Academic journal article The Journal of Developing Areas

Dynamics of Private Capital Flows to India: A Structural Var Approach

Academic journal article The Journal of Developing Areas

Dynamics of Private Capital Flows to India: A Structural Var Approach

Article excerpt

(ProQuest: ... denotes formulae omitted.)


Foreign capital plays an important role in the transformation of the developing economies as they become more open and integrated with the world economy. Many studies such as World Bank (1995), Calvo, Leiderman and Reinhart (1996), Ying and Kim (2001), Sahoo (2006), Ralhan (2006) and Obstfeld (2009) have highlighted the importance of foreign capital for the developing countries. First, developing countries need foreign capital to bridge saving-investment gap and finance current account deficits. Second, foreign capital by supplementing necessary technology helps developing countries to increase factor productivity, which is imperative for faster economic growth. Third, foreign capital by increasing the market liquidity, allowing risk sharing, broadening investor base and thereby reducing the cost of capital contributes significantly to the development of financial markets in the developing countries. Appreciative of these benefits, most emerging markets including India adopted the policies of liberalization and globalization in the 1990s, which resulted in massive increase in the international capital mobility towards emerging markets - from an average of $18.16 billion per year in 1980s to $107.32 billion per year in 1990s, and $293.66 billion per year in 2000s (World Economic Outlook Database IMF April 2014).

However, large foreign capital flows can also create potential costs for the host economy (Calvo, Leiderman and Reinhart 1993; World Bank 1995; Kim 2000; Kohli 2001; Ying and Kim 2001; Ralhan 2006; Obstfeld 2009; Kim, Kim and Choi 2013; and Ahmad and Zlate 2014). Some of these costs include rapid monetary expansion causing inflationary pressure, exchange rate appreciation leading to erosion of competitiveness of domestic goods and services, widening of current account deficits, difficulty in pursuing independent monetary policy. Moreover, foreign capital flows especially the portfolio flows are very volatile in nature and prone to sudden withdrawals, which makes financial markets highly unstable and contagious to financial crises (Stiglitz 2000). The evidence of such behaviour comes from Mexican crisis (1994), East-Asian crisis (1997-98) and the most recent Sub-Prime crisis (2008-09) where volatility and abrupt withdrawal of capital by portfolio investors played a major role in destabilizing the financial as well as foreign exchange markets in developing countries. Hence, the surge in capital flows to developing countries in the last two and a half decades poses serious trade-offs and dilemmas for macroeconomic management.

The issues, discussed above, are important in Indian context because of the large volume of capital inflows to India since 1990s particularly in the form of private capital flows (PCF) - foreign direct investment (FDI) and foreign portfolio investment (FPI)1. Moreover, the private capital flows to India, especially the portfolio flows have been very volatile in nature and prone to unexpected withdrawals with respect to global crises (Figure 1). The Figure 1 shows that there was sharp fall in the private capital flows to India in response to the Asian crisis (1997-98) and sub-prime crisis (2008-09). Such behaviour of private capital flows has ramifications for the financial as well as the real sector of the economy.

This is evident from the fact that prior to recent financial crisis, India's GDP growth rate was more than 9% for three consecutive years (2005-06 to 2007-08) and much of this acceleration in GDP growth was attributed to strong global economic growth and large foreign private capital which India received before the financial crisis. However, the 2008-09 financial crisis put an end to this story, pushing India's growth rate down to 6.7%, thereby underlining the importance of foreign capital in the growth process of Indian economy. The BSE Sensex, which rose from 14,650 to 20,287 between June and December 2007, also crashed to 13,462 in June 2008 due to massive outflow of foreign capital in response to the global financial crisis (BSE India). …

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