The copious flows from foreign institutional investors have prompted policy initiatives in many countries

One of the key challenges before policymakers in emerging economies is to balance the interests of foreign capital with the needs of the domestic economy. In many countries, including India, there is now a much more nuanced view on the role of foreign capital than what obtained even a few years ago.

In all developing countries there is a realisation that not all forms of cross-border capital inflows are equally desirable from a domestic perspective. The copious flows from foreign institutional investors (FIIs) especially (can be an embarrassment) have prompted policy initiatives in many countries. At the present juncture, many emerging market economies ranging from Brazil to Indonesia have placed restraints on inward foreign capital flows.

Quite different in India

The situation in India is, however, quite different. Even though at varying times in the recent past different people have argued for some form of controls or other, the position has not changed over the years. While there are ceilings for foreign investors in the debt and government securities markets, the equity markets are practically free from controls. And that is where the bulk of the foreign institutional money has been going into. The sheer volumes are a factor to be reckoned with.

Equally important the fact that the flow is particularly strong during specific periods — the investments from abroad seem to have a herd mentality — lends a new edge to the debate concerning such flows. For instance, between July and the third week of November, net capital inflows have been a record $28.6 billion. Obviously, the term herd mentality can describe movements in the other way too. FII money tends to flee emerging markets in droves. Most important of all, FIIs' action, to invest or withdraw, is governed less by factors specific to India (or any other emerging market) and more by circumstances prevailing in their home countries.

Second, even factors that are only remotely connected with India seem to have a direct bearing on the flow and direction of such investments.

Third, in the scheme of things, as it exists today, most fund managers do not differentiate between countries classified under the same category such as, say, emerging markets. A decision to pull out (or to invest) is taken on the basis of such wide classification. Hence, increased risk-aversion on the part of the fund mangers would imply that all the emerging markets would come under the scanner.

The last point is best illustrated by the reaction of the markets to the heightened tension between North and South Korea on Tuesday last. Suddenly all emerging markets — not just those located in the vicinity of the Korean peninsula — became risky. Indian stock markets witnessed one of its most volatile days of trading in recent memory. Also, last week the Irish debt crisis, with all its political and economic ramifications, hit the headlines. That, like the hostilities between North and South Korea, is no doubt a portentous development, but it seems incomprehensible that it should sway stock markets everywhere in the way it did.

India's approach to FII inflows is conditioned by the fact that they are necessary to bridge the current account deficit and provide a small cushion in the balance of payments. But what about the surge in inflows, which are expected for a variety of reasons? Is the policy stance valid even if capital inflows increase enormously to, say, $70-75 billion this year as anticipated by top policymakers?

There is near unanimity that aggregate flows to India are set to increase. Bulk of them, almost 80 per cent, will be in the nature of short-term flows. Like other countries, India's preference is for the more permanent foreign direct investment (FDI). In recent years, FDI is increasing, but has fallen far short of the FIIs. Despite their being of short-term nature and hence having the propensity to flit in and out of countries FIIs are needed at this juncture.

More to the point, even the expected surge in capital inflows can be managed. The current deficit is widening and is forecast to be over 3 per cent of the GDP in the current fiscal. That would be around $40-45 billion and can be bridged by the short-term flows. Making the point recently, the Chairman of the Economic Advisory Council to the Prime Minister, C. Rangarajan, and Planning Commission Deputy Chairman Montek Singh Ahluwalia felt that since a large proportion of the capital flows would be absorbed there was no need for controls over them.

India's dependence on the short-term flows, however, poses risks. A reversal of capital inflows, in case of an extended period of risk aversion, could lead to a sharp sell-off in equities, currency and bonds and cause a sharp liquidity crunch leading to a fall in output. In fact, the strengthening of the rupee in the wake of the dollar inflows has made exports from India less competitive. Since the widening trade deficit, on account of larger imports, is primarily responsible for the widening current account deficit, the rupee appreciation contributes to the deficits.

Keywords: FDIFIIcapital inflow

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