Capital account liberalisation in an emerging economy: private capital flows, exchange rates and stock markets in India

Journal of the Academy of Business and Economics, Jan, 2004 by Sushil Khanna

ABSTRACT

The emerging economies of Asia have in 1990s, emerged as the epicentre of private capital flows in the global economy, attracting a significant proportion of FDI and portfolio flows. India too has attracted more than $40 billion, during the second half of 1990s.

External capital inflows were expected to have a positive impact on the emerging market economies. At the macro level, capital account liberalisation is expected to lead to more efficient resource allocation at the global level Flows into capital scarce emerging economies would lead to decrease in interest rates, accelerated investment and higher growth. At the micro-level, integration of the capital markets in such economies with global portfolio flows should lead to risk diversification and lower the cost of capital for individual firms by raising Tobin's q.

This paper examines the experience of India at the macro and micro level, which accompanied by large fluctuations in the quantum of lows. At the macro level, periods of large inflows with low current account deficits, forced the central bank to mop up the excess flows. To sterilise the impact of this reserve accumulation, the Central bank mopped up liquidity, raising interest rates and slowing down the growth. At other times, outflows of capital, specially during 1997 crisis forced central bank to defend the currency by raising short term interest rates. Hence interest rates remained high during periods of inflows as well as outflows, slowing down the economy and aborting corporate restructuring necessary under industrial reforms.

The impact at the micro-level is analysed by studying the impact of portfolio flows on the Indian stock market and the cost of capital for firms that accepted investment from foreign investors. The analysis shows that Tobin's q for such firms actually declined and the stranglehold of foreign pension and mutual funds reduced availability of funds from capital market to the Indian corporate sector.

1. INTRODUCTION

The decade of nineties has witnessed a radical change in the external sector in the emerging economies of Asia. From a regime of fixed exchange and regulated interest rates, tight control on foreign direct investment (FDI) and a complete absence of foreign portfolio investment, the region has become the epicentre of private capital flows, attracting more than half of the FDI (Foreign Direct Investment) and portfolio investment.

Along with the economies of the East and South Asia, almost all the countries of South Asia too embarked on capital account liberalisation. By international standards, India has been a late liberaliser. Even in the 1980s India continued to shelter its economy even when Latin America was opening itself to commercial borrowings and the East Asia economies changed their policies to attract private international portfolio capital. This changed with liberalisation in the 1990s when Indian policy makers embarked on a conscious strategy to integrate the economy with global financial markets. The Asian crisis halted this process briefly, but insulation of the South Asian economies from the turmoil of 1997-98, encouraged the central banks to continue with the opening up of the financial markets for foreign investors.

The role of volatile private capital flows across borders has been debated widely in other countries (Helleiner, G.K., 1998), but the impact of such flows on the Indian economy is yet to be evaluated. The earlier discussion in India on foreign inflows has tended to revolve around the benefits and costs of Foreign Direct Investments (FDI) and the problem of capital flight rather than those of short term financial inflows (Chandra, N.K., 1988).

The inflows have qualitatively changed the balance of payments situation in India. Today, private flows have replaced official assistance as the main source of meeting the current account deficit. The increase in FDI and portfolio inflows has had a wide ranging impact on the economy. These flows have begun to dominate the Reserve Bank's monetary policy and protecting the economy from the consequences of these flows has been the hallmark of the nineties. They also account for sharp increase in India's foreign exchange reserves, currently estimated to be above US $ 70 billion. However, these flows have not proved to be an unmixed blessing.

Some authors have argued (Ahuluwalia, M.S., 2002) that India has gained substantially from the liberalisation of capital account and given the controls on residents and strict limits on debt creating inflows, Indian economy is not vulnerable to shocks from such inflows and outflows. The fact that India has escaped any serious capital flight is often cited as evidence.

The impact of FDI inflows has been studied in some detail by some authors (Saha, B., 2001 and Subrahmanian, K.K. et al, 1996). This paper looks at the experience of Indian economy to private capital inflows and the costs and constraints imposed on the economy as the central bank struggled to manage the impact. It tries to evaluate the costs and benefits and to assess whether India has derived any of the expected benefits.