Capital inflows: Balancing market gains with economic risks

The decision to welcome FPI depends on an economy's capacity to use this liquidity for productive investment. (Image: Pixabay)
The decision to welcome FPI depends on an economy's capacity to use this liquidity for productive investment. (Image: Pixabay)


  • The influx of foreign capital can boost investment and wealth but may also lead to a stronger national currency, undermining export competitiveness

Bloomberg could join JPMorgan in adding India to its government bond index, increasing the chances of global investors deploying more funds in India. This comes as China's stock market struggles, enhancing India's appeal as a destination for equity investments. The net result would be good news for capital markets.

However, for the real economy, that flood of dollars could push up the rupee to an unsustainable level, hurting India's export competitiveness. This phenomenon, known as the Dutch Disease, was identified by The Economist while examining the Netherlands’ loss of export competitiveness and rise in unemployment subsequent to the discovery of oil and gas in the North Sea in 1959. The export of hydrocarbons brought in so much of foreign exchange that the Dutch guilder (this was before the EU was formed and most EU members adopted the euro as their currency) became overvalued, rendering non-gas Dutch exports less competitive.

Similarly, in resource-rich Africa, exports of minerals like copper, diamonds, oil, or gold have led to the Dutch Disease, as these exports bring in significant foreign exchange but don't necessarily promote broader economic activity, and can even make other exports less competitive, now that their self-same domestic price translates into a higher price in foreign currencies that have depreciated against the currency of the commodity exporter.

Sure, the Reserve Bank of India (RBI) tries to manage the rupee's value to prevent it from becoming too strong due to financial inflows, which can be volatile and detached from the real economy's fundamentals. Interest rate cuts elsewhere in the world, or quantitative easing, the creation of money by central banks, could suddenly lower the cost of capital for the rich world’s investment pools, as well as the rate of their domestic returns, incentivizing them to hunt for higher returns in a country like India. If the policy triggers behind the sudden influx of capital into India were to reverse, the money would flood out, as well.

To counter this resultant volatility, the RBI intervenes in the currency market, buying dollars to prevent the rupee from appreciating too much. The obverse of a cheaper dollar is, of course, a stronger rupee. When the RBI buys up dollars, it buys them with rupees, releasing an addition to the supply of rupees. This excess liquidity could fuel inflation. To combat this, the RBI might sell bonds to absorb excess rupees, but the increased supply of bonds would depress their prices, and that would push up the yields. The net result of dollar inflows that increase the number of billionaires based on stock market valuation, apart from raising the worth of the existing ones, would be to raise interest rates, strengthen the currency, eroding export competitiveness.

In other words, from a short-term perspective, what brings joy to financial markets could well hurt the real economy. For example, strong US job data indicating economic strength can lead to fears of inflation, discouraging the Federal Reserve from cutting interest rates, which in turn negatively impacts stock markets.

Does this mean that additional inflow of portfolio capital does no good to the economy? That, of course, is not the case. Even when portfolio flows come and go, some of it remains sticky, so that net inflows remain positive. And this not just deepens the capital market, but also offers investible capital for the real economy.

When foreign direct investment comes in, the funds flow into the company and the sector where new income generating activity would be triggered as a result of this investment. When capital flows into the secondary market, it adds to the pool of liquidity in the system, allowing banks to lend cheaper than in the absence of such liquidity. Further, higher share prices resulting from the inflows allow fresh loans to be raised by pledging the shares, that is, offering the shares as collateral, the money then being used for capital formation. Someone who makes a killing on the stock market could well decide to plough their profits into a new enterprise, as happened with Akasa Air, in which investor Rakesh Jhunjhunwala had a 46% stake. The additional capital formation that takes place as a result of portfolio inflows could be in companies and sectors different from the companies, in whose shares the portfolio funds were invested.

FDI leads directly to fresh income-generating investment, foreign portfolio investment (FPI), feeds investment and income generation indirectly.

The decision to welcome FPI depends on an economy's capacity to use this liquidity for productive investment. If an economy can absorb the extra funds effectively, FPI should be encouraged. However, if the market is already correctly priced, regulating inflows might be wise, possibly through a modest tax to slightly reduce expected returns and deter some investments. The International Monetary Fund, for long a champion of free cross-border capital flows, no longer sees capital controls as anathema.

In these decolonized times, it would make little sense to import an old European disease, only to benefit a tiny minority of billionaires and stock market punters, while harming the real economy.

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