Bang-on!

Updated: Jan 6 2006, 05:30am hrs
Finance minister P Chidambaram has set at rest any doubts about Indias openness to foreign capital. In an interaction with Harvard Business School students, he has made it clear that India will not try to keep out foreign capital, especially the non-debt creating variety. At the same time, he has made it known that there is a graded scheme of preferences. Thus, remittances by non-resident Indians and foreign direct investment (FDI) are preferred to portfolio flows or foreign institutional investment (FII) inflows. This is not surprising. While overseas funds go a long way to supplement domestic savings in capital-scarce countries like India and provide them the much-needed resources for investment, there is a cost attached to this. Sudden inflows and, more important, sudden outflows can have a destabilising effect by affecting the external value of a countrys currency in the short-run and, in the long run, by creating repayment obligations that could prove excessively onerous.

Understandably, even as countries are eager to access overseas funds, they are also anxious to see that the downside from such flows is minimised. The best way of doing that is to encourage long-term (rather than short-term) capital inflows that go to augment their stock of capital permanently. It is here that remittances and FDI score over FII flows. Both tend to be much less foot-loose than portfolio flows that, typically, are forever looking for quick profits. While remittances are normally meant either for family support or for building a nest egg and are unlikely to be taken out of the country, FDI also has a longer timeframe. The initial investment decision may take longer. But once a company takes the plunge and sets up shop, it is unlikely to down the shutters and exit. Not unless there is some fundamental change in the macro environment, as with the passage of the Foreign Exchange Regulation Act (Fera, 1973), when companies like Coke and IBM opted to exit the country rather than be forced to sell shares to the Indian public.

Thus, a Suzuki or a Hyundai, for instance, is unlikely to pull out of the country once it has invested in a manufacturing facility. But a pension fund like CalPERS (California Public Employees Retirement System) will promptly pull out if it finds returns are higher on the Karachi or Sao Paulo stock exchanges. Countries like China have for long realised and capitalised on the stickiness of FDI by encouraging direct rather than portfolio investment. We need to take a leaf out of their books.