With the Great Recession behind us and India quickly re-emerging as a favoured destination for foreign capital flows, the question as to how much of external capital is good for the country is once again being posed. Prior to the crisis, India had experienced a surge in capital inflows in the years after 2002-03. From a level of $10.8 billion in 2002-03, net capital inflows into the country rose to $28 billion in 2004-05, $45.2 billion in 2006-07 and a huge $106.6 billion in 2007-08.
The problems this capital inflow surge had created for monetary and exchange rate management, coupled with policy initiatives in other emerging markets like Brazil, had revived interest in the use of capital controls. But the discussion was rendered irrelevant by the 2008 recession, which resulted in FII outflows and reduced inflows that brought the net capital inflow figure down to $7.2 billion in 2008-09.
However, matters have changed since then. Net capital inflows recovered to $53.6 billion in 2009-10, and early figures suggest that while there may be some change in composition, aggregate flows are likely to rise this year. Should India, with foreign currency assets of $283 billion, plan for moderating inflows if another surge follows?
According to a media report (Indian Express August 4, 2010), sections of government believe that India has the capacity to “absorb” upto $150 billion of capital inflows in a year, since strong growth will result in a rising current account deficit that needs to be financed. This figure is even higher than the already large figures of $73 billion in 2010-11 and $91 billion in 2011-12 that the Prime Minister’s Economic Advisory Council has speculatively predicted would flow into the country, which it too feels can be “absorbed”.
The notion of absorption here is difficult to understand. If it means that India would be able to put this large volume of foreign capital to good use, the evidence thus far is not supportive. To start with, in most years only a small part of this capital is need to finance our import bill. As the chart shows, in the first three of the years between 2001-02 and 2009-10, India recorded a small current account surplus and, therefore, required no capital inflow to finance a deficit. Over the rest of this decade the ratio of the current account deficit to net capital inflows was above one only in a single year, and it was well short of half in four years out of six. In the single year the ratio exceeded four, the reasons were external. The recession adversely affected India’s export revenues and widened the current account deficit, while the decision by foreign investors to book profits here and cover losses or meet commitments at home resulted in a sharp fall in capital inflows. These exceptional and contrary movements in the size of the deficit and the volume of net inflows resulted in a sharp rise in the ratio.
So even ignoring the fact that India’s current account deficit needs to be reined in, the inflows we receive are far in excess of what we require. The resulting surfeit of foreign exchange in the economy exerts upward pressure on the rupee, with the possibility of a currency appreciation that can undermine India’s limited export competitiveness. This forces the Reserve Bank of India to step into the market and buy foreign exchange to stabilise the rupee. The net result, as depicted, is that much of the inflow results in reserve accretion with the Reserve Bank of India. While this was warranted initially as a means of creating a foreign exchange buffer to insure against outflows, the central bank’s foreign assets are now well above the required level. This calls for caution in adding excessively to reserves in future especially given the costs involved in holding such reserves and the problems it creates for monetary management.
It is not only as foreign exchange that the capital inflow is not being “absorbed” by the system. It is also not true that the rupee counterpart of these funds is sustaining productive investment in the economy. Much of the money is being invested in already subscribed equity through the stock market, through the financing of acquisitions or through privately negotiated equity sales to investors expecting capital gains. Very little of the inflow goes to finance investments in “greenfield projects”. This also implies that the inflow is not creating the capacity to deliver or actually delivering the export revenues that can partly or fully finance the payments commitments in foreign exchange that are associated with those inflows.
In sum, foreign capital inflows of recent years are far in excess of what can be “absorbed” in ways that are economically rational. On the other hand, the stock of foreign investment resulting from these large inflows renders the country vulnerable to sudden outflows that are destabilising and create problems for macroeconomic management, as happened in 2008-09. Hence, rather than celebrate the inflows as recognition for India’s economic success and wrongly argue that they are being absorbed, the government could do well to think of instruments that can help moderate such flows, especially in periods when the country is faced with a surge in capital inflow.