Saturday, January 14, 2017

Measuring outputs v. outcomes: Did the restriction on foreign investment in local debt achieve the intended outcome?

[The following guest post is contributed by Anurag Dutt, Arpita Pattanaik and Bhargavi Zaveri, who are researchers at the Finance Research Group at the Indira Gandhi Institute of Development Research, Mumbai.]

A good policymaking process requires significant regulatory capacity. Before the policy is enacted, the State must (a) identify a market failure and an appropriate intervention to address it, (b) conduct a cost benefit analysis of the intervention, and (c) conduct an effective public consultation where the public knows about (a) and (b). Even after the policy is enacted, the policy by itself is merely an 'output'. After allowing for a reasonable lag for transmission, the State must identify whether the intended outcome of the policy has been achieved. For example, the intended outcome of the Insolvency and Bankruptcy Code (IBC) is to improve the debt recovery rates in India. The IBC was enacted in May 2016, and most of its provisions were notified in November 2016. The IBC is an output. Allowing a medium term horizon for the impact to play out, an impact assessment exercise will be due in November 2020 to assess whether the debt recovery rates have improved. The impact on debt recovery rates would be the outcome.

In the field of capital controls in India, we find that State interventions are almost never accompanied with the steps mentioned above (Burman and Zaveri (2016)). An ex-post impact assessment of interventions in this field is unheard of. We wrote an article measuring the impact of a regulatory intervention in February 2015, which banned Foreign Portfolio Investors (FPIs) from investing in onshore bonds with a maturity period of less than three years. Our findings of this research are summarised below.

The intervention

On 3 February 2015, the Reserve Bank of India (RBI) prohibited FPIs from investing in (a) debt instruments with a maturity period of less than three years (such as corporate bonds with less than 3 years maturity and commercial papers), and (b) money market and liquid mutual fund schemes (as these schemes invested in corporate debt with less than 3 years maturity). In this post, for ease of reading, we call the onshore bonds with a maturity period of less than three years "prohibited instruments", and onshore bonds with a maturity period of at least three years "permitted instruments". The restriction was effective from 4 February 2015. However, FPIs were allowed to continue holding the prohibited instruments that they already held on 4 February 2015. Also, no lock in period was imposed on instruments acquired by FPIs after the date of the intervention, that is, FPIs could invest in and sell bonds with a maturity period of at least three years, well before they matured.

The RBI circular did not specify what the market failure was or what the intervention was intended to achieve, except that the intervention was to bring consistency between the rules for FPI investment in corporate bonds at par with FPI investment in Government securities. It was not accompanied with a cost benefit analysis of the intervention, and it was not preceded by a public consultation process. We are not aware if RBI or the Central Government proposes to undertake an ex-post impact assessment of this measure.

Questions:

Due to the absence of a specific desired outcome in the RBI circular, we relied on statements made by RBI to the press. These statements, as well as our conversations with RBI employees on public forums since the intervention, indicate that the intervention was intended to 'nudge' FPI investment in long-term debt in India. Our analysis is, therefore, limited to the following questions:

Question 1: Whether the regulatory intervention led to an increase in FPI investment in the permitted instruments?

Question 2: Whether the regulatory intervention led to any change in the behaviour of FPIs in relation to the permitted instruments?

Findings:

We use the daily holdings data from NSDL to identify the kind of debt instruments held by FPIs from January 2014 until March 2016. With this data, we identify the change between (a) the percentage of permitted instruments held by FPIs during 12 months before the intervention; and (b) the percentage of permitted instruments held by FPIs during 14 months after the intervention. We take a long time-frame for the study, which helps in filtering out the effect of other macroeconomic conditions and monetary policy changes that could have caused short term fluctuations in FPI participation in the Indian corporate debt market. Our findings, on the basis of this data and methodology, are summarised below:

Question 1: We find that after the intervention, there is a marginal increase of 0.47% in the annual average FPI investment in the permitted instruments.

Question 2: We find that there is no change in the behaviour of FPIs in relation to their holding of permitted instruments, before and after the intervention. From anecdotal conversations with market participants, we know that FPIs do not hold their local currency debt until maturity, especially where such debt is of a long-term nature. We notice this finding even in our data. We observe that even after the intervention, they continue to sell-off the permitted instruments held by them shortly after listing.

Conclusion

An ex-post impact measurement exercise measures whether an intervention has achieved the intended outcome. It helps analyse whether any changes must be made to the intervention or the manner of its implementation, to make it more effective. For example, if an ex-post impact assessment of the IBC in 2020 shows that there has been no improvement in the debt recovery rates in India, it should be a sufficient ground to re-visit the design of the law. It is to facilitate such an exercise that the Indian Financial Code drafted by the Justice Srikrishna-led Financial Sector Legislative Reforms Commission requires every regulation to be reviewed three years after its enactment.

Our ex-post impact analysis of the intervention of restricting FPI investment in corporate debt with a maturity period of less than three years finds no evidence of having achieved its intended outcome of channelising foreign capital from the short to long end of the corporate bond market. We find that neither do FPIs increase their participation in long term bond holdings as a result of the intervention nor do they alter their behaviour by holding the long term corporate debt securities until maturity.

We find that an attempt to centrally plan the allocation of foreign capital inflows did not have the intended effect on at least one occasion. On the other hand, the intervention withdrew foreign capital from the most liquid part of the Indian debt market. Pandey and Zaveri (2016) show that a substantial proportion of the bond issuances in similarly placed economies, such as Indonesia and South Korea, belong to the maturity bracket of one-three years. None of these economies prohibit foreign portfolio investment in local currency debt of this maturity bracket. In India too, before the intervention there was significant FPI interest in the bond market with a maturity profile of less than three years. This is evident from the rapid utilisation of the debt limits for CPs. The reason for this is simple. It is easier to price currency and credit risk in debt of this maturity profile. For small to mid-sized Indian companies which are not known to foreign investors, it is easier to raise debt in this maturity profile from foreign investors. Globally, being able to raise foreign debt in local currency is a boon for debtors, as the currency risk is taken by the foreign investor. At a time when India is struggling to set up its corporate bond market, the intervention has resulted in depriving the relatively more liquid part of the market of significant participation.

- Anurag Dutt, Arpita Pattanaik & Bhargavi Zaveri

References

Regulatory Responsiveness in India: A normative and empirical framework for assessment, Anirudh Burman and Bhargavi Zaveri. IGIDR Working Paper IGIDR Working Paper WP-2016-025, October 2016.

Radhika Pandey and Bhargavi Zaveri, Time to inflate economy's spare tyre, Business Standard, 18 April 2016.


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