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Changing Contours of Capital Flows to India

The Indian experience with capital flows during the period 1950s to the first decade of this century reveals a paradigm shift from a prolonged period of capital scarcity to one of surplus, however characterised by a volatile pattern of inflows. The key structural aspects include a significant shift from official to private capital flows and from debt to non-debt flows. Non-resident Indian deposits show considerable sensitivity to interest and exchange rate fluctuations. The corporate preference for overseas borrowings is predominantly influenced by domestic activity; but the persistence of interest rate arbitrage and global credit market shocks also have a significant impact. Foreign institutional investment inflows and stock prices have a bidirectional causal relationship with a time varying nature of the stock price volatility. Volatile capital flows rather than trade flows seem to drive real exchange rate movements with consequences for the real economy.


Changing Contours of Capital Flows to India

Bhupal Singh

The Indian experience with capital flows during the period 1950s to the first decade of this century reveals a paradigm shift from a prolonged period of capital scarcity to one of surplus, however characterised by a volatile pattern of inflows. The key structural aspects include a significant shift from official to private capital flows and from debt to non-debt flows. Non-resident Indian deposits show considerable sensitivity to interest and exchange rate fluctuations. The corporate preference for overseas borrowings is predominantly influenced by domestic activity; but the persistence of interest rate arbitrage and global credit market shocks also have a significant impact. Foreign institutional investment inflows and stock prices have a bidirectional causal relationship with a time varying nature of the stock price volatility. Volatile capital flows rather than trade flows seem to drive real exchange rate movements with consequences for the real economy.

The views expressed are the author’s personal views and not those of the Reserve Bank of India.

Bhupal Singh ( is in the Department of Economic Analysis and Policy of the Reserve Bank of India, Mumbai.

he trade channel was considered as the traditional mode of the integration of the global economy. However, international mobility of capital, particularly since the 1970s, has provided a new dimension to the concept of openness and economic integration. The liberalisation of India’s external sector and increasing integration into the global economy in the 1990s and the current decade have resulted in the relative dominance of the financial channel over the conventional trade channel. While the aggregate trade flows increased from 10% of the gross domestic product (GDP) in the 1970s to 28% in the first decade of the 2000s, gross capital flows (inflows + outflows) increased sharply from 4% of GDP to 30% during the same period. These developments were underpinned by a sustained momentum in domestic real activity, corporate sector restructuring, a positive investment climate, a long-term view of India as an investment destination and favourable credit conditions in the global market. However, the absorption of capital flows has remained low with a moderate level of the current account deficit (CAD) in the 1990s and the current decade and the consequent build-up of foreign exchange reserves.

Against the above backdrop, large capital inflows have implications for the real sector of the economy through interest and exchange rate channels.1 The excessive capital inflows beyond the absorptive capacity, in conjunction with workers’ remittances and software exports, could have the potential for creating an overvalued exchange rate and the consequent erosion of long-term competitiveness of the traditional goods and services sectors – the Dutch disease phenomenon. It is argued that given the employment dimensions of the traditional sectors of the economy, the Dutch disease syndrome is managed by way of reserve management and sterilisation, the former preventing excessive nominal appreciation and the latter preventing higher inflation (Mohan 2007). Some of the concerns emanating from the expansionary phase of the capital flow cycle have abated with a reversal in the cycle since the mid-2008. However, a sudden shift from expansionary to contractionary phase of the capital flows cycle to emerging market economies (EMEs) and India has potential costs in terms of financial market instability, and an adverse impact on investment and the real sector of the economy. Thus, the rapid movement of capital flows and high volatility associated with capital flows is a challenging issue for macroeconomic management.

The literature on international capital flows reveals that mobility of flows is associated with various benefits and costs. In terms of benefits to the financial markets, the increased mobility of capital contributes to the development of markets in terms of liquidity and price discovery. At the same time, as evident from various crises across countries during the 1990s, an increase in volatility of capital flows poses several risks to the financial markets and the real

october 24, 2009 vol xliv no 43

economy. The surges in capital flows to the EMEs and the associated overshooting of the exchange rate and the currency crises have led to the proliferation of literature on the subject.2 It broadly focuses on two major implications of volatile capital flows, i e, for macroeconomic stability and financial stability. Short-term volatile capital flows have a significant influence on asset prices, exchange rate, interest rate, consumption, investment, trade and thus, the aggregate demand, rendering some of the earlier anchors of monetary policy formulation possibly obsolete. The aggregate demand, in turn, affects output and prices, the two key policy objectives.

This paper analyses the key structural shifts that occurred in respect of capital flows to India. Section 1 provides an analysis of the broad policy shifts, changes in the gross magnitude of capital flows and the major compositional shifts. Section 2 analyses structural aspects of the various types of debt flows with the decline in official aid and the emergence of private capital flows. The issue of the primacy of foreign investment flows is analysed in Section 3 with a focus on the stability of foreign direct investment (FDI) inflows versus the volatility of portfolio flows. Section 4 analyses the spill over of capital flows to monetary management. The key findings of the paper are presented in Section 5.

1 Policy Shifts, Magnitude and Composition of Capital Flows

A historical account of the policy approach to international capital flows to India suggests that beginning with the 1950s, a complex maze of controls was imposed on all external transactions between residents and non-residents independent of trade or other policies. In fact, a significant part of the control regime to subserve the developmental efforts of the planning era was built upon the framework of war-related controls, which was put into a more rigorous framework through legislation in 1973 due to fears of capital flight (Reddy 2000). Thus, external financing was done dominantly through reliance on official flows from the 1950s through the 1970s. The decade of the 1980s, however, heralded a regime shift in capital flows to India with ascendancy of private capital flows in the form of external commercial borrowings (ECBs), non-resident Indian (NRI) deposits and short-term trade credit. The liberalisation of the foreign investment regime in the 1990s heralded a further shift in the capital flows to India, particularly the equity flows. In the aftermath of the balance of payments (BOP) crisis of 1991, policy actions were initiated as a part of the overall macroeconomic management to achieve stabilisation and structural changes.

The external sector policies designed to progressively open up the Indian economy formed an integral part of the structural reforms. In the 1990s, the lessons drawn from managing the crisis led to external sector policies that emphasised consolidation of external debt and a policy preference for non-debt creating capital flows. The key policy responses to capital flows have been in the form of a strong hierarchy in the sources and types of flows, liberalisation of inflows relative to outflows, but freeing up of all the outflows associated with inflows and a shift from administrative or quantity-based controls to price-based measures. The anatomy of the instruments of controls reveals that restrictions on capital inflows are a mix of both quantity and price, taking into consideration the hierarchy of capital flows. However, the controls on outflows are mainly quantity-based (Table 1). These appear to be broadly successful in achieving the desired objectives. The gradual withdrawal of restrictions on capital inflows and the liberalisation of outflows seem to have reinforced capital inflows.

The current global financial crisis has, however, highlighted the strong sensitivity of global capital flows to financial shocks and swift changes in the perception of risk towards EMEs. The sudden reversal in the capital flow cycle to India led to policy responses in the form of an upward adjustment of the interest rate ceiling on NRI deposits, substantial relaxation in the ECB regime for corporates, allowing access to ECBs to non-banking financial companies and housing finance companies and relaxation in the interest rate ceilings for trade credit. Thus, the emphasis shifted from the policy dealing with consequences of heavy inflows to sudden reversals of such flows and the potential volatility. Thus, the inherent volatile nature of capital flows to EMEs underlines the importance for an active capital account management.

Table 1: Types of Major Restrictions on Capital Inflows and Outflows in India

Items Administrative/Quantity-Based Price/Market-Based FDI into India Substantially free but subject to some sectoral caps with a negative list of the sectors of strategic national importance. American Depository Receipts Subject to overall FDI sectoral caps. (ADRs)/Global Depository Receipts (GDRs) ECBs/Foreign Currency Convertible Bonds (FCCBs) Under the automatic route, ECB up to $500 million per company Ceiling on interest rate linked per financial year is permitted for foreign currency or rupee expenditure to London Interbank Offer Rate (Libor). with sectoral restriction to invest in industrial sector including SME and infrastructure. ECBs above $500 million are under the approval route. Short-term trade credit for imports into India Short-term trade credit up to $20 million per import transaction for all Ceiling on interest rate linked to Libor. permissible imports with a maturity period of one year is allowed under the automatic route. Trade credit up to $20 million per import transaction with maturity period of less than three years is allowed for import of capital goods under the automatic route. Overseas borrowings by banks Restricted to 50% of Tier I capital of banks or $10 million whichever is higher. NRI deposits – Ceiling on interest rate linked to Libor. FII investment in debt Ceiling of $15 billion in corporate debt and $5 billion in government securities. Indian overseas investment (outward FDI) 400% of net worth of the company Outward portfolio investment Mutual funds allowed to invest abroad up to $7 billion. Portfolio investment by listed Indian companies 50% of the net worth in listed shares and rated and listed debt instruments. Liberalised remittance scheme for individuals $200,000 for permissible capital and current accounts. Economic & Political Weekly october 24, 2009 vol xliv no 43 59

During the past six decades, dramatic shifts have occurred in the capital account, leading to a 13-fold increase in gross transactions as a ratio to GDP between the 1950s and the current decade (Table 2). The annual gross capital inflows to India witnessed a level shift Table 2: Size of India's Capital Account ($ billion) during the 1990s and the

Period Averages 1950s Capital Receipts 0.4 Capital Gross Transactions Payments (Receipts + Payments) 0.2 0.6 current decade, after a moderate growth during
(1.4) (0.9) (2.3) the 1950s through the

(3.2) (1.4) (4.6)

flows as a ratio to GDP

1970s 2.4 1.7 4.1

(2.5) (1.8) (4.3) rose to 3.8% of GDP dur

1980s 8.5 4.7 13.2 ing the first decade of
1990-91 (3.5) 22.8 (1.9) 15.7 (5.4) 38.5 this century from 2.2% in
(7.2) (5.0) (12.2) the 1990s and 1.2% dur
1991-2000 30.6 22.8 53.4 ing the period 1950-80.
2000-09 (8.8) 151.4 (6.6) 122.9 (15.4) 274.3 This voluminous in
(17.1) (13.3) (30.4) crease was a reflection

Figures in parentheses are ratio to GDP.

of a shift from the con-

Source: Computed from India's Balance of Payments: 1948-49 to 1988-89, RBI and Handbook of Statistics on the trolled capital account Indian Economy, RBI.

to a progressively liberalised regime, the development of financial markets, real sector reforms and the returns on capital. Thus, while till the 1980s capital inflows were barely adequate to finan ce the CAD, the 1990s marked a paradigm shift with the inflo ws far exceeding the CAD, turning the BOP into surplus from a prolonged phase of capital scarcity.

In tandem with the growing size, the capital account of India’s BOP has been characterised by a significant compositional shift

Figure 1: Compositional Shifts in India’s Net Capital Flows


100 80 60 40 20 0 Debt FDI 30.3 2.0 86.2 2.3 64.6 Grants 33.1 29.9 43.4 24.1 29.4 11.9 10.4 30.5 Portfolio equity

1970s 1980s 1990s 2000s

from debt and external aid to non-debt investment inflows (Figure 1 and Table 3). During the reform period, external aid ceased to be an important element of capital inflows with the ascendancy

Table 3: Net Capital Inflows to India

of private capital flows, a phenomenon observed also in other developing countries. Over the years, the decline in debt flows reflected the policy-induced changes in the composition of the capital account in favour of non-debt flows. The FDI inflows have witnessed rapid growth in recent years, catching up with that of China. Portfolio equity flows remained steady, reflecting the long-term growth potential and the lower risk perception of the Indian economy. However, this perception changed in 2008-09 with large foreign institutional investors (FII) outflows from the Indian stock market and drying up of liquidity for the Indian American depository receipts/global depository receipts (ADR/GDR) and foreign currency convertible bonds (FCCB) markets overseas.

2 Shift from Official to Private Debt Flows

It is argued that foreign aid can facilitate economic and social transformation by overcoming temporary shortages in specific human and material resources, promoting strategic activities, inducing and facilitating critical government policies and providing working capital for carrying out programmes involving a transformation of the structure of the economy (Mikesell 1968). A time series analysis of several countries in Asia, including India, Pakistan and China, suggests that aid contributed to growth both in poor and middle income countries (Krueger 1978; Islam 1992). There is no evidence to suggest that countries that received a large amount of external aid have performed poorly (apart from countries suffering from civil or external conflicts) and the empirical evidence that high aid levels exert an independent negative impact on governance is unconvincing (World Bank 2003). It is often argued that governments of the aid-receiving countries divert foreign aid from intended purposes to various unproductive uses and/or to support general government expenditure. Various studies have indeed found fungibility of foreign aid. Despite differing viewpoints, the role of external assistance in the development process of developing countries cannot be overemphasised.

External assistance in the form of concessional, non-marketbased finance from bilateral and multilateral sources remained as a mainstay of the capital account of India’s BOP till the early 1980s. Towards the end of the 1970s, the concessionality in the aid flows dwindled. Thus, with the rising external financing requirements in the 1980s and the recognition that reliance on ex

ternal assistance was not favourable, there was a

Period Averages Investment External ECBs NRI Deposits Net Capital Flows shift in the overall approach towards aid flows. In $ mn % of GDP $ million % of GDP $ million % of GDP $ million % of GDP $ million % of GDP

the recent decades, the policy towards management

1950-55 12 0.1 18 0.1 – – – – -26 -0.1

of external liabilities has changed and the initiative

1955-60 46 0.2 194 0.6 – – – – 278 0.9

is towards attracting private capital flows, especi ally

1960-65 55 0.1 718 1.6 – – – – 724 1.7 1965-70 41 0.1 986 1.9 – – – – 967 1.8 non-debt creating direct investment inflows. Thus, the

1970-75 60 0.1 278 0.4 78 0.1 – – 164 0.3 share of official assistance in total capital flows to

1975-80 13 0.0 1,046 0.9 149 0.1 171 0.1 1,067 0.9 India has consistently declined from 33% in the 1970s

1980-85 --1,149 0.6 574 0.3 457 0.2 2,042 1.0 to about 6% in the first decade of this century. 1985-90 349 0.1 1,825 0.7 1,513 0.6 1,813 0.7 5,821 2.2 In the 1980s, a widening CAD, increasing financing 1990-91

requirements and diminishing role of official aid led

(Crisis year) 103 0.0 2,210 0.7 2,248 0.7 1,536 0.5 7,056 2.2

to a shift in the poli cy choice towards commercial

1990-95 1,990 0.7 2,107 0.8 997 0.3 1,041 0.4 6,449 2.2 1995-2000 4,790 1.2 924 0.2 2,559 0.6 1,616 0.4 8,964 2.2 borrowings from international capital markets.3 The

2000-09 19,920 2.5 594 0.0 5,813 0.6 2,237 0.4 29,495 3.8 recourse to commercial borrowings by the Indian

- Nil.

corporates, though began in the 1970s, remained

Source: Computed from India’s Balance of Payments: 1948-49 to 1988-89 and Handbook of Statistics on the Indian

Economy, RBI.modest due to the dominance of external aid. The

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commercial borrowings were, however, regulated by an approval procedure subject to conditions on cost, maturity, end use and ceiling. In the second half of the 1980s, financial institutions and public sector undertakings increased their participation in the international bonds market, consequently the share of ECBs in net capital flows to India more than doubled to 27% in the 1980s from that in the 1970s. Following the BOP crisis of 1991 and downgrading of sove reign ratings, firms’ access to global markets virtually dried up.

Thus, a prudent external debt management policy was pursued to bring the external debt to a comfortable level. The ECBs rose significantly in the latter half of the 1990s responding to the strong domestic investment demand, favourable global liquidity and credit rating, lower risk premia on EME bonds and an expansionary phase of the global capital flow cycle. During this period, ECBs constituted about 30% of net capital flows to India. In the subsequent period (late 1990s and the early years of this decade), the demand for ECBs remained subdued due to a host of factors such as the global economic slowdown, reversal of the cycle of capital flows to EMEs and moderate domestic demand. The period beginning 2003 marked the resumption of debt flows to EMEs, which was a combined outcome of a higher interest rate differential, robust growth expectations and a low risk perception. During this period, Indian corporates also increased their recourse to ECBs, which contributed to about 25% of the net capital flows to India.

A key issue in relation to ECBs is what drives the borrowing behaviour – the domestic demand or the interest rate arbitrage. The utilisation pattern reveals that ECBs are largely used to finance the imports of capital goods (i e, machinery, equipments). Thus, capital goods imports are the conduits linking ECB demand to the real activity. External borrowings show strong comovement with the domestic activity (Figure 2). The correlation Figure 2: External Commercial Borrowings and Domestic Industrial Activity


1991-92 1993-94 1995-96 1997-98 1999-2000 2001-02 2003-04 2005-06 2007-08 2008-09 (A-0) −−−−−−−−−− Growth rate of ECBs Growth rate of IIP (right scale)


50 12 0





-100 4 -150




between index of industrial production (IIP) growth and ECB mobilisation is observed to be high.

The persistence of significant interest rate differentials (i e, the commercial banks’ prime lending rate minus the six-month Libor) is observed to be influencing corporates’ access to overseas markets (Figure 3). The correlation between ECB disbursements and interest rate differentials between domestic and external markets is found to be high. Empirical studies suggest that Indian corporates’ long-run demand for overseas commercial borrowings is predominantly influenced by the pace of domestic real activity, followed by interest rate differentials and the credit conditions in domestic markets. However, domestic demand was found to dominate the price variable (Singh 2008). However, the evidence from the current global financial crisis reveals that the international credit market shocks play an important role in explaining corporate borrowings

Economic & Political Weekly

october 24, 2009 vol xliv no 43

from overseas market. The growth in corporate borrowings from international markets sharply declined with the onset of the global financial crisis, notwithstanding persistence of large interest rate arbitrage (Figure 3). Thus, while during the normal periods the overseas borrowings are influenced by the underlying domestic demand shocks, the external credit shocks seem to be the most dominant factor during the periods of financial crisis.

2.1 What Determines the NRI Deposit Inflows?

In the 1970s, the oil shocks shifted substantial resources towards oil exporting countries which engendered investment and employment opportunities in such countries. At the same time, a number of developing countries with migrants in oil exporting countries, attempted to mobilise the savings of their migrant workers by offering special non-resident deposit schemes with incentives such as a higher interest rate, tax incentives and exchange guarantees. Such schemes have been successful in countries with a large expatriate population such as Turkey, Israel,

Figure 3: ECB Disbursements and Interest Rate Differentials






-200 1993Q:2 1994Q:4 1996Q:2 1997Q:4 1999Q:2 2000Q:4 2002Q:2 2003Q:4 2005Q:2 2006Q:4 2008Q:2

Interest rate differential between PLR and 6-month Libor (right scale) Growth in ECBs

Egypt, Lebanon, Greece, Spain, India, Pakistan, Sri Lanka, Thailand and some east European countries. Most of these countries instituted deposit schemes denominated in both foreign currency as well as the local currency. In most cases, the principal of the deposit along with the accrued interest were freely repatriable. In the Indian case, NRIs were allowed to open and maintain bank accounts

– both the rupee and the foreign currency denominated – in India under special deposit schemes in the mid-1970s. In the 1980s, investor preference clearly shifted in favour of foreign currency denominated deposits partly due to the interest rate differential and also due to the exchange guarantees. The deposits of NRIs proved to be a stable source of support to India’s BOP up to 1990.

The external payments difficulties of 1990-91 demonstrated the vulnerability associated with such flows. Consequently, since the 1990s, the policy with respect to the NRI depo sits has been to reta in the attractiveness while at the same time reducing the effective cost of borrowings and aligning the overall interest rate structure. In the recent period, such deposits have declined in significance as

an important source of Table 4: Trends in NRI Deposits ($ million)

Year Inflows Outflows Net Flows Share in Net

capital inflows (Table 4).

Capital Flows (%)

Another key aspect of

1975-76 – – 42 4.6 NRI deposits has been a 1980-81 – – 226 13.6

structural shift from for-1985-86 – – 1,444 32.0

eign currency to rupee 1990-91 7,348 5,811 1,536 21.8 1995-96 6,775 3,425 1,103 27.0

denominated deposits.

2000-2001 8,988 6,672 2,316 26.2

The share of rupee de

2005-06 17,835 15,046 2,789 11.9

posits in total outstand

2008-09 27,760 25,645 2,115 13.8ing NRI deposits in- (April-December)

- Indicates not available.

creased from 28% at

Source: India’s Balance of Payments, 1948-49 to 1988-89 end March 1991 to 68% and RBI Bulletin, RBI, various issues.

at end March 2009. This shift towards domestic currency depos flows. Consistent with the principle of hierarchy of capital flows,
its can be attributed to a number of factors such as the withdrawal India has been making efforts towards encouraging inflows
of exchange guarantees on foreign currency deposits to banks, through FDI and enhancing the quality of portfolio flows by a
the relatively higher returns on rupee deposits and the growing strict adherence to the “know your investor” principle (Reddy
home bias in NRI deposits. 2007). Reflecting the above mentioned developments, India’s
Regarding the determinants of non-resident deposits, it is con share in FDI flows to emerging and developing economies has
tended that migrants may remit funds into savings deposits pro shown a considerable rise from 1.6% in 1998 to 9% in 2008.
vided they can have foreign currency denominated accounts with The foreign investment policy of India can be broadly classi
higher than normal interest rates, tax exemptions and better ex fied into four phases: (i) cautious non-discrimination in controls
change rate (Meyers 1998). On the contrary, some studies reveal during the period 1948 to the mid-1960s; (ii) selective restric
that the relative rate of return on savings in the host and the home tions and control from mid-1960s to end 1970s with the promul
countries as also the incentive schemes such as foreign currency gation of the Foreign Exchange Regulation Act (FERA), 1973 and
accounts and premium exchange rates, do not significantly influ the Industrial Licensing Policy, 1973, as the main instruments of
ence remittances flows (Lucas and Stark 1985). In the Indian case, control; (iii) gradual and partial liberalisation in the 1980s with
Nayyar (1989) has argued that repatriated deposits had grown at special incentives for investment in export-oriented units; and
a faster rate in response to interest rate differentials resulting from (iv) wide-ranging liberalisation since 1991. As per the extant pol
declining interest rates in international capital markets. Another icy, FDI up to 100 % is allowed under the automatic route in most
study concludes that the flow of NRI deposits respond positively to activities with ceilings for some sectors crucial from the view
the difference between interest rates on these deposits and the point of strategic considerations or financial stability (Table 6).
Libor (Gordon and Gupta 2003). Further, the NRI deposit inflows Table 6: Sectoral Caps on FDI in India in Some Key Sectors
revealed the exchange rate sensitiveness (Jadhav 2003). We estimate a vector error correction model (VECM) for determination of Sector Ceiling Conditions (% to Equity Capital)
NRI deposits given that the Johansen co-integration test suggests a Private sector banks 74 Subject to guidelines of RBI for
single co-integrating vector. We use monthly data for the period 1993:1 to 2009:3 with two lags based on the various information branches/subsidiaries. Public sector banks 20 Prior approval. Insurance 26 Licence from Insurance Regulatory
criteria. The west Asian region was the main source of NRI depos & Development Authority (IRDA).
its inflows from the 1970s through the 1990s. Since there is no Investment in commodity exchanges 49
single indicator of real activity for the west Asian countries, we use the index of oil price as a proxy. Inte rest rate differential between the NRI deposits and six-month Libor indicates the arbitrage op- Asset reconstruction companies 49 Foreign Investment Promotion Board (FIPB) approval. Telecommunications 74 Automatic up to 49%, beyond that under FIBP route.
portunity to investors. Similarly, in case of the rupee denominated Trading 51 Automatic route.
deposits, depreciation of the rupee against the dollar yields higher 100 Exports, bulk imports with exports,
value in terms of domestic currency and hence provides incentive for higher inflows given the home bias built in the rupee deposits. cash and carry wholesale trading, trading of items sourced from small- scale industries (SSIs).
The estimated model sug-Table 5: Long Run Co-integrating Estimates Infrastructure/services 49 FIPB route.
gests that NRI depositsof NRI Deposits Air transport services 49 Subject to no direct/indirec equity
are significantly influenced by the economic activity in the host country (Log Poil). These deposits are also significantly impacted by the exchange rate move-Dependent Variable: NRI Deposits C 1.95 Log Poil(-1) 0.49 (5.25) rdiff(-1) 0.11 (4.29) Log Ex(-1) 1.51 (4.08) participation by foreign airlines with 100% participation for NRIs. Defence production 26 FIPB route subject to licensing under Industries (Development & Regulation) Act, 1951 and guidelines on FDI in production of arms and ammunition. Print media 26 Newspapers and periodicals subject to FIPB approval. Source: Ministry of Commerce and Industry, Government of India.
ments (Log Ex) and are found to be sensitive to interest rate dif- The sectoral dimensions of FDI flows provide important insights
ferentials (rdiff) (Table 5). Thus, the interest rate and exchange rate of the sector-specific pull factors as well as the industry-specific
sensitivity imparts an element of instability to NRI deposits flows. FDI policies and regulations. First, unlike the dominance of manu
facturing in the east Asian economies, FDI in India is concentrated
3 Emergence of Investment Flows in the services sector. Information technology has enabled a
greater growth potential and tradability of a number of business
3.1 Bi-Directional Movement in FDI Flows and professional services. With greater potential for growth of
In the 1990s, a major part of capital inflows to India was led by such services, FDI has also emerged as a vehicle for cross border
foreign investment, reflecting a shift from a prohibition of foreign delivery of services. Second, within the services sector, financing,
investment in the pre-reform period (before 1991) to a liberal insurance, real estate and business services have witnessed a
policy regime. Recognising the macroeconomic implications of large increase in their share in FDI flows to India between 2002-03
volatility associated with capital flows, India has adopted a policy and 2007-08. Computer services have also remained a key sector
of managing the capital account with a preference for non-debt for FDI as the captive business process outsourcing (BPOs) or
62 october 24, 2009 vol xliv no 43 Economic & Political Weekly

subsidiaries have been the principal mode of offshore delivery. Third, the manufacturing sector which constituted about 50% of the total FDI in India during the 1990s, has witnessed a sharp decline in its share to about 19% in 2007-08. Although the growth of FDI in the manufacturing has remained steady, it is the rapid expansion of FDI in the services sector that has resulted in the shrinking share of the manufacturing in total FDI inflows. Fourth, the construction sector has emerged as the next important activity attracting FDI with an average share of around 10% during 2002-08. Fifth, although the electricity sector has a large potential for investment, its share in total FDI has remained a meagre 2.7% during the period 2002-08, which could be mainly attributed to a lack of regulatory reforms in pricing and user charges (Table 7).

Table 7: Sectoral Distribution of FDI Inflows to India (Percentage distribution)

Sectors 2002-03 2005-06 2007-08
Fisheries 0.5 0.8
Mining 0.5 0.2 2.4
Manufacturing 29.0 37.4 19.2
Food and dairy products 2.4 4.4
Electricity 2.9 2.5 4.3
Construction 14.3 5.7 13.1
Trade, hotels and restaurants 2.4 2.8 2.5
Transport 0.7 2.0 4.2
Financing, insurance, real estate and business services 13.4 13.5 32.7
Computer services 17.9 22.9 5.3
Education, R&D 0.1 0.3 0.8
Miscellaneous services 1.1 1.5 2.3
Others 14.8 6.1 13.2
Total 100.0 100.0 100.0

FDI inflows relate only to the equity of incorporated entities, excluding acquisition of shares.

A discernable consistency in the source and direction of FDI flows to India is evident in the 1990s and the first decade of the 2000s. Mauritius, the United States (US), the United Kingdom (UK), Singapore, Germany, the Netherlands and Japan, which contributed 71% of total FDI to India during the 1990s, continued to dominate FDI flows to India during the current decade with a share above 70%; however their shares have been volatile. Many companies routed their investment to India through Mauritius to avail of the tax benefits under the bilateral tax treaty (Tab le 8). However, some diversification is evident in the regional sources of FDI in the recent period, away from the traditional source countries.

A unique feature of FDI flows to India is that even during the Asian crisis and the current global crisis such inflows have shown

Table 8: Source Regions of FDI Inflows to India (Percentage distribution) Figure 4: Movement in FDI and FII Inflows to India ($ million)12000


Country 1991-92 2000-01 2007-08
Mauritius 62.3 44.1 49.0
US 12.2 16.8 2.5
UK 1.5 3.2 3.1
Singapore 1.8 1.2 14.6
Germany 2.5 5.9 2.5
Netherlands 2.3 4.0 3.1
Japan 4.8 8.2 2.4
France 2.9 4.9 0.7
Others 9.7 11.7 22.1
Total 100.0 100.0 100.0
Source: Annual Report, Reserve Bank of India, various issues.
Economic & Political Weekly october 24, 2009 vol xliv no 43

9000 6000

3000 -0

-3000 -6000 2000 Q:1 2001Q:1 2002Q:1 2003Q:1 2004Q:1 2005Q:1 2006Q:1 2007Q:1 2008Q:1 2009Q:1

stability to the global financial market shocks. Further, such flows have displayed the lowest volatility among the components of capital flows and have worked as counterbalancing flows in the event of portfolio equity outflows (Figure 4). The volatility of FDI flows (in terms of coefficient of variation) during the period 2003:Q3 to 2009:Q1, the phase that coincided with the rising capital flows to the EMEs – has remained much lower (98%) as compared with that of FII equity inflows (194%).

India’s Overseas Investment

The growing competitiveness of Indian firms and their desire to venture abroad to access the wider global markets, operate near to client location, acquire technology, raw materials and brands, are the key drivers pushing Indian firms to invest abroad. The significant policy changes that began in 2000, contributed to the rapid expansion of Indian outward investment. Following the phased liberalisation in the regime for foreign investment, investment in the joint ventures (JV) and wholly owned subsidiaries (WOS) abroad emerged as the key vehicle for facilitating global expansion by the Indian companies. Furthermore, the bilateral investment and double taxation treaties enhanced the certainty and confidence with which Indian firms could invest in the partner countries.

The major policy initiatives that accelerated the pace of outward FDI included permission to invest in JVs/WOSs up to 400% by way of special purpose vehicles (SPVs) and through the swap of shares put under the automatic route, to hedge exchange risk on overseas investment, to invest in the financial sector subject to certain conditions. Overseas investment is being funded through a variety of sources such as drawal of foreign exchange in India, capitalisation of exports, balances held in exchange earners’ foreign currency accounts, swap of shares and funds raised through ECBs, FCCBs and ADRs/GDRs. Firms are also taking recourse to leveraged buyouts (LBOs) by setting up SPVs abroad which typically raise funds from international markets. The recent developments suggest that despite the collapse of international capital markets and the LBO conduit, the Indian corporate sector continued to finance the foreign acquisitions by substituting foreign sources of funds by domestic sources. Thus defying the recued access to external sources of funds, the outward direct investment of the Indian corporates reached $13 billion in 2008-09 (April-December) – the highest level achieved since the 1990s.

Overseas investment which started off initially with the acquisition of foreign companies in the information technology related services spread to other sectors, particularly pharmaceuticals, petroleum and minerals and ores. During the initial phase, the major FDI outflow was in manufacturing, which subsequently concentrated in

Table 9: Sectoral Concentration of India’s Overseas Direct Investment (Percentage share in total investment)

Year Manufacturing Financial Services Non-financial Services Trading Others Total

2000-01 23.9 0.8 66.4 7.3 1.6 100.0

2001-02 53.8 0.4 35.7 8.1 2.0 100.0

2002-03 70.7 0.2 22.5 4.6 2.1 100.0

2003-04 59.8 0.1 30.5 7.6 2.1 100.0

2004-05 64.8 0.4 17.2 11.0 6.6 100.0

2005-06 64.8 3.5 19.5 8.0 4.3 100.0

Source: Annual Report, RBI, various issues.

non-financial services and trading through mergers and acquisitions (Table 9). Such services are mainly the ones where Indian firms are exploring modes of delivery closer to the customer locations.

3.2 Volatility in Portfolio Equity Inflows

The most striking feature of change in the cross-border capital flows to emerging market economies during the 1990s is the emergence of portfolio equity inflows. Portfolio investments are generally expected to originate from countries with high levels of financial market infrastructure but low growth potential (i e, industrialised countries) and directed towards countries with a high growth potential but relatively less developed financial markets (i e, EMEs). Cross-country experience, however, does not support such a linear relationship on a universal basis. The debate on the relative importance of domestic and external factors in determining portfolio investment flows towards a country, however, remains inconclusive (Calvo et al 1993; Chuhan et al 1998; Buckberg 1996). The link between cross-border portfolio flows and domestic stock returns, especially the direction of causality also continues to remain a contentious issue (Bohn and Tesar 1996; Richards 2002; Brennan and Cao 1997). Certain studies observed a positive feedback of high stock prices on portfolio inflows in certain east Asian countries before the crisis, which did not hold true after the crisis (Kim and Wei 2000). Studies on the determinants of portfolio flows to India find co-movement between FII flows and the Bombay Stock Exchange Sensitive Index (BSE Sensex) to be fairly high (Chakrabarti 2001). A combination of domestic, regional and global variables was found to be significant in determining equity flows to India (Gordon and Gupta 2003). Among the domestic factors, strong macroeconomic fundamentals, stable financial sector, performance of the corporate sector and expectations of long-term high growth in valuations led to large portfolio flows.

Portfolio investment in India started in 1993 by way of the equity and debt investment by FIIs in the Indian stock markets and global offerings of ADRs/GDRs by the Indian corporates. A key feature of FII flows has been that the gross inflows from FIIs have emerged as the largest component of capital account. Although FII flows to India have risen steadily, these have been marked by significant reversals during the major global financial market shocks such as the Asian crisis, the meltdown of the information technology bubble and the current global financial crisis. The geographic origin of portfolio flows provides an indication of the degree of diversification and the potential volatility to external shocks. The country-wise distribution of portfolio liabilities reveals that Mauritius, the US, Luxembourg, the UK, Spain, Japan, Singapore, and Hong Kong together accounted for almost 93% of the portfolio liabilities of India (Table 10). Thus, there appears to be relatively less diversification in the sources of portfolio flows to India.

Table 10: Geographic Breakdown of Portfolio Investment ($ million)

1997 2001 2005 2007
Total 10,454 13,378 105,652 302,204
Of which:
Australia 50 79 608 3,254
France 25 48 1,338 4,463
Hong Kong 817 2,312
Ireland 179 234 2,776 2,638
Japan 903 31 2,749 6,009
Korea 275 5,635
Luxembourg 1,369 12,181 37,259
Mauritius 314 37,348 106,522
Netherlands 193 1,377 866 3,124
Singapore 43 218 1,117 11,196
Spain 3,444 11,988
UK 2,053 2,020 5,345 14,240
US 6,308 6,897 32,753 81,755

..Not available, – Negligible. Source: International Monetary Fund.

The greater interlinkage of FII flows to domestic stock prices is evident in their increasing share in the total turnover in the cash segment of the BSE and the National Stock Exchange (NSE) (Figure 5). Given that the FIIs turnover accounts for a significant share of the cash segment turnover of stocks, shocks to FIIs flows have potential for large volatility in the asset prices.

Figure 5: FII Share in Total Stock Markets Turnover (Share in Cash Segment of BSE and NSE) (Rs billion)


70 60 40

40 10

20 -20

-50 1995-96 1997-98 1999-2000 2001-02 2003-04 2005-06 2007-08 2008-09 0

The trend in volatility measured in terms of standard deviation of net FII investment and the changes in the BSE Sensex based on daily data reveal two key features (Figure 6). First, there is a co-movement of volatility of daily net FII inflows and stock return (price changes). Second, the volatility of both the FII investment and stock return shows an increasing trend with time varying nature of the price volatility. Thus, unlike the FDI flows, which are driven by the underlying fundamentals, FII inflows are Figure 6: Volatility of FII Investment (Net) and Stock Return

(Daily Data: April 2000 to March 2009)
(Rs billion) (%)
13 2.5
5 1
-1 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 0
FII turnover (purchase+sale) as percentage of total cash segment turnover Net FII investment (right scale)
SD of average daily return on BSE (right scale) SD of FII daily net inflows

october 24, 2009 vol xliv no 43

highly sensitive to global financial shocks, given their short-term investment horizon. The recent financial turmoil has led to large outflows of FII investment from the equity market and highlighted the vulnerability associated with such flows (Figure 4).

The Granger causal analysis reveals that portfolio flows and the stock prices have a simultaneous interaction due to their bidirectional causal relationship. The augmented Dickey-Fuller (ADF) unit root test for monthly

Table 11: Johansen’s Co-integration Test – data since the mid-1990s Stock Price and FII Investment

Hypothesis Test Critical values

indicated that the log-

Null Alternate Statistics 95% 90%

transformed cumulative

r = 0 r = 1 16.7 15.9 13.8

FII investment and the BSE r <= 1 r = 2 4.6 9.2 7.5

Sensex are non-stationary. The Johansen’s approach to the co-integration analysis suggested a long-run relationship between the two variables (Tab le 11).

Given the potential implications of such flows for financial market stability, it is important to understand the origin of such inflows and the nature of investors who directly and indirectly participate in the capital market. Among the portfolio investors, while the FIIs have more transparency regarding their investments and are regulated entities, a number of entities such as hedge funds and investors taking exposures through participatory notes (PNs) are not regulated and there is lack of transparency about the origin of funds invested by such entities. Hedge funds are highly leveraged institutions which can considerably add to capital market volatility. Direct regulation of hedge funds becomes difficult in the face of inadequate disclosures and their ability to escape supervisory framework in many respects. Monitoring by the national regulators of the leverage deployed in the financial markets by hedge funds is hampered by the lack of reliable sources of information for evaluating developments in the hedge fund industry and identifying the potential source of systemic risk.

The PNs are instruments used by foreign funds that are not registered in the country. These are derivative instruments issued against an underlying security which permits the holder to share in the capital appreciation/income from the underlying security. The advantages are that the investor gets an exposure in a market without actually directly investing in that market and at a lower cost and can avoid regulatory oversight. In the case of PNs, the nature of the beneficial ownership or the identity of the investor is not known unlike in the case of FIIs registered with a financial regulator. Trading of the PNs also leads to multilayering which makes it difficult to identify the ultimate holder. In view of the concerns of some unregulated entities taking positions in the stock market through the mechanism of the PNs, the FIIs and their sub-accounts were not permitted to issue or renew offshore derivative instruments (ODIs) with underlying as derivatives and were required to wind up the existing position over a defined horizon. Further issuance of ODIs by the sub-accounts of FIIs was discontinued. The issuance of ODIs/PNs was limited to the regulated entities and not the registered entities.

4 Capital Account Management and Sterilisation

The literature suggests that initial policy response to deal with volatile capital flows has been market intervention combined with sterilisation. Sterilisation is found to have either halted or delayed

Economic & Political Weekly

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appreciation of the domestic currency, but not effectively check inflows, mainly due to the persistence of interest rate differential. Direct controls on portfolio inflows in particular have been found to be effective only in limited cases, that too for a short period and circumvented through financial engineering. Therefore, capital controls have been interpreted as a short-term palliative within the gamut of policy options. While the mature and well developed financial markets absorb the risk associated with exchange rate fluctuations with limited spillover to the real activity, the developing countries with underdeveloped financial markets and lack of resilience to absorb the shocks have inherently higher volatility arising of external shocks. Thus, large swings in capital flows over a very short period of time impose significant adjustment costs and large output and employment losses on the EMEs (Mohan 2009). Exchange rate volatility arising of volatile capital flows has significant adverse consequences, particularly for countries which specialise in labour-intensive and low-intermediate technology products in an intensely competitive global market (Mohan 2007).

During the expansionary cycle of capital inflows to India, a clear comovement of higher trade deficit and appreciating real effective exchange rates (REER) was evident (Figure 7). Particularly since 2004-05, despite a large trade deficit, a rise in capital inflows led to appreciation of the real exchange rate. Capital flows have emerged as the key driver of the REER movements rather than the movements in the trade or current account. The contractionary phase of capital inflows has been associated with a depreciating REER. Thus, the volatile movement in capital flows to India, beyond its implications for monetary management, poses challenges for trade competitiveness and the real economy.

Figure 7: Relationship between Trade Deficit, Capital Flows and Real Exchange Rate

($ billion) 40

Trade deficit Net capital flows Six country REER (right scale)
140 30 130

20 120

10 110

0 100

-10 90

-20 80

-30 70


60 2001 Q:1 2001 Q:4 2002 Q:3 2003 Q:2 2004 Q:1 2004 Q:4 2005 Q:3 2006 Q:2 2007 Q:1 2007 Q:4 2008 Q:3

Unsterilised intervention in the short run could lead to asset price volatility, imprudent lending and adverse selection which could have inimical effects on the real economy. This necessitates the sterilisation of the expansionary liquidity impact of external flows. The central bank uses various instruments for sterilisation of liquidity, viz, cash reserve ratio, open market operations, liquidity adjustment facility (repo/reverse repo) and market stabilisation scheme (MSS). However, the sterilisation of capital flows has attendant fiscal cost. In simple terms, the cost of sterilisation involves exchange of domestic securities against foreign securities. This amounts to return on domestic securities less the return on the foreign currency assets. Owing to interest rate differential in India and abroad, the cost of sterilisation is sometimes large, although the cost should also be visualised in terms of market stability and possible crisis avoidance in the external sector. The sterilisation operations of the Reserve Bank through MSS operations moved in

65 tandem with the capital Table 12: MSS Issuances and Cost (Rs crore) in domestic liquidity and associated sterilisation costs. A sudden

Year MSS Outstanding Interest Payments

flow cycle beginning shift in the risk perception to EMEs emanating from the global


2004 and reaching a peak 2004-05 64,211 2,057 financi al crisis was evident in the reversal of the capital flow cycle in 2008. The rising trend 2005-06 29,062 3,421 to India in 2008 with challenges of large inflows giving way to the in capital flows, forex 2006-07 62,974 2,942 concerns of sharp reversals and their implications for the domestic market interventions and financial market stability and the real sector. Second, the decline

2007-08 1,68,392 8,351 2008-09 88,077 12,437

the associated sterilisa- in debt flows reflected the policy-induced changes in the composi-

Rs 100 crore = Rs 1 billion. tion of the domestic Source: Finance Accounts and Union Budget, tion of the capital account in favour of non-debt flows. Reflecting Government of India and Reserve Bank of India.

liquid ity growth were the service-led growth of the economy and the comparative also evident in the rising fiscal costs (Table 12). advanta ge in trade in services, FDI inflows to India have been

The global financial shocks on the foreign exchange markets in increasin gly concentrated in the services sector. Another key feathe latter half of 2008 were transmitted through the capital flows ture is that such inflows have displayed stability even during the channel with large outflows of FII investments and low access to various episodes of major global financial shocks. the international capital markets for ECBs, short term trade Third, responding to the policy changes in favour of progresfinance and ADRs/GDRs. The policy stance, thus, shifted from sive liberalisation of outward investment, Indian corporates have concerns related to excess capital inflows and the consequent expanded with an increasing concentration into trading and nonhigh domestic liquidity growth to the challenges of drying up in-financial services – a shift from the manufacturing. Fourth, FII flows and domestic liquidity. Consequently, the Reserve Bank’s investments are characterised by higher volatility and sudden net foreign exchange assets contracted to provision dollar liquid-reversals. The causality analysis showed that FII flows and the ity to the foreign exchange market to impart market stability. stock market have a bi-directional causal relationship with time

varying nature of the stock price volatility. Fifth, while the over

5 Conclusions

seas commercial borrowings are significantly influenced by the The analysis of capital flows to India from the 1950s to the first pace of domestic activities, interest rate arbitrage also plays an decade of this century reveals a structural shift in the 1980s from important role. However, the current global financial crisis shows the dominance of external assistance to the primacy of private that the global credit market shocks have a significant impact on capital flows. The consequent effects of the expansionary phase in raising ECBs. Sixth, NRI deposits display a sensitivity to interest capital flows were evident in the overall movement in the REER and exchange rate expectations, which builds in an element of driven by capital flows rather than the trade deficits, the expansion instability to such inflows.

Notes – (1996): “Inflows of Capital to Developing Coun-Meyers, W D (1998): “Migrant Remittances to Latin tries in the 1990s”, Journal of Economic Perspec-America: Reviewing the Literature”, International

1 Capital flows can be stated to be dominating the

tives, Vol 10(2), 123-39. Dialogue – The Tomas Rivera Policy Institute.

exchange rate movements, rather than movements in the trade account or the current account. Chakrabarti, R (2001): “FII Flows to India: Nature Mikesell, R (1968): Economics of Foreign Aid (London: Thus, large capital flows are leading to a pheno-and Causes”, Money and Finance, Vol 2(7), October-Weidenfeld and Nicholson). menon analogous to the “Dutch disease”. December. Mohan, R (2007): “Capital Account Liberalisation 2 Typically in the absence of central bank intervention, Chuhan, P, S Claessens and N Mamingi (1998): “Equi-and Conduct of Monetary Policy: The Indian heavy inflows lead to an appreciation of the domestic ty and Bond Flows to Latin America and Asia: The Experience”, paper presented at the seminar currency, which eventually threaten competitiveness. Role of Global and Country Factors”, Journal of on “Globalisation, Inflation and Financial Intervention, however, leads to moneta ry expansion Development Economics, Vol 55: 439-63. Markets” organis ed by Banque de France in Paris, and inflation, unless sterilised (Calvo, Leiderman Fernandez-Arias, E and P J Montiel (1995): “The Surge 14 June. and Reinhart 1993, 1996; Fernandez-Arias and in Capital Inflows to Developing Countries: Pros-– (2009): “Global Financial Crisis: Causes, Conse-Montiel 1995; Altinkemer 1998). pects and Policy Response”, Working Paper 1473, quences and India’s Prospects” presented at 3 ECBs include commercial bank loans, buyers’ World Bank. London Business School on 23 April. credit, suppliers’ credit, securitised instruments Gordon, J P and P Gupta (2003): “Portfolio Flows into Nayyar, D (1989): “International Labour Migration and borrowings from the private sector window India: Do Domestic Fundamentals Matter?”, IMF from India: A Macro-Economic Analysis” in of multilateral institutions and foreign currency Working Paper No 03/20, International Monetary Rashid Amjad (ed.), To the Gulf and Back Migraconvertible bonds. Fund. tion: Studies on the Economic Impact of Asian

– (2003): “Nonresident Deposits in India: In Search Labour Migration (Geneva: International Labour of Return?”, IMF Working Papers 04/48, Interna-Office), pp 95-142.


tional Monetary Fund. Reddy, Y V (2000): “Operationalising Capital Account

Altinkemer, M (1998): “Capital Inflows and Central Islam, A (1992): “Foreign Aid and Economic Growth: Liberalisation: Indian Experience” presentation Bank’s Policy Response”, The Central Bank of the An Econometric Study of Bangladesh”, Applied at the seminar on “Capital Account Liberali-Republic of Turkey, Research Department Discus-Economics, Vol 24(5), 541-44. sation: The Developing Country Perspective” sion Paper. Jadhav, N (2003): “Maximising Development Benefits of (London: Overseas Development Institute),

Bohn, H and L L Tesar (1996): “US Equity Investment Migrant Remittances: The Indian Experience”, paper 21 June. in Foreign Markets: Portfolio Rebalancing or presented at the International Conference on Migrant – (2007): “Indian Economy: Review, Prospects and Return Chasing?”, American Economic Review, Remittances (London: Department for International Select Issues”, address at the Banco Central de Vol 86, pp 77-81. Development and World Bank), 9-10 October. Chile, 7 June.

Brennan, M J and H H Cao (1997): “International Kim, W and S Wei (2000): “Foreign Portfolio Invest-Richards, A (2002): “Big Fish in Small Ponds: The Portfolio Investment Flows”, Journal of Finance, ments before and during a Crisis”, Journal of Momentum Investing and Price Impact of Foreign Vol 52(5), 1851-80. International Economics, Vol 56(1), 77-96. Investors in Asian Emerging Equity Markets”,

Buckberg, E (1996): “Institutional Investors and Asset Krueger, A (1978): Foreign Trade Regimes and Econo-Resear ch Discussion Papers 2004-05 (Sydney: Price in Emerging Markets”, IMF Working Paper mic Development: Liberalisation Attempts and Reserve Bank of Australia). No 2. Consequences (Cambridge, Mass: Ballinger for Singh, B (2008): “Corporate Choice for Overseas Bor-

Calvo, G A, L Leiderman and C M Reinhart (1993): National Bureau of Economic Research). rowings: The Indian Evidence”, RBI Occasional “Capital Inflows and Real Exchange Rate Appre-Lucas, R and O Stark (1985): “Motivations to Remit: Papers, Vol 28(3), winter. ciation in Latin America: The Role of External Evidence from Botswana”, Journal of Political World Bank (2003): Global Development Finance: Factors”, IMF Staff Papers, March, pp 108-51. Economy, Vol 93(5), 901-18. Striving for Stability in Development Finance.

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