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Emerging markets: In come the flows…

Jul 5, 2003

The last decade is witness to a large number of economic and financial crises that gripped several emerging economies. And this seems to continue in this decade as well. Most of these crises were brought about by mis-management of the mobility of capital flows that has been a natural effect of increasing globalization of world economies. This article deals with the experience that the emerging markets (with specific reference to India) had with capital inflows, lists some of the economic benefits associated with such flows, and finally articulates some thoughts on the times ahead.

Source: Institute of International Finance

Capital flows to emerging markets have been robust despite crises in many countries. Equity flows have been the predominant source of capital flows to these markets. While the financial crises (Mexico-1995, East Asian countries-1997, Argentina-2001) exposed the inherent weakness in the financial systems of these nations, there is no denying the fact that they have gained tremendously from capital inflows. However, a rise in portfolio investment (FII inflows) has tilted the composition of international capital inflows towards short-term investments, thus exposing individual countries to enhanced volatility and sudden withdrawal risks. In fact, one of the perils of the post-liberalization period has been the fact that when capital leaves (outflows), it leaves faster than it came in. And this has a crippling effect on the said economies and leads to financial crisis that the emerging nations have seen (in 1997-98, for example).

While capital inflows affect a wide range of economic variables like exchange rates, interest rates, forex reserves and domestic monetary policies, they bring about capital market integration. And this integration brings with it benefits in forms of reduced cost of capital (as supply increases), expansion in the size of markets (as number of investors increase) and improved liquidity. Also, market-integration serves as a channel to enforce internationally accepted practices for corporate governance, accounting and auditing. The key underlying economic principle is that as long as foreign investors invest in countries with companies driven by sustainable operational efficiencies, foreign investment will result in value creation. And this is seen in the increase in growth rates witnessed by these emerging nations as and when capital flows came in greater proportions (see GDP chart).

Source: Institute of International Finance

India, in particular, has gained from increased capital inflows post-liberalization. However, India receives a small percentage of portfolio flows to emerging markets. India received an average of 3% (1992-2000) of portfolio investments going to emerging markets as compared with 1.7% of FDI flowing to these markets. However, outflow from the Indian markets was nearly 2% of the outflow from emerging markets. Due to their small size, the volatility of inflows to India has been on a lower size as well, in comparison to other emerging nations. However, the small size is just one of the reasons for low volatility of inflows into India. The most important reason has been the inherent strength of the Indian financial system in comparison to those of the ‘Asian miracles’ (Indonesia, Malaysia, Korea, the Philippines and Thailand). Also, India was insulated from the Asian crisis, as the Indian Rupee is not fully convertible on the capital account. However, FII inflows into India have become volatile since 1998, but this applies to other emerging markets as well.

The trickle of FII inflows that began in the beginning of 1993 has gradually expanded to an average monthly inflow of close to US$ 200 m during the first six months of 2003. The total amount of FII investment in the country has however accumulated to a formidable sum of US$ 24 bn during this time (1993-June 2003). These FII inflows however come from varied sources. The FIIs registered with India (SEBI) come from as many as 28 countries. However, this is not the truest indicator of whether the actual investor funds come from these countries. In particular, institutions operating from places like Cayman Islands or Mauritius, or even those based at Singapore or Hong Kong are more likely to be funds based in other countries. Even so, the regional distribution indicates the relative importance of these regions in FII inflows to India.

Others include Japan, Mid-East and India

According to a recent report from the Institute of International Finance (IIF), net private capital flows to emerging markets are expected to increase, though modestly, from US$ 113 bn in 2002 to around US$ 137 bn in 2003. Recent weakness in capital flows to emerging markets reflects both cyclical (short-term) and structural (long-term) problems. Here, the former represent the downturn in the global economy since 2001 and heightened risks in the stock markets worldwide. The latter, however, is representative of the convergence of certain negative factors like the financial crises that hit emerging nations hard, bursting of the stock-market bubble, corporate governance scandals, terrorism and geopolitical tensions (Afghanistan, Iraq). While the short-term concerns are likely to correct themselves with time, the long-term structural problems have dealt a major blow to investors’ appetite for risks (in this case, investments in emerging markets).

However, the sustainable increase in flows to emerging markets rest on the expectations of sustained improvement in the economies of these countries and their ability to outperform markets in the developed world. The challenge facing emerging markets is to maximize the benefits that arise from access to vast pools of global capital and minimize the costs associated with it. The costs from financial crises in terms of loss of output and employment are substantial. However, guided by the lessons learnt in the past and the wisdom gained from the same, emerging markets need to initiate institutional building, bring about micro-economic reforms and have a contingency plan ready to deal with short-term disruptions going forward.

India: The journey so far…
Year Net FII investment
(% of GDP)
(% of GDP)
(% of GDP)
P/E Ratio
1990-91 - 16.0 6.3 19.7
1991-92 - 49.5 11.0 44.3
1992-93 - 25.1 6.1 29.3
1993-94 0.6 42.8 9.8 46.8
1994-95 0.5 43.0 6.7 30.4
1995-96 0.6 44.3 4.2 17.3
1996-97 0.5 33.9 9.1 14.6
1997-98 0.4 36.8 13.7 15.2
1998-99 -0.04 31.0 17.7 14.6
1999-00 0.5 46.7 35.0 22.7
2000-01 0.4 26.2 45.9 15.8
2001-02 0.6 29.2 NA 15.2
Source: RBI, Handbook of Statistics

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