During the earlier part of this decade, managing fiscal expenditure was the prime concern of economic policy makers in the country. Then came the fiscal responsibility legislation of 2003, the dramatic pick-up in the growth rate (with burgeoning tax revenues), decline in interest rates and in the case of the states, the report of the Twelfth Finance Commission.
The next big concern faced by the decision makers in India is now the rapid rise in private capital flows. It appears ironical that a decade and a half after the country had to turn towards the IMF due to its dwindling foreign exchange reserves, we are now grappling with the problem of too much inflow.
The questions facing us are twofold ? how to manage the monetary implications of this inflow and how the inflow should be channelized in the correct direction. The rapid rise in private capital flows has happened in most emerging countries over the past two years. The chart shows how foreign direct investment, portfolio flows, and other investment flows have risen more steeply, especially to emerging economies in Asia, Europe, and the CIS.
Different countries have dealt with managing capital flows in different ways. For short term measures, China and Malaysia have introduced exchange rate reforms to manage large capital inflows. Fiscal expenditure restraint has also been helpful in managing large inflows in a number of countries (Hong Kong, Malaysia, and Taiwan) where further fiscal consolidation was required. For longer term impact, easing of limits on holdings of foreign assets by local mutual funds and pension funds, was done by Argentina, Brazil, Chile, Colombia, and Peru. Relaxing norms for private investors to acquire and hold foreign assets, was done by China, Korea, Malaysia, and Thailand.
In India, the central bank bought over $24 billion (more than the forex reserves of the Netherlands, Saudi Arabia or Kuwait) in September in order to keep the Rupee appreciation under control. This enabled them to restrict the rupee at about 39.3 but resulted in a rise in liquidity.
With inflows accelerating, and the central bank unable to control these flows, it was left up to the central bank to do something. As a result, we saw Sebi try and restrict P-Notes, and with the markets tanking, the government backed down.
In the meanwhile, the central bank raised CRR in order to flush out excess liquidity. It is interesting to note that this might be the first time that the central bank has raised the CRR and the stock market has not fallen. It is apparent that the investors buying at this level are the FIIs who do not directly get affected by the change in the CRR levels in any way.
Other than managing monetary implications of these capital inflows, it is also up to the government and the regulator to ensure that these inflows are channelised into those sectors which are in need of capital. In this respect, the effort to ensure that capital flows enter into the infrastructure sector has been minimal while it is estimated that almost $150 bn was required by the sector over the next few years. Here, various different instruments can be created.
Above all else, there is a need for a vibrant corporate bond market that can be tapped into by construction companies for long-term debt. Given the current yields that the Indian infrastructure sector is providing, it is very likely that a large part of the foreign inflows will be aimed towards this sector. For more conviction, one only needs to see the rising share prices of the large construction companies in the Indian stock exchanges. If only the government can put together the right infrastructure, most funds would get channelized into this sector by themselves.
Other ways are in the form of innovative instruments such as the loan by the central bank to the SPV formed to enable long gestation projects or private equity channels. Of the two hundred billion dollar reserves, with the central bank, the government had asked it to lend almost 2% to the SPV. While such methods are useful, they are less effective that direct follows into the infrastructure sector using corporate bonds and other direct investments.
On the monetary front, there is a need for the central bank and the government to work hand in hand to ensure that inflation and growth are not affected in the process of maintaining the exchange rate. In this, there are lessons to be taken from other similar emerging economies who have managed to focus on inflation well despite large capital flows. On the fiscal front, the need of the hour is to build the right financial infrastructure in order to ensure that the flows are targeted into infrastructure projects. If we are able to successfully manage both, then we would not only reduce the negative impact of these capital flows, but also exploit their positive impact in the manner best possible for the country?s economy.
?The author is national leader, Global Financial Services, Ernst & Young