New issues in Indian macro policy.



the rise of outbound FDI, many Indian firms have turned themselves into multinational
corporations. They are now able to do transfer pricing with their offshore subsidiaries, and
thus achieve capital flows. If misinvoicing of 10% takes place on average on all current
account transactions, then this could be used to move 6% of GDP across the boundary.
This constitutes an enormous movement of capital.

Putting together the channels of misinvoicing, FII flows, inbound and outbound FDI,
debt flows, structured financial transactions, etc, substantial capital flows are now feasible.
While a debate continues to take place on whether and when India should usher in capital
account convertibility, the facts on the ground are that there is already substantial
de facto
convertibility.

The capital controls that remain are yielding various kinds of microeconomic distortions
and rent-seeking. The removal of capital controls is important from the viewpoint of
eliminating frictions, improving competition in finance, and in reducing risk through global
diversification (Mistry, 2007). However, in thinking about
macroeconomics, India is closer
to full convertibility than is generally perceived. The useful mental models are those drawn
from open economy macroeconomics.

2.2 Government control of finance has partially eased

In the old India, key financial markets were banned, or were vitiated by the government.
In recent decades, one element of finance has largely broken free of government control -
the equity market. The equity market has achieved a full ecosystem with high levels of
liquidity and market efficiency (Thomas, 2006). It has:

• Private equity investors;

• The IPO market;

• A fairly liquid secondary market, with electronic trading, competing exchanges, nationwide
anonymous electronic trading, risk management at the clearing corporation;

• Derivatives trading comprising onshore exchange-traded derivatives and offshore OTC deriva-
tives;

• Mutual funds;

• Stock market indexes, index funds and index derivatives;

• Barring barriers faced by pension funds, few domestic participants are blocked from market
access;

• Convertibility for ‘foreign institutional investors’.

While the government is involved in regulation and supervision of the equity market,
it has no role in determining prices of equity securities. This is in contrast with the three
other elements of finance - currencies, commodities and bonds - where speculative price
discovery does not take place in India, and government is integral to determining prices.



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