Friday, January 1, 2016

Can We Get More Foreign Capital?

After witnessing very strong inflows in 2014 and early 2015, foreign portfolio inflows dropped sharply from the middle of this year. Indeed, several months saw net outflows. In contrast, foreign direct investment (FDI) has been much more stable and has increased. (April-September saw $16.6 billion worth of inflows compared to $14.7 billion in the same period last year.) So, what should we expect of foreign inflows in 2016 given that the US Federal Reserve has started to tighten? Is the Indian economy prepared to absorb the inflows should they accelerate?

Let us clarify right at the onset that global capital is unlikely to become expensive in 2016 because of US Fed hikes. As the Fed statement emphasized, the pace of hikes will be very gradual and US interest rates will most probably still below a year from now.

Moreover, many of the world's largest economies have a problem of excess savings. According to estimates by International Monetary Fund (IMF), China currently has an investment rate of 44.3% of GDP and a savings rate of 47.4%. The balance of risk is that this gap will widen in the next few years. Similarly , Germany has an investment rate of 18.8%, but a savings rate of 27%. In short, the availability of international capital is not the problem.

The real problem is finding a home for all this excess savings. Textbook economics would suggest that the capital would flow to capital-starved emerging markets (or to countries like Greece). However, this does not happen because most emerging economies are based on commodities and their creditworthiness moves procyclically. With the collapse of commodity prices, most emerging markets are not in a position to attract the capital.

This leaves India as an obvious destination for international money in 2016.Thus, the quantum of flows into India will not be constrained by the availability of global capital, but on the country's ability to respond to the opportunity -both in terms of reforms to attract investors and policies that subsequently allow the economy to absorb the inflows.

Much has been written about reforms needed to attract investment: labour laws, tax simplification and so on. Hence, let us focus here on the less discussed issue of absorption. This relates to the ability to digest large inflows without widespread misallocation, overheating and so on.

This is not an idle issue because it is at the root of many emerging markets crises, including the Asian crisis of 1997-98.

So far, the Reserve Bank of India (RBI) had been very wary of the impact of international capital and has been sterilizing the inflows, i.e., neutralizing the flows by selling government bonds. In turn, this has held down reserve money growth at a modest 12% year-on-year.

M3 growth is even lower at 10.7% due to a jammed financial system. This quantitative stance is, in my opinion, currently the more important source of monetary tightness than benchmark interest rates. In short, there is no point asking for more foreign money if we are not willing to let it flow through to the economy .

So, why is the central bank keeping liquidity so tight?

Most of the debate has centered around inflation targeting. However. The real unsaid reason is a fear that the financial system is incapable of efficiently al locating capital. Rather, Rajan probably worries that taking his foot off the brake pedal would lead back to real estate bubbles and ever-greening of loans. Unsterilized foreign capital would just add to the fire.

This is the context in which we should appreciate the urgency of financial sector reforms in the country and the proposed bankruptcy code.

There is also the wider issue of enforcement of financial contracts, including the speed of the bankruptcy process. e country's investment rate has dropped from The country's investment rate has dropped from a peak of 38% of GDP a few years ago to an estimated 31% in 2015. Foreign capital is needed to kick-start the investment cycle.

As discussed, enough global capital is available. But it will help only if policy makers work both to attract and absorb the funds. The latter requires creating the conditions for a big expansion of the financial system without risking a subsequent crash. 

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