Y V Reddy: Government-owned investment vehicles and capital flows -
Indian perspective
Address by Dr Y V Reddy, Governor of the Reserve Bank of India, at a session on "The Role
of Government-owned Investment Vehicles in Global Capital Flows" at the International
Capital Markets and Emerging Markets Roundtable, Washington DC, 14 April 2008.
* * *
Chairman Bill Rhodes, distinguished speakers and fellow participants,
I am thankful to the organisers for inviting me to participate in the Roundtable on a subject of
great contemporary relevance. The invite has provoked me to deliberate on the subject, hear
distinguished speakers and also meet here to interact with friends.
We know that government-owned investment vehicles (GIVs), also referred to as Sovereign
Wealth Funds (SWFs), existed for long but they have acquired significance very recently due
to their proliferation, growth in size and, above all, active participation in capital infusion in
the aftermath of the recently observed financial turbulence. The International Monetary Fund
(IMF) has to be complimented for its pioneering work and excellent document on the subject.
The role of SWFs in global capital flows is also being debated in several fora, namely, the
O.E.C.D., the G7 Ministers, the European Commission, the Peterson Institute for
International Economics, the Central Banking Publications, the G 30, the Institute of
International Finance and the World Economic Forum.
Towards greater transparency
It is useful to recognise in the above context that, of late, there have been initiatives to
increase the transparency of all kinds of pools of capital as evidenced by the reports of the
U.K. Hedge Fund Working Group (January 2008), led by Sir Andrew Large, and the Private
Equity Working Group on Transparency and Disclosure (November 2007), led by Sir David
Walker.
Briefly stated, while there is intense debate on the subject of comfort with SWFs in global
capital flows, the present discussion could be considered both as a part of the wider and
significant debate on transparency and regulation of certain broad categories of investors
and also as one that addresses specific factors relevant to one category, namely SWFs. It is
useful to recognise in this regard that there is an overlap among the categories in terms of
sources of finance since SWFs invest on their own account and also through hedge funds
and private equity funds. In other words, one of the broader issues is regulatory safeguards
in place with regard to investors of a kind that may not necessarily assure regulatory comfort
to the host country. A related, and in a way the other side of the coin, is the transparency and
governance arrangements in regard to operation of SWFs in the home country. It is
heartening to note that the IMF has begun covering in its Global Financial Stability Report, in
addition to the SWFs, the issues relating to hedge funds and private equity funds.
Public policy initiatives on SWFs
The OECD approach in regard to SWFs is that international co-operation can build mutual
trust and keep markets open. The OECD Investment Committee and its non-OECD partners
have agreed that over the coming period they will follow a two-track approach to these
issues. First track would involve dialogue among governments, SWFs and the private sector
to improve understanding of both home and host country approaches to foreign investment.
The second track would involve exchange of experiences in relation to national security
protection, developing shared views on investment policies that observe the principles of
proportionality, transparency and predictability, accountability, and that also avoid
unnecessary restrictions to international investment, including by SWFs.
The OECD has recently, on 4 April 2008, released a report which is intended to develop
guidance for recipient country policies toward investments from SWFs. The OECD has also
proposed to work on how governments can maintain their commitment to open international
investment policies - including for SWFs - while also protecting essential security interests.
The resulting framework is expected to foster mutually beneficial situations where SWFs
enjoy fair treatment in the markets of recipient countries and these countries can confidently
resist protectionist pressures.
The European Commission (EC) is proposing a common EU approach to respond to
concerns over SWFs and enhance the transparency, predictability and accountability of
SWFs' investments while maintaining an open investment environment. It has laid out the
principles which should shape that approach. These are (a) commitment to an open
investment environment both in the EU and elsewhere, including in third countries that
operate SWFs; (b) support of multilateral work, in international organisations such as the IMF
and OECD; (c) use of existing instruments at EU and Member State level; (d) respect of EC
Treaty obligations and international commitments, for example in the WTO framework; and
(e) proportionality and transparency.
The recent joint release by United States, Abu Dhabi and Singapore sets out Policy
Principles for the SWFs as well as the countries receiving SWF investment. The
responsibilities enjoined upon SWFs mainly relate to greater transparency in areas such as
purpose, investment objectives, institutional arrangements, and financial information, strong
governance structures, internal controls, and operational and risk management systems and
the need to respect host-country rules by complying with all applicable regulatory and
disclosure requirements of the countries in which they invest. The prescriptions for the SWF
host countries stress on transparent inward investment rules, which are "publicly available,
clearly articulated, predictable, and supported by strong and consistent rule of law" and
favour non-discriminatory treatment for SWFs vis-à-vis other foreign investors.
Of particular interest from a host country perspective, is the Media Release of the Treasurer
of the Commonwealth of Australia in February 2008, which illustratively lays down a set of
principles to enhance the transparency of Australia's foreign investment screening regime.
The principles set out the main factors that are considered during the screening, which
include determining on a case by case basis and consistency with national interest; while
assessing the national interest in any given case, a balanced view against principles is
proposed. The principles set out the additional factors that need to be considered in relation
to investment proposals by foreign governments and their agencies, over and above those
that apply to normal private sector proposals. While the Australian Government welcomes
foreign investment, the purposes of Australia's foreign investment screening is to ensure
consistency with their national interest. The Treasurer can reject proposals that are deemed
contrary to the national interest or impose conditions on them to address the national interest
concerns. The concerns may relate to Australia's national security or economic development.
The examination includes implications for other government policies, competition and
operations of Australia's businesses.
Recent reports suggest that Germany is contemplating a legislation which will enable it to
block "unwanted" investments by SWFs. The proposed law is expected to enable scrutiny of
all investments where the investor's stake in the investee entity is likely to exceed 25 per
cent, even up to three months after the investment has been made. This concern seems to
stem from the suspicion that some of the SWFs may be driven by "political and other
motivations" and not purely by economic and commercial considerations.
India as a host country
In India, the regulatory regime governing capital inflows does not recognise SWFs as a
distinct category. Hence, their investments are subject to normal regulations governing
capital flows under the category of Foreign Direct Investment (FDI) and Foreign Institutional
Investments (FII). In regard to some sectors, such as banking and financial market
infrastructure companies, there are limits on individual holdings and the investment
proposals are subject to an element of due diligence processing with regard to fit and proper
requirements. For this purpose, no discrimination is made between a domestic investor and a
foreign investor, or between SWFs and others, as long as the policy criteria are met. Let me
further elaborate on this position.
The existing FDI policy permits investments under the "automatic route" and the "approval
route" in most, though not all, of the activities. Under the automatic route, the investors are
allowed to invest in the identified sectors up to the threshold specified for those sectors,
without the need for a prior approval from regulators or the Foreign Investment Promotion
Board (FIPB). In respect of the other sectors, the investors will need a prior approval of the
FIPB, before undertaking any investment. The FIPB is functioning under the aegis of the
Ministry of Finance and comprises representatives of various government departments, who
are expected to ensure that the proposed investment addresses the administrative and other
concerns before allowing investments in the concerned activity. Similarly, under the FII route,
the FIIs registered with the securities market regulator (the Securities and Exchange Board
of India - SEBI) can invest in the secondary market, without prior approval, subject to certain
limits on individual FIIs and an overall aggregate limit for all FIIs, as a category, as well as
the sectoral thresholds and other conditions applicable to FDI. SWFs can also invest directly
as an FII or indirectly as a "sub-account" of a registered FII, which include hedge funds and
investment funds. Accordingly, any SWF can invest under the FDI route (automatic or
approval routes, as the case may be) or under FII route either directly or indirectly. Thus, on
the inflows, there is generally no discrimination on the basis of the country of origin of the
foreign investor or on the basis of category of foreign investors.
The policy, however, does provide for a framework in regard to ownership and management
of the entity investing in some sectors, particularly the financial sector, which is applicable
equally to resident as well as non-resident investors.
In respect of banks, acknowledgement from RBI for acquisition/transfer of shares is required
for all cases of acquisition of shares which will take the aggregate holding (direct and
indirect, beneficial or otherwise) of an individual or group to equivalent of 5 percent or more
of the paid-up capital of the bank. The relevant factors for "fit and proper" assessment of the
investor include the source of funds for the acquisition and, where the investor is a body
corporate, its track record of reputation for operating in a manner that is consistent with the
standards of good corporate governance, financial strength and integrity. The process also
envisages a higher level of due diligence when the share holding of the investor exceeds 10
per cent in the investee bank's paid up capital, which includes fit and proper status of the
investor entity.
An amendment to the Banking Regulation Act has been proposed which envisages prior
approval of the Reserve Bank for acquisition of more than five per cent of the paid up share
capital of a bank by any investor "directly or indirectly, by himself or acting in concert with any
person". The approval will be accorded after ensuring that the investor would be "fit and
proper" from the perspective of public interest, interest of banking policy, emerging trends in
banking and international best practices, and the interest of banking and financial system in
India.
In the case of investments in financial market infrastructure companies, such as stock
exchanges, the guidelines stipulate a desirable dispersal of ownership. Investment by
individual entities, including investments by persons acting in concert, is subject to a
threshold of five per cent of the equity in these companies.
In regard to Securitisation and Reconstruction Companies (SRC), the RBI conducts due
diligence on the sponsors / investors before giving a certificate of registration to the SRC.
Any subsequent investment by any individual entity in excess of 10 per cent of the paid up
equity capital of the SRC also acquires the status of a "sponsor" and requires prior
permission of RBI which, as the regulator, is required to satisfy itself, among other things, of
the "fit and proper" credentials of the investor.
Foreign investment in an Indian company in the financial services sector, through
acquisitions, requires prior permission of the Reserve Bank which allows such investments
only after ensuring that the regulatory concerns, if any, are appropriately addressed and that
the bonafides of the overseas investor are satisfactory. Wherever necessary, the clearance
or comments of the home country regulators of the investing entity are also sought while
examining the requests.
In case of investments by foreign investors in activities other than the financial services
sector, where there are security or other administrative concerns, for instance, in defence
and strategic industries, and print media and broadcasting sectors, investments are allowed
only under the "approval route".
In order to assess the eligibility of an entity to be registered as FII or as Foreign Venture
Capital Investor, SEBI takes into account all factors relevant to the grant of a certificate and
in particular the applicant's track record, professional competence, financial soundness,
experience, general reputation of fairness and integrity as well as the fact whether the
applicant is regulated by an appropriate foreign regulatory authority.
In brief, India is yet to consider a policy addressing investments by SWFs, except as a part of
due diligence in regard to all investors.
India as a home country
In India, the foreign exchange reserves are on the balance sheet of the Reserve Bank of
India (RBI) and are managed as per the provisions of the RBI Act, consistent with the global
best practices. The Reserve Bank adheres to appropriate prudential norms and the
transparency and data dissemination standards in regard to reserves management.
Given the significant increase in the level of foreign exchange reserves, there is an
increasing expectation in regard to returns. The returns on the foreign exchange reserves,
under the present framework, are constrained by the mandate to Reserve Bank of India,
which understandably lays a greater emphasis on safety and liquidity.
It may, however, be possible to argue that a part of the reserves, which may be considered
to be in excess of the usual requirements, be managed with the primary objective of earning
higher returns. Given the limitations placed on the central bank by its mandate, it can be held
that it will be appropriate to bestow this responsibility on a different sovereign entity. If and
when the country considers setting up of a SWF for the purpose, one of the methodologies
could be to fund SWF by purchasing the foreign exchange from the central bank, to the
extent required. These foreign currency funds could then be used by the sovereign entity for
seeking higher returns by investing in assets, which a central bank's mandate may not
permit. As the SWF will be a public enterprise, it will be required to conform to the applicable
governance, transparency and disclosure standards.
While it is possible to make a case for an Indian SWF, there are also weighty arguments for
caution in this regard. First, it would be very difficult to reckon in the Indian context - as is the
case with many other countries, the "reserve adequacy" in a dynamic setting and on that
basis divert a part of "excess" reserves for a higher return from riskier assets. The current
reserves management policy recognises this, based on experience during periods of both net
inflows and outflows and, therefore, the overall approach to the management of India's
foreign exchange reserves takes into account the changing composition of the balance of
payments and endeavours to reflect the "liquidity risks" associated with different types of
flows and other requirements.
Second, while most other countries that have set up SWFs have amassed large reserves
either on account of persistent current account surpluses or due to revenue gains from
commodity exports, in particular of oil and gas, the Indian economy has twin deficits - a
current account deficit as also a fiscal deficit. India's export basket is diversified and does not
have any dominant "exportable" natural resource output, which might promise significant
revenue gains at the current juncture.
Third, India has experienced consistent but manageable current account deficits barring very
few years of a modest surplus. India is also having a negative international investment
position (IIP) with liabilities far exceeding the assets. The large reserves have been built,
over time, mostly on account of capital flows like foreign direct investments (FDI), portfolio
flows through foreign institutional investors (FII), external commercial borrowing (ECB) and
short-term credit. Further, the increasing reserves also reflect, in part, the lower absorption
capacity of the economy, which may pick up with the economy moving on to a higher growth
trajectory.
In brief, the public policy is yet to take a conscious view on the desirability of establishing a
SWF.
SPV for use of reserves
In the context of growing developmental needs, particularly of the infrastructure sector, a
step in the direction of using a small part of reserves for development has recently been
taken after considerable deliberations. An announcement was made by the Finance Minister
in the budget Speech 2007-2008 on February 28, 2007 to "use a small part of the foreign
exchange reserves without the risk of monetary expansion" for the purpose of financing
infrastructure development projects. Accordingly a scheme has been finalized which
envisages RBI investing, in tranches, up to an aggregate amount of USD 5 billion in fully
Government guaranteed foreign currency denominated bonds issued by an overseas SPV of
the India Infrastructure Finance Corporation Ltd. (IIFCL), a wholly owned company of
Government of India. The funds, thus raised, are to be utilized by the company for on-lending
to the Indian companies implementing infrastructure projects in India and/or to co-finance the
ECBs of such projects for capital expenditure outside India without creating any monetary
impact. The lending by the SPV under the arrangement would be treated as external
commercial borrowings (ECB) and would be subject to the prescribed reporting and
disclosure requirements. The bonds will carry a floating rate of interest. The investment by
the RBI in the foreign currency denominated bonds issued by the SPV will not be reckoned
as a part of the foreign exchange reserves, but will be a foreign currency asset on the RBI
balance sheet.
It is noteworthy that this arrangement is distinct in the sense that India is both a home and a
host for the IIFCL's subsidiary, as it is basically a SPV for channelising foreign exchange
funds for meeting the requirements of the Indian private sector for infrastructure projects in
India by drawing upon the foreign exchange reserves of the country available with the central
bank.
Summing up
To sum up, India has not yet considered regulatory initiatives specifically addressing SWFs.
Existing provisions in regard to fit-and-proper or take-over code are, however, applicable to
pros cons
all investors, including SWFs. Currently, the and for the establishment of an Indian
SWF, as generally understood now, are still under debate. India is monitoring recent
developments in regard to enhancing transparency and disclosure in respect of hedge funds,
private equity and SWFs. In particular, India is watching with great interest the development
of global codes, standards and practices in regard to SWFs, both in view of the presence of
SWFs in the Indian financial markets and the ongoing debate on establishing an Indian SWF.