Indian economy: arguments against a wider opening of the economy to free financial capital flows

Responding to an alarm from Congressman Shashi Tharoor about major financial and equity outflows, Nirmala Sitharaman told parliament last week that the economic outlook really depends on foreign direct investment (FDI), which has shown no tendency to leave the country. The central question underlying this exchange is whether the utility of capital inflows differs by form.

In one sense, different forms of capital inflows serve the same purpose: to augment investable resources available to the economy beyond domestic savings. Whether a foreign investor invests $1 billion in a greenfield project, an existing factory, stocks (stocks), or debt, the action adds $1 billion to the country’s investable resources.

No death penalty

Despite this commonality, however, the different forms of capital inflows differ significantly and have therefore been the subject of lively debate among economists. This debate became particularly intense in the 1990s, when the International Monetary Fund (IMF) aggressively advised developing-country members to open themselves to the completely free flow of foreign capital, and the latter found themselves in the midst of two major currency crises: the Mexican peso crisis of 1994 and the 1998 Asian currency crisis.

The most influential dissenter came from none other than the world’s leading free trade advocate, Jagdish Bhagwati. In an influential paper entitled “The Capital Myth: The Difference Between Trade in Widgets and Dollars” (bit.ly/3JqJfI2), published in Foreign Affairs in 1998, just as the Asian monetary crisis was unfolding, Bhagwati made the claim Asked that it was virtually free trade in goods and services, the free movement of capital across borders brought clear benefits.

He argued that while there is evidence that foreign direct investment and equity investment bring profits to recipient countries, there is no similar evidence for finance capital. On the contrary, countries like Mexico, Thailand and South Korea that had opened up to the latter suffered from currency crises and accompanying economic downturns. Bhagwati therefore warned the developing countries against hasty introduction of completely free capital mobility.

There are good analytical reasons why foreign direct investment is the most productive form of foreign capital inflow. In making such an investment, the foreign investor takes the usual risk of his investment failing and therefore strives to make his business a success. She also brings new technologies, management practices and connections to the world market that benefit not only her company but also other local companies engaged in similar economic activities through dissemination. Because investments are made in plant and machinery, the risk of outflow of this form of foreign capital in the face of fluctuations in exchange rates and interest rates is minimal.

In terms of hierarchy, investment (stock investment) comes next. Investors in this capital do not bring new technologies, management practices or connections to global markets. But they take the usual investment risk and are therefore keen to direct their investments into high-return companies, thereby contributing to profitability. However, this capital is more sensitive to interest rate and exchange rate movements than foreign direct investment. Rising foreign interest rates and fears of a devaluation of the host country’s currency may lead it to seek a quick exit.

A valid flight risk

Foreign financial capital inflows represent the least advantageous form of foreign capital. In a country like India, the bulk of this capital goes into government bonds, which offer safe and significantly higher yields than the debt of the country of origin. Therefore, the only risk that the investor takes is the devaluation of the local currency. From the perspective of the host country, the risk of losing this capital is high. Each time interest rates in the home country, such as the US, rise, this capital outflows on a large scale, exposing the local currency to the risk of sharp depreciation.

Indeed, once a country accepts unrestricted free capital mobility, an even greater risk arises from the outflow of savings from its own residents in response to rising returns on foreign stocks and financial assets. Left to their own devices, large capital outflows can cause the local currency to depreciate sharply and destabilize the economy. The only protection against this threat is the central bank’s accumulation of foreign exchange reserves, which it can use to stabilize the local currency when large outflows occur. Not surprisingly, countries like India, which have increasingly opened up their financial markets to foreign finance capital, have simultaneously expanded their war chests of foreign exchange reserves through their central banks.

But this war chest comes at a price. While we pay a high yield to foreign investors on our debt securities, our own foreign exchange reserves, which must be held in highly liquid assets such as US Treasury bills in order to be readily available for foreign exchange market intervention, yield a tiny yield. In fact, we borrow foreign capital at high interest rates and lend it back to foreigners at low interest rates.

This fact and the increasing risk of currency crises are the reasons why some of us remain skeptical about opening the economy more broadly to free financial capital flows, at least until domestic financial and capital markets are much deeper.

https://economictimes.indiatimes.com/opinion/et-commentary/the-case-against-opening-the-economy-wider-to-free-financial-capital-flows/articleshow/90765950.cms Indian economy: arguments against a wider opening of the economy to free financial capital flows

Jaclyn Diaz

InternetCloning is an automatic aggregator of the all world’s media. In each content, the hyperlink to the primary source is specified. All trademarks belong to their rightful owners, all materials to their authors. If you are the owner of the content and do not want us to publish your materials, please contact us by email – admin@internetcloning.com. The content will be deleted within 24 hours.

Related Articles

Back to top button