Inflows as a share of GDP are at 2002 levels; policymakers must address structural concerns
Neelkanth Mishra | Last Updated at October 2, 2018 23:00 IST
(This was published in the Business Standard: link)
Like a company that needs external capital to grow faster than it would just with its own savings, maintaining a steady inflow of foreign capital has always been part of the plan in India. However, this year India is likely to receive only about half the capital inflows that it did a decade ago. Capital flows as a share of GDP are at 2002 levels. As important as the discussion around trade and current account deficits is, the drop in this ratio does not receive as much attention as it deserves. After all, taking forward the example of the household we used in the previous Tessellatum (“Why consumption must slow down”, September 5), the quantum by which consumption can exceed income is determined by the availability of external capital. That is, the size of the current account deficit India can sustain is determined by the foreign capital flows it can attract.
To be sure, one must consider the advisability of India’s persistent need for external capital: The ‘rent’ on the nearly $900 billion of foreign capital that has come in cumulatively since 1991 is now $30 billion a year. This ‘rent’ takes the forms of royalties and dividends to foreign equity holders and interest to foreign debt providers. But so long as the capital coming in is put to productive use, implying that it is helping India grow rapidly, it may be manageable: As a share of GDP it has stayed in the 1 to 1.2 per cent range for several years now. Shortage of external capital would mean slower economic growth.
So, why have capital flows slowed? Recency bias makes most observers put the blame on the reversal of both quantitative easing (QE) and zero interest rate policies (ZIRP) in the developed markets, in particular the United States. While this does appear to have played a role in the acceleration and then the slowdown in flows over the past few years, we note that even before QE and ZIRP started, capital inflows to India were much higher. This is also not just an Indian phenomenon: In recent years there has been a slowdown in capital inflows for most economies that depend on them, suggesting that there could be cyclical factors at play. However, the fact that even in the best years, capital inflows as a share of India’s GDP have been lower than those for the rest of the world also points to structural constraints.
Foreign capital flows take various forms, but can placed into five buckets for ease of analysis: Portfolio flows into equity (FPI-Equity), portfolio flows into debt (FPI-Debt), foreign direct investment (FDI), foreign loans, and a fifth hold-all category of “others”.
The media attention on foreign portfolio flows would imply that much of the drop in capital flows came from them. However, the source of capital that has seen the steepest decline over the past decade has been foreign loans: Net inflow of foreign loans in 2007 was $40 billion, but has since dipped to just $10 billion. This decline has mostly been for good reasons: Having burnt their fingers in the currency volatility during the Global Financial Crisis, corporations have eschewed loans with unhedged currency risk (hedging makes them less attractive); and the Reserve Bank of India (RBI) has also insisted on hedging. Similarly, over-dependence on short-term trade financing in 2013 had exacerbated currency volatility during the “taper tantrum”. While one need only look at the problems in Turkey to understand the problems with excessive foreign loans, this understanding does not solve the problem of capital shortage.
Foreign portfolio flows have also slowed. Some of this is clearly cyclical: With the prescribed limits for FPI-Debt investors steadily rising, flows have increased over the past decade, and the recent outflows appear to be more tactical in nature. The by now well-flagged constraint of India not being in any bond market index makes investing in India a somewhat riskier choice for bond investors, and concerns around the currency and the somewhat unnecessary volatility in bond yields over the past nine months may have catalysed a temporary exit by some. In FPI-Equity, despite the recent sell-off, India has actually been better off than most Asian and Emerging Markets this year. Over the past three years too, even though net inflows have been less than one per cent of market capitalisation, they have been better than peers.
FDI, while meaningfully higher than in the past, and now the mainstay of India’s capital inflows (it is likely to account for more than half the foreign capital flowing in this year), seems to have stagnated too, at around $35 billion a year. Further, it has consistently lagged peers when seen as a percentage of GDP. The “Others” category includes Non-Resident Indian (NRI) deposits, banking capital and multi-lateral loans, and is generally steady, unless the government taps the NRIs for dollars in times of crisis.
While analysing capital flows it helps to consider the countries supplying this capital. Countries that run current account surpluses (that is, they produce more than they consume) also have surplus capital to deploy abroad. However, the similarities end there. How each country chooses to deploy this capital is different, and also changes over time. For example, the unexpected oil-related bonanza a decade ago saw west Asian oil exporters start Sovereign Wealth Funds, which mostly took the route of passive portfolio investments into other markets: In the 2012-13 period, even as the Indian economy was decelerating, and structural concerns were being raised, FPI-Equity flows were nearly $20 billion every year. European nations with surpluses generally export capital through banks. Countries like Japan and China on the other hand also use strategic routes, as they have the capabilities and needs for them.
As feared, the slowdown in consumption (and growth) to bridge the balance of payments deficit seems to have started. If some of the cyclical factors around foreign inflows turn, like say inflows into Emerging Market equity funds, the current shortage of capital may be addressed. However, structural concerns would still remain, and policymakers need to actively identify and address any structural limitations to capital, in our view, as the sources and nature of flows evolve. Given the concerns around trade wars that threaten to jeopardise global capital flows as well, we believe attracting foreign capital needs to be a policy priority.