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There is a 5 per cent chance that potential portfolio outflows can average up to 3.2 per cent of GDP or $100.6 billion in a year in an adverse scenario, cautioned an article titled ‘Capital Flows at Risk’ in the Reserve Bank of India’s (RBI) latest monthly bulletin.
The capital outflows could be response to (i) a Covid-type contraction in real GDP growth, or (ii) a Global Financial Crisis (GFC) type decline in interest rate differentials compared to the US, or (iii) a GFC type surge in the VIX (Volatility Index).
In a ‘black swan’ event, comprising a combination of the aforementioned shocks, there is a 5 per cent chance of potential portfolio outflows rising to 7.7 per cent of GDP and short-term trade credit retrenchment of 3.9 per cent of GDP, highlighting the need for maintaining liquid reserves to quell such potential bouts of instability, per the article put together by senior RBI officials led by Deputy Governor MD Patra.
Sensitive to sentiments
For India, portfolio flows are the most sensitive to shifts in risk sentiment globally and spillovers, the article’s authors said. “With the spate of emerging market crises since the 1990s and the experience with the global financial crisis and its aftermath, attention has turned from the benefits associated with capital flows to their consequences such as accentuating financial vulnerabilities, aggravating macroeconomic instability and spreading contagion,” they said.
The authors noted that financial openness can be a double-edged sword — a fifth of all surges in capital flows to EMEs have ended in financial crises, and EMEs are at least three times more likely to experience a financial crisis after these cascades than in normal times (Carney, 2019).
“Our findings suggest the predominant role of pull factors in attracting capital flows to India, key among them being growth differentials and domestic term premia. On the other hand, it is global risk aversion, reflected in the VIX, that drives capital outflows,” the official said.
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