Andy Mukherjee: India should not deter hedge fund capital

money.jpg The Bloomberg colunmist Andy Mukherjee has a very interesting insight into the effort of large emerging economies and their attempt to maintain and build up credibility of their capital markets on the one hand as well as actually attracting capital and thereby spawn growth on the other.

More specifically Andy's article deals with hedge funds investment in the Indian stock market through the derivatives market which is the only possible way for hedge funds to invest in Indian stocks. According to Andy the hedge funds' investment eager has greatly helped to propel the Indian Mumbai Sensex (stock index) to a most reasonable gain. 

"Without hedge funds the benchmark Mumbai Sensex probably wouldn't have scaled the peak of 10,000 as effortlessly as it did last week. The Sensex surged to a new record of 10,173.25 yesterday, a 52 percent gain from a year earlier."

Should this not be all well and good then?

Well, as mentioned above, the hitch is that most hedge funds(biased link!?) do not have the option to buy Indian stocks directly which has created a market for derivatives issued by those of the lucky institutional investors who have been granted the possibility to invest directly on Indian stock markets.

"P-notes, as the derivatives are called, are issued to those overseas investors who aren't eligible to buy stocks directly in India by those that are. The first group includes mostly hedge funds. The latter category comprises international investment banks (...) The issuer buys and sells the local share behind the derivative on behalf of the P-note holder, who avoids having to appoint a custodian and hire an accountant to file local tax returns in exchange for paying a slightly higher brokerage fee."

However, there are a couple of stakeholders in the discussion concerning access to the Indian stock market and essentially the effect of the derivatives on the Indian economy and market.

One the one hand there are the Securities and Exchange Board of India whose chairman M. Damodaran sees the growing market for the P-note derivatives as a second-best solution to that of allowing full access to all institutional investors. On the other hand is the Indian central bank which is more weary of the capital from hedge funds narrated as speculative hot money.

"Damodaran appears quite willing to live with P-notes because he can't immediately offer the better alternative: allowing all manner of overseas investors to buy local stocks without prior registration. It's the other Indian regulator, the central bank, which is paranoid about offshore derivatives."

Andy is not holding back in his critique of the Indian central bank which he accuses of excess paranoia. He argues that the CB is looking at the world in shades which are too black and white.

"Even though they have poured billions of dollars into the country and helped finance a growing current-account deficit, hedge funds get contempt and scorn from the central bank. The Reserve Bank seems to believe that there are two kinds of money in the world. The kind that comes to India via banks or mutual funds is good because the identity of the beneficiary can be established; the kind that flows in via hedge funds through offshore P-notes is suspect."

Ending his argument I believe Andy really makes an interesting point in pondering why the Indian central bank actually is voicing concerns over hedge funds' ownership by proxy of Indian assets.

"Could it be that the real reason for the Reserve Bank's reluctance has less to do with suspicions of tainted money and more with the reality that an inexorable surge in hedge fund investments might take away the central bank's ability to simultaneously manage money supply and the exchange rate?"

I believe the article is a compelling read because it provides an excellent case study of economic issues pertaining specifically to emerging economies; Creating an open and credible financial market as well as keeping the currency afloat and free from speculative moves or as Andy puts it invoking the ""impossible trinity'' tradeoff, which postulates that a country with an open capital market can't pursue an independent monetary policy if it targets a fixed exchange rate."

For more on this issue;

Foreign investors seduced by India's attractiveness are being questioned for their so-called 'sneaky' overtures -

"Allow hedge funds? Are we out of our minds? Didn't these guys bounce the pound out of the Exchange Rate Mechanism and wreck entire economies of East Asia? The Clinton-esque reply to that would be: it depends on what you mean by 'wrecked'. If bailing out of economies that are on the verge of collapse is equivalent to 'wrecking' them, then they sure did. But from an investing point of view, it can be considered as rational behaviour. If you know that the bank where you deposit your money is going bankrupt, you would want to withdraw your money. With a soaring market, healthy foreign exchange reserves, and stronger institutional framework in the capital markets (as compared with the rest of Asia), India should take a more mature view of hedge funds."