India - Capital Inflow Challenges

Benefits of capital inflow for a country are-
1. External capital can supplement domestic savings and stimulate economic growth. International borrowing and lending enable countries to neutralize fluctuations in income and attain smooth consumption stream.
2. This improves welfare. However, as to the developing countries, capital inflows have been markedly pro-cyclical so that the gap between boom-time and bust-time consumption was actually widened and not narrowed.
3. The lenders gain from higher return and better international portfolio diversification.

Problems of Foreign Capital (Global Perspective)
1. Appreciation of real exchange - In most Latin American countries inflow has been accompanied by marked real appreciation. This has not occurred for the Asian economies, with the exception of the Philippines.
2. Accumulation of FER - How much FER should a country hold at any point in time to counter speculative attack on its currency? There is no unique answer. However, from a macroeconomic viewpoint, government policies in a demand-deficient situation should try to ensure that the economy’s expenditure on capital accumulation is met through domestic, not foreign finance. FDI can be beneficial if it leads to additional investment which cannot otherwise be undertaken or if it acts as a vehicle of better technology or other positive supply-side factors.
3. Widening of current account deficit (CAD) - Although Williamson’s rule of thumb suggests a safety limit of 40% for the debt-gross domestic product (GDP) ratio, Mexico’s crisis started when it was only 8%. Prudent fiscal policy is by itself not enough to avert crisis, as demonstrated by the experience of East Asia. However, with public deficit under control, the financial system can handle inflows better.
4. Monetization - The heavy capital inflows of the 1990s have been accompanied by slightly higher levels of inflation in Asia, while inflation has fallen in Latin America due to sharp real appreciation of currencies.
5. Financial crisis - Increased openness to international capital flows has been associated with an increasing frequency of financial crises. One-third of these crises are twin banking and currency crises. Pure currency crises have declined as countries have moved towards more flexible exchange rate systems but banking crises have loomed larger with the dismantling of capital controls and regulations. The average cost of an emerging market currency crisis is estimated at 8% of forgone GDP, rising to as high as 18% when a banking crisis occurs simultaneously. For Indonesia in 1997 the cost was more than 30%. According to one estimate each percentage point fall in growth raises the poverty rate by 2 percentage points. For preventing financial instability, regulations that limit the exposure of banks to the volatility of equity and real estate markets, as well as ensuring risk-based capital adequacy are in order; but the flip side is that these policies may promote disintermediation, which refers to new institutions that develop to bypass these restrictions. Moreover, greater control on banks may amount to a reversal of the trend of financial liberalization currently in progress in developing countries.

For India the Govt. and RBI have been unsuccessful in managing capital inflow.
Two basic mistakes made by the Govt. which has lead to this situation are-
1. The Govt. misread the evolving economic trends toward acceleration in economic growth and related risks to inflation that would warrant tighter monetary policy. The Govt. forgot that a boost to economic activity - even if it were designed to expand capacity eventually - would worsen demand-driven inflation pressures in the near term.
2. The government favored an accelerated pace of capital account liberalization at a time when the RBI was already having difficulty in dealing with the existing magnitude of capital inflows. There was an unprecedented global liquidity seeking a favorable place to be parked and India became the most favored destination. This further complicated the monetary management task.
Other factors that played a role in this mismanagement are –
1. Single door entry to foreign investment is a root cause of high pressure building up in the equity market.
2. The lack of policy coordination between various policymakers. This helped the financial market in thriving by taking advantage of the policy inconsistency.
3. There were very few economic reforms when compared to the encouragement given to the capital inflow.
4. The govt was short of tools to deal with surged capital inflow.
5. The signals of accelerated pace of capital account convertibility only fuelled expectations of further rupee appreciation, already in place owing to a combination of the attractiveness of India's economic rise, weaker US dollar and surging global liquidity.
In the future we can expect more problems from the rising rupee. So far we have seen how it has affected the exporter’s margins and lead to job cuts. In the future we may witness impacts on domestic producers due to cheap imports.
The way out -
1. The govt should come up with policies to check rupee appreciation. Hedging against currency movements can be an affective way.
2. Increasing the absorptive capacity of the economy. This can be achieved by better education and infrastructure.
3. Extending the entry of foreign investors through different options, including the commodity market, to diffuse excess funds. (All funds seek solace in the equity market as interest rates and forex hedging can be done through the process of trading in equities.)
4. Provision of export sops.