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Capital flows in India: Trend, magnitude and composition - Views on News from Equitymaster
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  • Jan 6, 2009

    Capital flows in India: Trend, magnitude and composition

    In the last article, we discussed the history and evolution of capital flows into India. In this article, we will focus on the trends, magnitude and composition of capital flows in India.

    Trends: As discussed in the previous article, capital flows experienced a compositional change from mainly official and private debt flows to non debt creating flows in the post reform period. Since the introduction of reforms process, India has registered a significant increase in capital flows. The net capital inflows have increased from US$ 7.1 bn in 1991 to around US$ 108 bn in 2008.

    Magnitude: India's strong capital flows reveal sustained economic growth of India, positive investment climate, favorable liquidity and interest rates in the global markets. Furthermore, higher domestic interest rates coupled with stable growth rate had created a lower risk perception that attracted higher capital flows.

    Net capital flows as percentage of GDP increased from 2.2% in 1990-91 to around 9.0% in 2007-08. However, if we see gross capital inflows as a percentage of GDP, then it increased from around 7.2% in 1990-91 to around 36.6% in 2007-08. While capital outflows as a percentage of GDP increased from 5% in 1990-91 to around 27.4% in 2007-08. Most of the capital outflows were on account of Foreign Institutional Investor (FII) portfolio transactions, Indian investment abroad and repayment of ECBs. All this has offset a lot of increase in capital inflows. However, India has large excess of capital flows over the amount required to finance current account deficit and that resulted in accretion of forex reserves to the tune of around US$ 308 bn by July 2008.

    Composition: The composition of capital flows has undergone a complete change from official debt flows to non debt flows as a result of thrust of policy reform after the balance of payment crisis in 1990s, that encouraged non debt creating flows instead of short term debt flows. The official flows got replaced by private equity and external commercial borrowings (ECB). Non debt flows, particularly private foreign investments witnessed a significant rise.

    Non debt flows mainly consisted of foreign direct investment (FDI) and foreign portfolio investments. The FDI inflows registered a significant increase since 1990s, revealing the liberal policy regime and increased investor confidence.

    FDI flows mainly concentrated in the services sector in India. This reflects the service led growth of the Indian economy and its comparative advantage in international trade in services. It may be noted that IT sector has enabled greater international trade for India and thus received major investments since liberalization. Furthermore, financing, insurance, real estate and business services have also witnessed a large increase in their share in FDI flows in last few years. FDI has emerged as a vehicle to deliver services to the international markets

    Flows from foreign portfolio have dominated the FDI flows to India during various periods of time. This is unlike the developing and emerging market economies in the world where FDI has always surpassed the FII in flows. FII flows in India however, were more volatile and moved in tandem with domestic and international sentiments. The foreign portfolio investments flows were mainly driven because of lower long term returns in advanced economies. Furthermore, strong macroeconomic fundamentals, resilient financial sector, deep and liquid capital market, improved financial performance of the corporate sector and attractive valuations in India provided them with better returns. Thus, FIIs inflows increased significantly.

    However, India is consistently making efforts to encourage more flows through FDI route than the portfolio route and moreover, enhancing the quality of portfolio so as to safeguard its financial markets from the abnormal momentum.

    *This write up has been influenced by a paper presented by Deputy Governor of RBI, Mr. Rakesh Mohan.



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