C.P. CHANDRASEKHAR
JAYATI GHOSH

While most “emerging markets” in Latin America and Asia are expressing concern about and responding with capital controls to the surge in foreign capital inflows into their financial markets, policymakers in India are more sanguine and are declaring that the country can absorb far more than the net capital inflows it currently attracts. Is this confidence warranted?

With the US launching the second round of its quantitative easing, that involves Federal Reserve purchases of $600 billion worth of bonds to infuse liquidity into the system, attention has turned to the impact this would have on emerging markets, including those in Asia.

Expectations are that this cheap liquidity would fuel a surge in capital flows to these markets as financial investors borrow to invest in financial and real estate markets in these countries, which promise returns much higher than the cost of capital at home. The surge in turn would exert upward pressure on their currencies and threaten competitiveness or create a host of problems for monetary management.

Complacent ATTITUDE

Indian policymakers, however, seem complacent, arguing that India has the capacity to absorb far more net capital inflows from abroad than it does currently. Figures in the $70 to $100 billion range have been referred to by senior government officials such as the Deputy Chairman of the Planning Commission and the Chairman of the Economic Advisory Council to the Prime Minister. A Deputy Governor of the Reserve Bank of India too has said that India's absorptive capacity is far greater than the volume of the current inflow.

The implication is that the Government and the central bank do not seem to be too keen on adopting capital controls of the kind put in place recently by a number of developing countries aimed at moderating capital inflows even if not shutting off the tap completely.

Without such adoption India is likely on average to receive much larger inflows of such capital, though such flows tend to be extremely volatile.

As Chart 1 shows, while net inflows during the early part of this decade were small (less than $5 billion) and not too volatile, they have since increased substantially and turned much more volatile, especially in recent quarters.

Why moderate inflows

In sum, there are two reasons countries must think of adopting policies that moderate or limit capital inflows. First, the possibility that developments on the supply side (such as an infusion of liquidity by the Fed in the US) could lead to excessive inflows that result in currency appreciation or make macroeconomic management difficult.

Second, the likelihood that capital that has flowed into the country over time may exit all of a sudden for reasons unrelated to the economic performance of the country concerned, as happened in many countries during the recent financial crisis. Shutting out excess inflows that are not needed to finance imports or investment in the host country is a reasonable policy option.

Thus when government or central bank officials in India speak of its capacity to absorb larger inflows, they are in essence arguing that India “needs” more inflows, and would therefore absorb them if it indeed receives such inflows. The notion of absorption is, however, ambiguous.

Current account

The most obvious way in which capital inflows, net of outflows, can be absorbed is through the financing of current account requirements. On this count the evidence does seem to suggest that India has been receiving more capital inflows than it needs over the last few years.

To start with, since the beginning of this decade (2000-01), over the 41 quarters till the first quarter 2010-11, there have been 16 in which India actually recorded a current account surplus.

Further, since the beginning of financial year 2003-04, when there has been a capital flow surge into most emerging markets, the inflow of capital has fallen short of the current account deficit only in seven out of 29 quarters, with the ratio of net capital inflow to the current account deficit being below one (Chart 2: Negative figures are because of a current account surplus or negative deficit).

As a result, cumulatively there has been a huge excess of capital inflow into the country when compared to its current account financing needs.

In fact, if we take the cumulative sum of the excess of the capital inflow relative to the current account deficit, this has increased consistently since the first quarter of 2001-02 to the fourth quarter of 2008-09, and since then has more or less remained near that level despite the exit of capital associated with the global crisis (Chart 3).

There are two reasons why capital inflow has been in excess of India's balance of payments financing requirements. The first is that right through this decade, India has experienced an excess of capital inflows over outflows in all quarters excepting one (third quarter 2008) (Chart 4).

A host of factors have combined to ensure this result. India has been a favoured destination for foreign financial investors. Foreign direct investment has flowed in post-liberalisation to benefit from the large and growing domestic market.

And Indian firms have borrowed heavily abroad given the much lower interest rates in foreign markets and the liberalised conditions relating to external commercial borrowing.

The second reason why capital inflows have been in excess of India's balance of payments financing needs is that services exports and remittances from workers providing services on location abroad have substantially covered the country's merchandise trade deficit.

As Chart 5 shows, the net inflows on account of software and business services and remittances have exceeded the merchandise trade deficit during the first half of this decade and more or less equalled it subsequently.

Currency appreciation

Given the liberalised exchange rate system that Indian has, the resulting excess supply of foreign exchange creates conditions for an appreciation of the currency. If that appreciation has not occurred it is because of the intervention by the Reserve Bank of India that has resulted in the large reserves that it holds.

Given these circumstances it is difficult to see how India has absorbed excess capital inflows and therefore can be expected to absorb even larger inflows in future. The only argument that could remain is that these inflows in excess of balance of payments financing requirements are needed to supplement domestic savings and finance crucial investments.

This argument too is not sustainable. An examination of the financing pattern of corporate investment shows that internal resources and commercial bank borrowing rather than equity (domestic or foreign) have dominated the sources of funds.

Not surprisingly, much of the foreign capital that has flowed into the country has been on account of investments by foreign institutional investors in the secondary market for equity or on account of equity purchases in existing enterprises rather than in greenfield projects. In other words, much of the foreign capital inflow has not financed new investment.

Even where foreign capital has financed corporate investment this has been in sectors such as telecommunications and power that “produce” largely non-tradable services, or in plants producing largely for the domestic market. This implies that while the foreign capital inflow associated with these projects involves a commitment to pay out dividends and royalties in foreign exchange in future, they themselves do not contribute directly or indirectly to earning foreign exchange through exports.

External vulnerability

Thus, substantial dependence on foreign investment of this kind could contribute to an increase in external vulnerability in the future. Relying on “savings” that could exacerbate balance of payments difficulties is hardly a route to stable growth.

In sum, India has been the recipient of “excess” capital flows that it has by no means “absorbed”.

Given the accumulated legacy of such excess flows, when supply-side changes abroad threaten a further surge in capital inflows, the Government and central bank need to consider capital controls more seriously than seems to be the case currently.

There are many reasons why it would be smart for India's policymakers to follow the lead of their counterparts in other emerging markets.

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(This article was published in the Business Line print edition dated November 16, 2010)
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