including the finance minister and the prime minister continuously over the past four years pointed out to the spectacular rise of the stock markets as a conclusive proof of the brilliant handling of our economy! And when the stock markets fall, it is indeed amusing to see the UPA government defend its policies on an hourly basis.

It may be recalled that such inflows set the stock markets on a dose of high octane. The boom in stock markets translated into a real estate boom. And when the excess liquidity flowed into the potato markets, government realised, it was not a case of potato boom but classical inflation where too much money chased too little goods!

Therefore for the whole of 2008, the Indian government was left to fighting inflation by using a series of policy intervention. Naturally when the FII flows reverse, the government is constrained to reverse all its policy intervention of the past two years. To begin, the RBI has lowered its CRR rate from 9 to 7.5 per cent last week. In the process all of us seem to have forgotten about inflation.

But that brings us to the approach of successive Indian government, especially the UPA, which allowed unhindered Forex flows through the FII route. Like a mother administering steroids to her child and applauding the consequential unnatural growth, the UPA openly celebrated the rise of the stock markets which was caused by this gargantuan inflow.

It is not the question of ownership of Indian corporates that is only bothering experts today. Rather, it is this rush of flows and sudden reversal that has the calculated impact of not only dynamiting the stock markets but also the currency markets and the money markets.

Yet when the stock market was on a high, cheerleaders of the stock markets even went to the extent of opening the stock markets for the investments by approved provident funds. This needs to be seen in the context of the unprecedented amount redemption faced by our mutual Fund industry even since the markets went into a tizzy since last week.

The lessons from this are all too compelling for the policy framers. India is not yet evolved psychologically to be dependent on stock markets. We are still a risk averse society with very little fallbacks available from the government in case things go bad. Naturally, that would delay the return of the Indian investor to the stock markets in the future. And that would mean the exit of the FIIs would be painful to that extent.

Yet, despite all these Finance Ministry mandarins have repeatedly assured the Indian investor and implicitly pleaded with him to stay invested. Little do they realise that having goofed up on the management of the stock markets their credibility is matched only by the credibility enjoyed by the American financial sector.

The author is a Chennai based Chartered Accountant. He can be contacted at and 

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M R Venkatesh

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