Macroscan. The flight of the wealth-holder is leaving India vulnerable

Those who follow trends in India’s balance of payments trends have noted an unusual development. Outward remittances under the Liberalised Remittance Scheme (LRS) for resident Indians have recently spiked, from just above $1 billion in 2014-15 to nearly $14 billion in 2018-19 (Chart 1).

This spike is unusual even when compared to pre-2015-16 trends in the outflow under the LRS. Introduced in February 2004, for a long time the scheme did not open the gates for outflows of foreign exchange from India. As Chart 1 shows, having risen gradually to a little over $1 billion in 2010-11, the outflows under this scheme remained around that level for the next five years. When the LRS was first introduced, resident individuals were allowed to freely remit up to $25,000 per calendar year. This limit was then raised to $50,000 per financial year in December 2006, $1,00,000 per financial year in May 2007 and to $2,00,000 per financial year in September 2007. In August 2013, the RBI responded to fears of a possible run on the rupee by drastically reducing the LRS limit to $75,000, only to raise it again in stages to $2,50,000.

Thus, in much of the period when total outflows under the LRS stood at around $1 billion, the per person limit for annual transfers was, at $2,00,000, close to where it stands currently. And, even when the limit was slashed during the 2013-14 period, transfers were more or less of the same magnitude. So it was not a change in the limit that led to substantially enhanced outflows in recent years, which made the reasons behind such a spike a mystery.

Balancing act

The increased outflow under the LRS is now a significant drain on foreign exchange resources. For close to four decades now, an important source of foreign exchange inflow into India — which has a stabilising effect on the balance of payments — has been remittances from abroad. Together with earnings from exports of software services, remittances have helped India deal with various shocks on the balance of payments front. Moreover, while the earnings from software services exports are losing their buoyancy, remittances have shown a strong upward trend.

So, it would be useful to compare trends in remittance inflows from non-resident Indians with outflows on account of the LRS for residents. As Chart 2 shows, starting from a low of 2 per cent or less in 2013-14 and 2014-15, the ratio of LRS outflows to remittance inflows rose to 7.4 per cent in 2015-16, 14.4 per cent in 2016-17 and 19.5 per cent in 2018-19. That is, as much as one-fifth of the inflows on account of inward remittances are being drained out through the LRS window.

Reasons given

This sudden, steep and significant increase in outflows through the LRS window is not easily explained. However, there are some messages that can be gleaned from an examination of the composition of LRS outflows. In 2014-15, before the outflow spike, besides transfers as ‘gifts’ and donations, the main heads under which significant outflows were recorded were for financing ‘study abroad’ and ‘investment in equity and debt’, followed by maintenance of close relatives abroad.

With rich Indians known to make donations to institutions and universities abroad, send their children to study there and seek to diversify their asset portfolios, the first three of these exit routes are understandable. To that can be added a small outflow to maintain relatives abroad. However, as Chart 3 shows, along with the sharp increase in the composition of remittances, there have been significant changes in composition. Between 2014-15 and 2018-19, ‘travel’ has emerged as the dominant head for outflows, with its share in total LRS outflows rising from just 1 per cent to 36 per cent.

In just one year between 2016-17 and 2017-18, outflows under this head rose from $2.6 billion to $4 billion (Table 1). It is difficult to believe that all of a sudden, the number of Indians travelling and spending abroad rose by this proportion.

Besides travel, two categories that registered significant increases are transfer to finance studies abroad, the share of which rose from 22 per cent to 27 per cent; and transfers for maintenance of close relatives, which went up from 14 per cent to 21 per cent. The share of ‘gifts’ on the other hand fell from 32 per cent to 10 per cent and that of investment in equity and debt from 13 per cent to 3 per cent.

Ambiguous transfers

If travel, studies abroad and maintenance of close relatives are taken together, their share rose from 36 per cent of total transfers in 2014-15 to as much as 75 per cent of a much larger total of transfers in 2018-19. Since transfer for studies abroad must be based on some evidence of expenses to be incurred, this cannot be a head under which funds that are substantially in excess of requirements are transferred. In any case, the increase in the share of this head has been less than that for travel and maintenance of close relatives.

The latter two heads are more fungible, and can be used for purposes other than originally specified, and could reflect transfer abroad of savings from India to foreign locations, facilitated by the rule introduced as part of the LRS that Indian residents are allowed to hold accounts abroad to which foreign exchange bought with domestic currency can be transferred. Also, once outside the country, these funds are more easily transferred to the accounts of others.

The growing importance of these more fungible heads in total transfer, combined with the sudden spike in total outflows, suggests that the LRS has become a means for resident Indians to transfer wealth out of India, without having to necessarily invest in international debt or equity instruments, the values of which are shaky in the current environment. If that is true, the problem of ‘capital flight’ takes on a whole new connotation.

As evident from Latin America, when periods of instability have been associated with residents dumping assets denominated in domestic currencies, it is not only foreign investors who may retreat; domestic wealth-holders can choose to substitute domestic-currency denominated assets with assets denominated in foreign currencies.

That aggravates the problem of capital flight and increases the degree of vulnerability of countries with open borders, not only for foreign investors but also residents, as long as the cap on transfer of saving/wealth abroad is not too stringent.

The unusual spike in LRS outflows suggests that India’s external vulnerability has increased; unless, as in 2013, the LRS policy is revised.

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