Don’t underestimate the role of push factors
We have a tendency in India to move into introspective mode rather quickly when confronted with foreign criticism or adverse global circumstances that affect us directly. A recent, dramatic example is the spate of navel-gazing prompted by Barack Obama’s recent warnings on the dire consequences of the splintering of India on religious grounds unless we manage the extremist tendencies of a few. A more mundane, but perhaps more important manifestation of this tendency is frequent and panicked commentary on what the vagaries of foreign capital flows to India say about the state of the Indian economy.
Our extreme reactions are evidence of the importance that we give to pull factors, and our neglect of push factors, both equally important determinants of foreign words and money.
When reading the tea leaves, there are aspects of Obama’s statements worth considering carefully when reshaping our polity, and this column, to avoid doubt, does not seek to deny our very real problems. But we must maintain some sense of perspective about the role of Obama’s domestic political imperatives in shaping his comments—the role of push factors. It is by now commonplace for US presidents to use their bully pulpit to admonish other nations on the importance of promoting human rights, democracy and equality lest they be seen as soft by their domestic constituency in their projection of American values overseas. It is worth recalling, as Tip O’Neill once said, “All politics is local.” At least some portion of Obama’s statements should be interpreted as a response to his current difficulties with the Republican Congress, and a desire to project himself as a robust defender of the US’ interests around the world with (he will hope) positive domestic repercussions.
Analogously, similar inferences about the role of push versus pull factors need to be drawn from the actions of foreign investors in India. To begin with, capital flows, especially in liquid, traded assets are extremely volatile, and interpreting very short-term fluctuations and the attendant impact on domestic asset prices as signals of underlying value is a fool’s errand.
On a longer-term basis, the importance of push factors in foreign capital flows to emerging markets has been well-known for some time. One way to ascertain the importance of these factors is to try to explain foreign capital flows to emerging markets by the state of the source market (a simple indicator of push) in addition to the conditions prevalent in the destination emerging market (pull), as in this paper by Griffin, Nardari and Stulz. They show that source country returns matter significantly, even after accounting for the role of destination country returns, in explaining variations in capital flows from source to destination. A host of more recent evidence along the same lines has followed similar approaches and reached similar conclusions.
More recent insights show that foreign institutional investors are sometimes forced to make decisions that have little to do with careful calculations of value about destination country stocks. A portfolio manager is only as smart as his or her most emotionally volatile investor. For example, when there is a run (a sudden withdrawal of capital) from global mutual funds in the US for reasons having nothing to do with India’s economic prospects, it may generate sudden sharp outflows adversely affecting the Indian market. As this paper by Jotikasthira, Lundblad and Ramadorai shows, these episodes are frequent, and can have large impacts on the aggregate performance of destination country stocks, but they generally revert over a few weeks.
That push effects have temporary effects on aggregate emerging market performance might at first sound reassuring. But if we look more closely, significant doubts remain—listed firms in emerging markets seem to find it hard to disentangle the relative roles of push and pull in driving capital flows. We can see this from the very real effects of push-driven capital flows, which seem to have long-lasting consequences on real investment by emerging market firms in India and China. These problems most strongly affect firms which are dependent on external financing, as the same authors show in another paper. It is tempting to explain these negative effects on investment as Indian and Chinese firms and investors wrongly interpreting foreign capital flows as pulled rather than pushed, with adverse consequences for investment in response to these misinterpreted signals.
Overall, it is important to keep our cool in an increasingly interconnected global market in which volatility in both word (political pronouncements) and deed (capital flows) emanating from overseas can have multiple root causes. Let us not underestimate the role of push as we reshape India in accordance with our strategic priorities.
Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance.
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