BackCapital flows into India becoming slower and turning riskier
Foreign portfolio investments into India seem to be ebbing and tilting towards debt, raising macroeconomic and financial stability risks
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New Delhi: The government needs to closely monitor the trend and composition of capital flows.
Foreign portfolio investments into India seem to be ebbing. They are also tilting towards debt. Both features raise macroeconomic and financial stability risks.
Although total portfolio inflows aggregate $35.7 billion (net) until 27 October, or an average $3.6 billion every month, the trend is of steady decline after July.
The post-election jump in inflows from foreign institutional investors—to $5-6 billion in May-July—sobered to $3-4 billion in August-September. And in October so far, capital inflows have reduced to a trickle, just $1.37 billion.
Meanwhile, India’s trade deficit expanded from an average $11.7 billion over May-July to $14.2 billion in September; exports grew under 3% in the past two months, while total import growth accelerated sharply to 26% last month as Indians bought more gold.
The combination of slowing exports, rising imports and declining short-term capital inflows raises macro risks. True, India is no longer as fragile as during the previous year, but the severe gold import restrictions and tight monetary-fiscal policies that still aid current account compression shows the external constraint remains binding and that dependency upon short-term foreign capital keeps the economy vulnerable to capital flight.
A slowdown in capital flows thus underlines the need to contain external funding needs, for reasons of macroeconomic stability.
The other disturbing sign is the pronounced tilt towards debt investments. Overall, debt inflows ($19 billion) marginally pip those into Indian stocks ($15 billion) this year.
But a sharp incline towards debt with a turn away from equities is prominent from August.
Portfolio investments in the latter were in the region of $800 million in August-September, whereas debt investments rose three-four times that magnitude ($2.8-3.5 billion).
Bond flows are inherently more volatile because of their pro-cyclicality and influence beyond the business cycle due to future, associated liabilities.
By contrast, equity flows are risk-sharing in nature. Post the financial crisis, foreign portfolio debt flows exhibit greater volatility for India as they are prone to sharp reversals, as happened in December when the US Federal Reserve decided to start tapering its bond purchases. Inflows that culminate in sudden stops can pose grave risks to financial stability.
From a monetary policy perspective, an increased dependence upon short-term foreign debt investments vis-a-vis equity in the presence of slowing foreign currency receipts from exports constitutes an additional constraint.
The domestic-foreign interest rate differential matters for investors’ portfolio allocations. If this reduces—for example, if the central bank were to consider lowering interest rates—returns on foreigners’ debt investments would reduce proportionately, ceteris paribus.
Other factors such as US interest rates and currency movements would also have a bearing.
A stable rupee has attracted foreign interest in local-currency-denominated bonds this year. However, advanced countries’ monetary policies are now beginning to diverge.
The US cycle is on a tightening path, but Europe and Japan are in a loosening mode. And as the International Monetary Fund pointed out in its Spillover Report this July, “asynchronous adjustment from monetary accommodation" could result in larger swings in exchange rates of major currencies, which could be problematic for economies with balance sheet vulnerabilities and foreign exchange exposure. From all these perspectives, trends in capital flows and their composition need a watchful eye.
Renu Kohli is a New Delhi-based macroeconomist.
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