## Tuesday, April 11, 2006

### Quota raj for debt inflows

As is well known, this year, the quantitative limits on FII investment into rupee debt (both government and corporate) have been raised.

Unfortunately, there's a highly bureaucratic mechanism through which the limit is operationalised. First, SEBI defines two "routes" called the "100% debt FII" and the "70:30 FII". Each of these has different rules. What is worse, it looks like SEBI has taken upon itself godlike powers in determining how much of the quantitative limit will be used by one type or the other. I'm sure the lobbying will now start where the "70:30 FIIs" will request an increase in their quota.

What is worse, within these quantitative limits, SEBI seems to want to `equitably' allocate the limit amongst all firms.

This is a really crazy idea. If you look at the ownership of shares by FIIs - which, mercifully, has no such quota system - then some firms are big and some firms are small. Customers decide which firms gets to run money. If a government tries to impose an "equitable" quota system, this would hugely distort the market structure. Today, Business Standard has an excellent editorial criticising this "quota raj".

The SEBI framework is anti-competitive. Suppose there are 10 firms and an "equitable" allocation gives them $100 million each out of a total limit of$1 billion. When a smart firm fills up it's quota of \$100 million, it goes to sleep. It stops fighting in this space. A customer who wants Indian debt might like to go to a smart firm, but it will have to turn away customers because there is no room left in the quota. The customer will be forced to go to a lesser firm. The rules thus nurture weak firms and penalise strong firms.

As the BS edit suggests, there is really no role for the words "100% debt FII" or "70:30 FII". This is the disease that often afflicts Indian financial regulation - slicing up a competitive industry into walled-off slices with supreme power in the hands of bureacrats to shape the profitability of each slice. Once the walls are in place, each slice lobbies with RBI / SEBI for modifications of rules to increase its own profitability. I think we should try to do financial sector policy so that the world has not been broken up into fragments / By narrow domestic walls - where lots of finance companies have bareknuckle competition with each other, without slicing up the industry into categories which imply that firm i won't be able to compete with firm j.

It is not clear why SEBI is building this quota raj, for it does nothing to achieve the mandate of building a liquid and efficient securities market. The sensible path for SEBI is that India should only have one single "FII licence". After that, the FII should be free to invest in listed or unlisted equities, government bonds or corporate bonds, based on business considerations. Limits could exist on any one piece (e.g. a 24% limit on some company) and there can be a non-intrusive mechanism to ensure that limits are not violated as has been done with listed shares. There is no reason for the government to get into quotas.

This links up to the discussion on convertibility. Once again, we see that realworld capital controls - whether manned by RBI or SEBI - are not anywhere as elegant as the capital controls of the imagination. Realworld capital controls are manned by frail institutions, and involve all manner of rigidities and distortions. Convertibility is the solution chosen by all mature market economies, not because markets are perfect, but because the blemishes of the market are smaller than the blemishes of control raj.