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India: Play safe!

Sep 8, 2003

Of all the features that symbolise a globalized world, one that has gained immense importance is the free flow of capital among nations - emerging and developed. While capital flows have their advantage in initiating investments in the recipient country by supplementing domestic investment, they cause a host of adjustments in a country's monetary policies. In this article, we would discuss India's position with regard to capital flows in the last decade (1993-2003).

Source: RBI Annual Report, 2002-03

The past...
Post the process of liberalisation that began in 1991, India witnessed a surge in capital inflows, as compared to the pre-liberalisation era, mainly of the non-debt creating category, i.e., Foreign Direct Investment (FDI) and Portfolio Investment (or FII inflows). This benefited the Indian economy tremendously as these inflows supplemented domestic investment and led to the development of the Indian economy during that period.

However, during the period between 1996 and 1999, as seen from the chart above, the proportion of short-term debt creating inflows (external assistance, short-term credits, NRI deposits, Rupee debt-service, etc.), or 'hot money', increased rapidly. And this was not peculiar of the Indian economy. Rather, the entire East and South Asian region was in receipt of this kind of inflows. Apart from interest differentials and expectations of currency appreciation, the other major cause of this sudden surge of debt-creating inflows was the over-expectation about growth in these countries.

While the outflow (due to reversed expectations of the investors) that followed caused a crisis of huge proportions, India managed to remain insulated. One of the reasons for this was the fact that India received (and still receives) a very small percentage of portfolio inflows to emerging markets (an average of 3% of portfolio investments going to emerging markets during 1992-2000). However, the small size was just one of the reasons for low volatility of inflows into India. The most important reason was, and 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). However, FII inflows into India have become volatile since 1998, but this applies to other emerging markets as well.

The present...
Coming to present times, India has witnessed a surge in capital inflows (especially in to the equity markets) since the beginning of 2003. While any particular reason cannot be attributed to this optimism, it seems a combination of interest differential, the appreciating Rupee and the expectations of a higher growth of the Indian economy. Thus, more than ever before, there is an urgent need to manage this volatility that foreign capital inflows, mainly the short-term inflows, accompany. After all, we would not want a repetition of the Southeast Asian crisis. In this regard, the RBI has imposed an upper limit on NRI deposit rates to curb the volatility caused due to interest differential. Also, to mitigate the volatility on the currency side, it (the RBI) has widened the band in which the rupee moves in.

On the FDI front, the picture remains depressing. As can be seen from the table below, FDI in most industries has dropped from its 2000-01 levels. This is a disturbing trend because FDI inflows are considered to be the ‘most stable’ of all capital inflows and play a substantial role in the development of the economy. China, for example, has been one of the biggest beneficiaries of the FDI inflows that it has been receiving over the years. These inflows not only act as an appendage to domestic investment, they go a long way in improving foreign investors’ perception about long-term investment in a country. And, going from the facts and figures, India has been a laggard on this account.

Industry-wise FDI inflows: Depressing!
(US$ m)2002-032001-022000-01
Chemical & allied product5367137
Computers297368306
Engineering262231273
Electronics & electrical equipments95659213
Finance542240
Food & dairy products354975
Pharmaceuticals446962
Services5091,128226
Others309395578
Total1,6582,9881,910
Source: RBI Annual Report, 2002-03;
Note: This table excludes FDI inflows under the NRI direct investment route through the RBI and inflows due to acquisition of shares under Sec. 5 of FEMA, 1999.

And, the future...
Going forward, the sustainable rise in flows into the Indian financial markets rest on the expectations of sustained improvement in our economy and our ability to outperform markets in the developing world (we compete with the developing markets for capital inflows from developed nations). The challenge facing India is to maximize the benefits that arise from access to vast pools of global capital and minimize the costs associated with it. As said earlier, the small size of inflows that come into the Indian markets insulated us from the contagion that followed the Asian financial crisis. However, as the quantum of inflows India receives grows, our policies relating to the same need to be infallible and sound.

Even on the FDI front, how we move from here on would depend a lot on the policies of the government to improve the investment climate in the country by clearing a host of regulatory hurdles in the same. While on-paper work in this regard has been substantial, what is now required in the actual implementation of the policies.

This would involve a great deal of proactiveness on the part of the RBI and the government. However, guided by the lessons learnt in the past and the wisdom gained from the same, we believe that India would emerge successful in its pursuit of bringing about micro- and macro-economic reforms and have a contingency plan ready to deal with short-term disruptions going forward. This would not only bring in more of foreign money, but it would also go a long way in unlocking value for Indian investors who have invested their hard-earned money in the growth story that India is yet to witness.

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